"The D-word is back," says this morning's Financial Times. "Could deflation be the next big shock to the financial system?"

Where has the FT been? The world has never seen so much deflation. Stock markets around the world have deflated by about $10 trillion. U.S. housing has deflated by about $5 trillion. Oil has deflated to only half its high; it closed at $64 on Friday. Gold, down $13 on Friday, has deflated about 25%. Bear Stearns deflated to nearly zero.

Even the bond market is beginning to deflate. Yields are rising, to 3.97% for the 10-year T-Note.

The Dow rose 141 points on Friday. But year-to-date, the U.S. stock market - as measured by the S&P 500 - is down 35%. That means that U.S. stockholders alone have suffered a loss of nearly $5 trillion. And one in every five houses in America has sunk so low that it is now underwater; the mortgage level is higher than the value of the house.

The FT must be talking about consumer prices. Prices you pay for milk and gasoline. They're not going down yet. But they're not going up so fast either.

The headline U.S. inflation rate seems to have peaked out at about 5.5% and is now headed down. In Europe, the headline rate hit 4%. Now, that too is coming down. And everywhere you look, price cuts are beginning to appear. "Sale" signs are appearing in shop windows. Cheap flights are being advertised in the subways of Paris. Auction prices, according to an insider, are much softer than they were six months ago.

One thing that is sinking to the very bottom of the sea is the cost of sea-borne transport. The Baltic Dry Index measures shipping costs…and gauges the health of the globalized marketplace. Shipping prices rise when orders are being placed…and delivered. When orders decline, so does the index. Well, based on the index, there is no need for Misters Smoot and Hawley. World trade is collapsing without them. The index has gone down 14 days in a row, so that shipping barely costs 10% of what it cost a few weeks ago.

Deflation? What does that remind you of, dear reader?

Japan! Of course. This is the trend your editor saw coming 10 years too soon - a Japan-like slump.

"A deep and prolonged recession could raise the spectre of deflation of the sort that long plagued the Japanese economy," says a fellow at the American Enterprise Institute.

"Welcome to Hiroshima, mon amour," was how we put it, with Addison Wiggin, in our 2003 book, Financial Reckoning Day.

"If the United States were to repeat the Japanese experience, stocks could be expected to return to their 1995 trend line, with the Dow below 4,000, in the year 2012, at almost the very moment when America's baby boomers will most need the money," we warned.

(Financial Reckoning Day seems to be here, at last. John Wiley & Sons, the publisher, asked for an updated version…stay tuned.)

Meanwhile, "governments around the world are pulling out all stops to save the system and keep it running at all costs," says a strategist at Saxobank.

"All stops" are the things that keep the dollar worth something: the reluctance to spend too much…the reticence to 'crank up the printing press'…the residual instinct to protect the integrity of the world's dollar-based financing system.

Where does pulling out all the stops lead?

Peter Anderson, at RCM, took the words out of our mouth:

"We anticipate more taxes, more regulation, a bigger government and a massive deficit. This sets the stage for a potential inflation bubble of massive dimensions, but that is unlikely to occur until 2011-2012 at the earliest. It is in that environment that the dollar is likely to resume its decline against both the euro and the yen."

Deflation now. Inflation later. That is our guess how the reckoning goes. Falling asset prices…followed by falling consumer prices…followed by "money from helicopters"…followed by rising prices…followed by the end of the U.S.-dollar based worldwide monetary system.

Our Trade of the Decade was meant to capture the early stages of this - but only a bit of it: the relationship between gold and stock prices. In 1982, briefly, you could have bought every one of the stocks in the Dow index for a single ounce of gold. But by the time the stock market finished its epic rise, in January 2000, (while gold was doing an epic fall!) you would have needed 44 ounces of gold to buy the Dow. Now, that ratio has come down considerably. You only need about 13 ounces of gold to buy the Dow. And as stocks come down, the ratio is likely to fall below 5…and eventually back to 1 to 1 (at which time, remember, it will be time to sell gold and buy shares).

Looking ahead, our guess is that the gold side of the trade will be good for another 10 years. When the dollar begins to wobble, gold will fly. But if Mr. Anderson is right, the deflation stage will end sometime near the beginning of the next decade. For the moment, cash is king. Dollars - and US Treasury obligations - protect you from losses in the asset markets. But don't get too attached to your dollars. The king will mount the scaffold - sooner or later.

Yes, dear reader, everything is going according to plan. But whose plan? It's not the plan of consumers - who counted on having more and more money to spend. It's not the plan of investors; they're getting hammered by the markets. It's not the plan of Bernanke or Paulson either; they're desperately trying to stop it.

No, it's Nature's Own Plan…in which bubbles always pop…what goes up eventually comes down…and people always get, neither what they expect nor what they hope for, but what they deserve.

"Nature in her wisdom, and God in His grace," we wrote in Financial Reckoning Day, "make sure people get what they've got coming…"

Remember, a correction is equal and opposite to the deception that precedes it. A few years ago, we predicted that based on the level of mass hallucination in the markets in '05-'06, the coming correction "ought to be a doozy."

Now we find out what a doozy looks like.

*** "You're going to vote? Why waste your time?"

We had two conversations at the dinner table last night. The first was a repeat of a quadrennial discussion about democracy. The second was a conversation we have never before had to have.

"In the first place, your vote will have no effect," your editor began his argument. "It would only be meaningful if it had an influence on the outcome. Statistically, the odds are greater that you will be struck by lightening twice on the same day you win the lottery…and get trapped for hours, alone in an elevator with a beautiful nymphomaniac who had just been released from prison…. Well, never mind…

"In the second place, even if by some remote miracle your vote did have a consequence, it would be worse. Because then you would be responsible for what could be a disaster. Think of the poor conservative who might have cast the winning vote for George W. Bush because he said he wanted a smaller government with a more humble foreign policy. Or the guy who put Woodrow Wilson over the top because he promised to keep the U.S. out of WWI. Or the fellow who voted for Franklin Roosevelt because he promised to balance the budget. You don't have any way of knowing which candidate will do most damage.

"And by voting, you become like a collaborator in a POW camp…betraying your fellow prisoners in order to get a little extra ration. Isn't that what almost all voters are really up to? One wants more from Social Security. The other wants his fellow tax-slaves to pay for his medical treatment. Another wants a job. And still another wants a bailout - financed by the rest of the prisoners, of course. One wants government to ban gay marriages…the other wants the government to force gay people to get married."

"There's no point in your continuing," came the response. "I've heard all this before. And I still think it is nonsense. We live in a democracy. We can participate or not participate. But not participating doesn't make it go away. The best you can do is to try to make the best decision you can…"

"Well, who are you going to vote for? McCain? Or Obama? And what about the Senate and House races? You haven't even followed them…"

"I'm voting the party line…"

"Which party?"

"Republican, of course. I know. I know. They've erred and strayed like lost sheep. But at least they're in favor of low taxes. Or, at least, they say they are in favor of low taxes and lower spending. They may end up spending even more taxes, for all I know. But the Republicans tend to be a disaster by accident. The Democrats are a disaster by choice."

Speaking of Election Day, don't forget that you can get the I.O.U.S.A. DVD and its companion book, along with your subscription to Capital & Crisis. But only until midnight tomorrow night. Get yours now.

*** Then came the harder conversation. Pater Familias began:

"Look, the whole economic picture has changed. We are no longer in a world where we can spend more and more money. The world economy is shrinking…or at least our part of it. And that means we can't be so free and easy with our money. We have to adjust our expectations and our habits.

"Elizabeth, I know it's not nice having a husband whose earnings are going down…but that's just the way it is. And I know you wanted to remodel the kitchen…but I think you should put it off…or just do only the essential work now. Also, you wanted to go out to California to visit Maria, but maybe you should delay that trip too. Or, at least look for a discount airfare. And we were going to get a new car; well, forget that. Our old car is just fine.

"And if you're going to make a call overseas, use Skype; don't use the telephone. You can talk as long as you want on Skype, it doesn't cost anything.

"Edward, when you leave a room…turn out the lights. And stop ordering a pizza every time you get hungry. They're much more expensive than you realize. And no more shopping at Cyrilles, or whatever that fancy clothing place is called. It's back to K-Mart."

"Darling…we live in France; there isn't any K-Mart."

"Well, up by the office there's a Chinese guy with clothes on a rack right out on the street. You can get sweatshirts and jeans for only a couple dollars."

"Are they Diesel jeans?" Edward wanted to know.

"I don't know what they are. And it doesn't matter. Jeans are jeans."

"No they're not. And I'm not going to wear some jeans sold on the sidewalk by a Chinese guy up in your office neighborhood. I've got my image to protect."

"But seriously, dear," came the voice of Fair Reason, "if the world economy is melting down…not ordering a pizza is not going to make much difference, is it? In fact, it's going to make the situation worse. Because then the pizza guy won't have any money. Are you sure you're not overreacting?"

"I don't think so. This is the most serious economic downturn since the Great Depression. It could be worse than the Great Depression. I'm not saying we're broke - yet. But it's a different world. It's not a time for free spending. It's a time for thrift. Making do. Getting by. Saving every dime you can…because you don't know when you'll need it…or when you'll get another one. We've never lived in a world like that…at least, not that we can remember. But that's what we've got now. "

The FWD - First World Depression - is upon us. Everyone with any sense is cutting back as fast as he can.

This weekend, we also had a chat with the gardener. And then, the cleaning lady. What could we tell them? Only that we all had to make economies wherever we could.

Then, we wondered why the insurance was so high:

"Get in touch with Remy…ask him to give us another policy…cheaper," was the result of it.

"And look what we're spending in tractor repairs…what can we do to get that down?"

All up and down the budget…all over the planet…these conversations must be taking place. At the end of them come more cuts…more savings…fewer sales…less spending…as the whole world economy puts away the Perrier and goes back to drinking tap water.

Until tomorrow,

Bill Bonner
The Daily Reckoning

The Daily Reckoning PRESENTS: All fiat currency is essentially worthless. Why then, are some people touting the idea that gold - tangible money - is too volatile to back this cash? Apparently flooding the markets with more worthless paper is a better solution. The Mighty Mogambo expounds…

NO SOOTHING SALVE FOR ECONOMIC ILLS
by The Mogambo Guru

Information Clearing House started off a recent issue with quote from Kenneth Gerbino, who is referred to as "former chairman of the American Economic Council", who notes, "Historically, the United States has been a hard money country. Only [since 1913] has the United States operated on a fiat money system. During this period, paper money has depreciated over 87%."

In contrast, when the dollar was gold and gold was the dollar, "During the preceding 140 year period, the hard currency of the United States had actually maintained its value. Wholesale prices in 1913 were the same as in 1787."

I thought that this would have ended the discussion, and thus our work was done and we could call it a day, go out for pizza and beer and maybe hit a few strip clubs, but suddenly at Bloomberg.com I read, "Gold Standard Is Wrong Salve for Global Ills".

I agree with this only because there IS no soothing salve for the globe's economic ills with which to effect a cure, which means that there is no economic "solution" to over-indebtedness and governmental stupidity that does not involve incredible pain, herein defined as incredible inflation in the necessities of life and the incredible deflation of everything that is not.

I am pretty smug about this because I already know that every other government in the Whole Freaking History Of The World (WFHOTW) wanted to spend more money than it could take in through taxes and plunder, and the ones that tried to use a fake, fatuous, foolhardy fiat currency made only of paper and promises ended up destroying themselves and ruining their people by creating so much money and credit, which is why the Founding Fathers, who knew this first-hand, wrote into the Constitution that the dollar shall only be of silver and gold, which is the only thing that can prevent the government from destroying the USA by the over-creation of money and credit!

And now the Fed and the Treasury are doing that very thing right now, creating money at rates that are completely unprecedented in American history and, probably, the history of the world!

Tragically, all of this money supply inflation will, as it must, result in consumer price inflation, which is the bane of all economies, although you would not know it from the deplorable Fredric Mishkin, whom the Bloomberg article refers to as "an economics professor at Columbia University's Graduate School of Business and a former Federal Reserve governor."

He says that with the price of gold futures fluctuating from $253 to $1,034 an ounce during the past nine years, this automatically means that pegging currencies to bullion "would probably not produce the price stability that the advocates of the gold standard seek." Hahahaha!

The dollar goes to (in the original Spanish) El Grande Squatto Mundo because Mishkin and his brain-dead econometric cronies at the Fed and most of the nation's universities keep encouraging interest rates to be constantly lower than the rate of inflation, which increases borrowing, which further inflates the money supply, which makes the prices of the assets go up a lot, and the prices of everything else to drift upward, too, in response to all of this new money and credit; so when gold goes up in response to the Fed's irresponsible creation of money and credit creating inflation in prices by reducing the buying power of the dollar, Mishkin says that this means that gold is not stable! Hahaha! Too much! Hahahaha!

In fact, "hahaha" does not even BEGIN to cover it, and I will emend that last paragraph to end with "Hahahahahahahaha!" to indicate something really rude and disrespectful.

The Bloomberg article goes on that the gold standard is not necessary, although "no doubt, the abundant liquidity created by asset- securitization, derivatives and Asian countries amassing huge reserves while pegging their currencies to the dollar fed both bubbles and greed. Yet these excesses could - and should - have been harnessed by alert central banks acting in concert." Hahahaha! Like that's going to happen! "Trust us!" Hahaha!

This reminds me of Oscar Wilde saying, "I can resist everything except temptation", and who also famously said, "The only way to get rid of a temptation is to yield to it."

Until next time,

The Mogambo Guru
for The Daily Reckoning

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 November 2008 | Digg This Article