The Daily Reckoning’s Bill Bonner says the biggest credit expansion ever could now be turning into the largest credit contraction. Big mistakes were made in all quarters of the economy, and these take time to correct. Bill says he still favors gold over other asset classes, given the enormous downside potential for the U.S. dollar.

After the biggest spending and borrowing binge in history, Americans need time and money. They need to pay their debts. They need to build savings for their retirements. They need time and money to recover from their mistakes.

What kind of mistakes?

Well, down near the bottom of the ladder, people bought houses they couldn’t really afford to own in places they couldn’t afford to live. And cars they couldn’t afford to run. Those mistakes need to be undone. Which is why there are so many foreclosed houses on the market…and why house prices generally are falling.

S&P/Case-Shiller reports that house prices took their biggest hit ever in the second quarter of this year. They were down 15.4% from the year before.

Further up on the ladder, the rich are now embarrassed by their own housing mistakes. New Yorker magazine reports that it is the ’season of white elephants’ in Greenwich, Connecticut. Speculators began huge mansions – in the “Georgian Stockbroker” style, for example, complete with indoor swimming pools, wine cellars, movie theatres, dozens of bathrooms, even ice-skating rinks – and now find the buyers have disappeared. Want to buy a $28 million spec house? Go to Greenwich.

At the investment level there were plenty of mistakes too. Subprime mortgage lending dominated the headlines for the last 12 months, but the same reckless spirit found its way into transactions all over the economy. Private equity, IPOs, student loans, shopping malls, fast-food joints – while the going was good, everyone wanted to go along.

And now, they all need time and money to pay for their errors.

The baby boomers say they are postponing retirement. Some are going back to the office.

A county in Alabama says it will have to declare bankruptcy.

The FDIC says its “problem list” of banks lengthened by 30% during the second quarter.

Bank earnings fell to their second lowest level in 19 years, says Bloomberg.

In London, tens of thousands of jobs have already been lost in the financial sector, says the Financial Times. IPOs, where the City (equivalent to Wall Street in New York) made much of its money, have “fallen off a cliff.”

We have lived through the biggest credit expansion ever. Ahead is perhaps the biggest credit contraction ever. Why? Because it takes time and money to correct mistakes. The bigger the mistakes; the longer and more expensive the correction.

Corrections can be tough on the economy – and on the individual consumer. Most have no idea what lies ahead…but our friends at Strategic Investment have made some interesting forecasts. Read their latest report, which outlines not only the next 5 supershocks the U.S. economy should brace itself for, but how you can protect your portfolio – and even turn a nice profit. See the report here.

When money and credit flow, they tend to raise prices. You get inflation – first of asset prices…later, of consumer prices. When money stops flowing, prices come down. As George Soros puts it, the willingness to lend is directly related to the value of the collateral. Both tend to rise and fall together.

Currently, lenders are wary and the value of the collateral is falling. Everyone knows house prices are going down. But U.S. stock prices are going down too. Adjusted for consumer price inflation, they’ve been going down since the end of 1999. That is, a $50 stock is still worth about $50…but the 50 bucks ain’t what it used to be. It buys only 1/5th as much oil, for example.

This trend, towards lower asset prices, is likely to last a long time. To protect ourselves, we began buying gold in 2000. So far…so good…

But wait. “Gold hasn’t done too well lately, maybe it’s time to get out…”

The thought comes up from time to time, most recently from a visitor from Maryland.

“If the world economy is slowing down, commodities aren’t the place to be,” he went on. “Gold either. People buy gold to protect themselves from inflation. But inflation isn’t going to increase in a recession. You’d be better off in cash until this thing turns around.”

Our guest voiced what is probably the dominant opinion of the summer – that a worldwide slowdown means price increases will slow down too. Without the hot breath of the inflation hounds chasing it, gold will go back to sleep and the Fed can continue to rescue speculators from their mistakes.

That’s why the U.S. 10-year Treasury note yields all of 3.78%. Yes, investors know they will lose money if inflation remains above 4%. But that risk – they believe – is worth taking for the safety of the dollar and the full faith and credit of the U.S. Federal Government. Besides, inflation is almost sure to go down.

This view may turn out to be right. But when we think of moving to cash we pose the question: what cash? And there’s the problem. The planet’s alpha cash is the dollar. And while the dollar may have some limited upside in a punk market (it’s already gone up about 7% against the euro), the potential downside is enormous.

What if the bond market is wrong about inflation? What if the increase in producer prices – now running at nearly 10% – works its way into consumer prices? What if demand from the developing world doesn’t slack off as expected? What if there is war? What if the U.S. economy worsens…and the feds need to cut rates and offer further $100 billion bailouts? What if Asian, Arab and Russian creditors lose faith in the dollar and switch to euros?

Any of these things could be catastrophic for holders of U.S. Treasury bonds. At 3.78% yields – it hardly seems worth the risk. Shorter-term Treasury bills barely pay anything at all.

So what cash do you hold? We choose gold because it is cash that no central bank manages. No one prints. No government backs. And no one ever threw away a gold coin. Gold will always hold an intrinsic value – so we’ll keep holding gold. And perhaps you’ll want to take out a golden insurance policy for your portfolio as well. See here: Zero-Downside Gold

Source: Don’t Think About White Elephants