The Dow got walloped hard on Friday, down 315 points. But it still remains well above the lows it hit in January. Analysts don't know what to make of it. With so much bad news around, you'd think the Dow would react to the downside. Typically, the commentators reach the wrong conclusion: that the stock market is telling us not to worry; the economy will recover in the "second half."

Dear Readers are encouraged to worry anyway. What the stock market is telling us, we think, is that there are conflicting forces acting upon it. Inflation on the one side…deflation on the other. Neither is good for stock prices. But inflation tends to hold up nominal prices…while real prices collapse. A share of Google (NASDAQ:GOOG) may be worth $400 in 2010 for example. But so might an ice cream cone.

Stock prices in the '70s, for example, tended to bear up or fall a little. In real terms, however, they fell a lot. We seem to be coming upon a similar situation now - popularly known as stagflation. The economy is sinking…while inflation pushes up consumer prices.

Friday, for example, while the Dow fell 315 points, the price of gold shot up another $7.50 - to a new world record, $975. Oil stayed over $100. And the dollar gained a little bit on the euro (EUR), but it still takes more than $1.50 to buy one.

"Fed cuts not doing the trick," says a headline in the LA Times. The trick Fed cuts are not doing is the old, familiar one - they're not boosting the U.S. economy. As Paul Volcker put it, the Fed has lost control of the situation. It cuts rates…but its efforts to cause 'growth' in the economy only cause a growth in prices - commodities, gold and the consumers' cost of living.

Our old friend, Rick Ackerman, comments:

"The Fed's extraordinary steps thus far to reinflate the economy have been directed almost entirely at institutional lenders rather than individuals. (We ignore the $160 billion tax rebate, since it is just a drop in the bucket relative to total debt.) The result is that there has been little discernible economic stimulus, only a buildup of reserves on lenders' books with no corresponding demand for loans. (Actually, loan demand has been shrinking, and fast.)

"So, what Helicopter Ben appears to have achieved using measures that even we would concede are hyperinflationary is: nothing. The banks might be able to pass themselves off as solvent, provided the auditors are in on the con. But merely making the lenders appear not to be bankrupt has done absolutely nothing to achieve what the Fed had set out to do - i.e., re-kindle the housing boom. In fact, even though mortgage rates have trended lower, the lenders have been under great pressure to tighten their standards. The result is that, on balance, demand from home buyers has continued to fall."

Still, the Fed is not giving up without a fight. The smart money is betting that we'll get another rate cut later this month - another 50 basis points, bringing the key rate down to 2.5%.

"The party's over," says Warren Buffett. He was talking about the party in the insurance business, where profit margins are shrinking. But he may also have been referring to a much bigger, wilder party. In his annual letter to shareholders, he says that Berkshire Hathaway as seen its best days. He regards it is too large to produce the kind of above-market performance the group has had in the past.

And he probably also had the state of the U.S. economy in mind. The lights have been turned off and the bottles put away at the party in the housing market, for example. Buffett says the revelers got carried away by "fantasies." House buyers thought housing prices would go up forever. So did the people who lent them money. Since prices would rise forever, there was no need to worry too much about a borrower's ability to repay the loan; it was as though he'd never have to.

Another subject for the Sage's scorn were the self-serving fantasies promoted by pension funds, CEOs, and investment managers who imagine that they will be able to produce earnings far above what is really likely.

Of course, fantasies were behind the whole boom. For example, Americans lived beyond their means and thought they could do so indefinitely. This led to the curious situation in which fewer than 10% of the world's people - in the U.S.A - were spending more than 80% of the entire world's savings. The foreigners saved…and lent their money back to the United States, usually in the form of Treasury or government agency bonds (such as those from Fannie Mae (NYSE:FNM)). Americans took the money…and spent it, again, on things coming from overseas. Gradually, the foreigners built huge piles of U.S. dollars…some of which they've put into Sovereign Wealth Funds.

Buffett had something to say about these funds too. The SWFs are coming under attack in the United States. But they're not some underhanded way of stealing from Americans, he says. Instead, they're the logical consequence of spending more than you earn. That was a fantasy to you can't give foreigners pieces of green paper and expect them not to spend them.

Meanwhile, the weekend press brought more proof that Volcker is right; the Fed's cuts are not working. The BBC reports that HSBC (NYSE:HBC) is going to announce a writedown of $16 billion. And the hedge fund, Peloton, is sticking investors with $2 billion in losses.

In some areas of the United States, there are now more foreclosures than house sales.

Derivative trading predicts another 20% drop in housing prices, says former Treasury Secretary Larry Summers, which would put 10 million homeowners upside down, with more mortgage than house. If that happens, he says 2 million houses would be foreclosed over the next two years.

Summers goes on to propose a new law, which would prevent the lenders from foreclosing. Why not? Once you permit yourself to assign profits and losses according to your own desires…rather than let people get what they've got coming…well, the sky's the limit.

*** Alan Greenspan was back in the news too. He told a group of Arabs that the Gulf oil states should cut their currencies loose from the dollar. Good advice for everyone. But it's funny stuff from the mouth of the person who had more to do with the dollar's decline than any other human in history.

*** Over the weekend came news that Boeing (NYSE:BA) has lost its lock on the US Air Force. EADS, the European defense company, won the bid for $35 billion worth of refueling tankers…a job that may be eventually worth $100 billion.

*** "The biggest baby boom in history," the Financial Times calls it. No, this one is not in America…it's in Africa…Uganda to be precise, where the population has doubled in the last 20 years. By 2030 the population is expected to double again…to 60 million. Uganda is also the world's youngest country with more than half the population under the age of 18.

We don't think too much about population growth anymore…not in Europe or America. In places like Italy and Spain, the local population isn't even replacing itself. The Russians' birth rate is so low, they are practically disappearing. And the Japanese, too. But in other parts of the world, there are more and more mouths to feed - millions of them.

But while the world adds billions of new people…and billions (trillions!) of new paper money…it doesn't add very much in the way of wheat fields. Or cattle ranches. No, dear reader, there are some things are easily reproduced…and some things that are not. Back in the monetary Dark Ages, before the Enlightenment of 1971, people used to think you needed to bind a nation's currency to something that was not easy to reproduce - specifically , gold. It was a way of assuring that the supply of money didn't run wild. Now, we just have faith…we trust our financial authorities.

At least, some people do. Here at The Daily Reckoning, we have faith in our central bankers and financial policymakers. We have faith that they will act like men, not like gods. They will make mistakes…they will yield to temptation…they will screw up the nation's paper money and its economy; count on it. All things being equal…you could expect to see prices of gold, food, oil, etc, explode to the upside.

But all things are not equal, Malthus was wrong at the beginning of the industrial revolution; food production expanded faster than population. Will he be wrong now? Populations are exploding…and key resources (including food) are apparently reaching peak production levels. There's only so much land. And so much water. And so much oil. What next? We don't know…

*** Speaking of which, along come Nobel-Prize winning economy Joseph Stiglitz, with more bad news. He says the Iraq war could cost up to $5 trillion. In round numbers, that's about $50,000 per family.

Would you pay $50,000 for this war?

No matter. History does not care whether you want it or not; it gives you what it wants…when it wants. And what it seems to want now is to bring the U.S. Empire down. How? Destroy its money. Destroy its economy. And waste its military power on wars of little consequence and great expense. That's why we don't blame George W. Bush; he's merely doing History's bidding…a man dull-witted enough to play along…to preside over the worst possible policies at the worse possible moment.

The U.S. government, of course, has no extra $5 trillion. It is already broke, by business standards. In effect, it has to borrow the money to continue the war. From whom? Who has the biggest pile of dollars? The communist Chinese…and the Arab oil exporters. Hmmm….

In WWI, Britain's empire was on the downswing. It, too, had to borrow to be able to stay in the war. From whom? From the rising power - the U.S.A. America and Britain shared the same culture…the same ideas…the same legal system…even the same language, more or less. The Germans defeated, Britain could transfer leadership of the Anglo-Saxon empire to the United States with little disruption. But the rise, and subsequent triumph, of the next empire may not be so smooth or easy. We may wish we had that 5 trillion bucks.

Until tomorrow,

Bill Bonner
The Daily Reckoning

The Daily Reckoning PRESENTS: Who knows exactly what will happen in a crisis? The Mogambo takes a crack at the answer, and discovers that it can be summed up with one word (said repeatedly for emphasis): bankruptcy. Read on…

A WORLD WITHOUT DEMAND
by The Mogambo Guru

Bill Bonner at The Daily Reckoning writes, "One of the wild cards of the doomsday scenario is the performance of the derivatives market. No one knows exactly what is in some of these instruments…and no one knows how they will hold up in a crisis."

Instantly, The Mogambo was on his feet, finally able to show off for Bill Bonner, and then maybe he will notice me and be impressed, and maybe invite me to his office and offer me a drink, and then we'll sit around discussing this and that and gradually getting more and more sloshed, and then I'll bring the conversation around to pizza, and how he ought to send out for a pizza to be delivered, and we while away the time waiting for it by getting more drunk and talking about how he ought to give me a nice, cushy job at Agora Publishing making lots and lots of money with a benefit package that would make a CEO blush, but which surprisingly involves no work or effort of any kind. A figurehead of some kind, maybe.

So I say, "Hey! Over here! Mr. Bonner! I know! I know what will happen in a crisis, because I know what the crisis is, which is that derivative holders will not be getting the money they were supposed to be getting, because the guys who owe them the money are already bankrupt, because they didn't get the money they were supposed to get from guys who were bankrupt because the guys who owed them money were bankrupt, and they are all bankrupt because they put up a lousy $3 of their own money, and borrowed another $97 to buy an asset worth $100, and now that asset is worth only $90! Hahahaha!"

The place was suddenly silent at my rude interruption. I immediately got nervous, seeing my career going up in smoke, and I hurriedly said, "And so not only is the entire $3 investment of the investors gone - wiped out - but they owe $7 more on top of that! Hahahaha!"

As usual, neither Mr. Bonner nor anybody else was impressed with my stupid analysis, and he tries to keep the conversation above such petty things like dollars and cents, and says that the theoretical underpinning of the economic calamity is that, "One thing we do know here at The Daily Reckoning is that they will not hold up as expected. We know that because the assumptions behind them were, fundamentally, nonsense. The most sophisticated mathematical model in the world is not worth a campaign promise if the theory behind it is wrong. And the idea that you can model future prices on the basis of past prices with any predictive reliability is simply wrong."

I thought he was going to bring up how Black Swan events make their predictions wrong, or how the very thought of modeling the complex human behaviors of fear and greed with simplistic equations in a computer is ludicrous and laughable (but only if you disregard the sheer magnitude of the damage these nitwits have done), but even more worrisome is the amount of money that has been lost, as, "so far this year, new derivative sales are off 93% from the year before".

Oops! Without demand, supply overwhelms supply, and prices plummet, and without new derivative sales to finance the existing clot of derivatives, things go from bad to worse!

But before I could really work into another Screeching Mogambo Tirade (SMT) about how the supply/demand thing rules the world, Dan Amoss from Strategic Short Report illustrates it perfectly by reporting that, "Many CDOs could be worth less than 5 cents on the dollar."

And that means, even to a simpleton like me, a loss of 95 cents. Ugh.

Until next week,

The Mogambo Guru
for The Daily Reckoning

The Mogambo Sez: Once again, silver, gold and oil have prospered more than anything else. To those who can see what is right in front of their eyes and who buy silver, gold and oil as a result, nothing more needs to be said.

Everybody else can go to hell, as far as I am concerned, which shows that I am anticipating the coming huge rise in silver, gold and oil by buying lots of each, and am now developing the fabled haughty and snotty attitude towards lesser beings for which we fabulously-rich, beautiful people are so famous, and which is a disdain that lowlifes deserve because they could have bought silver, gold and oil at these low prices, too, when even an idiot like The Mogambo can see they were a screaming bargain, but did not.

Anyway, I assume that we rich people will be so busy having a wonderful time that we won't even notice the lower classes, which makes it only SEEM like we are haughty and snotty! Hahaha! I'm gonna love being rich!

And that's why I am buying silver, gold and oil stocks! And you should, too!

Editor's Note: Richard Daughty is general partner and COO for Smith Consultant Group, serving the financial and medical communities, and the editor of The Mogambo Guru economic newsletter - an avocational exercise to heap disrespect on those who desperately deserve it.

The Mogambo Guru is quoted frequently in Barron's, The Daily Reckoning and other fine publications. Click here to visit the Mogambo archive page.

-- Posted Monday, 3 March 2008 | Digg This Article