A hellish week thus far…entering a scarier, uglier phase of the cycle.`Wall Street waits for the next domino to fall. Inflation and deflation: working together? Is it time to do a little contrarian buying? A well-thought out comment from a dear reader…and more.

“Hell Week.”

That was the bad news borne by Bear.

“Scramble to calm markets,” is today’s frontpage headline on the Financial Times . Yesterday, the Dow went up…the Dow went down…and the Dow ended almost where it started the day.

Gold went down $3. Oil fell $4.53. And commodities got hit hard; the CRB fell 23 points.

And the dollar took another beating too. It sank to a 12-year low against the yen. Against the euro, it dropped to $1.56.

“We have entered a new, scarier, uglier phase of the crisis,” said Marco Annunciata of UniCredit.

A major failure on Wall Street usually means the end of a market downturn, says John Authers in the FT : Continental Illinois in ’64, Drexel Burnham Lambert in ’90, Kidder Peabody in ’94 and Longterm Capital Management in ’98.

But was Bear the end of the problem…or just the beginning?

“Wall Street waits for the next domino to fall,” says an FT headline from yesterday.

In the aftermath of the Bear saga, investors started asking questions about Lehmann Bros. The firm had to publicly announce that it was solid. Of course, Bear said it was solid too. And as Walter Bagehot remarked in 1873, “every banker knows that if he has to prove he is worthy of credit…in fact, his credit is gone.”

Soon, other Wall Street institutions are going to begin announcing their latest results. The tide has gone out; we’re going to see who’s been swimming naked, says Buffett. One thing we’re going to see is huge leveraged loan portfolios written down. Goldman Sachs and Morgan Stanley are expected to write off about $1 billion. Deutschebank says the writedowns will be about $9 billion over the next 6 months. DB itself has more than $50 billion of leveraged loans (to private equity) on its books. Goldman has nearly $40.

But not to worry, U.S. Treasury Secretary Henry Paulson says, “our financial institutions are strong” and that he will do “whatever is necessary” to keep the system working properly. The president of the all the Americans, George W. Bush, too, has said that while the times are “challenging,” he and his team are “on top of the situation,” which is what we were worried about. Meanwhile, the papers say that Ben Bernanke is being pressured to cut rates…and the bookies are giving long odds that he won’t.

We will worry anyway, thank you. Because we doubt that the science of central banking as practiced by Bernanke, King and Trichet is really any more reliable than the science of modern portfolio management as practiced by the geniuses at Bear, Lehmann and all the others. (More on that later in the week…)

But let us step back and look again at the big picture.

We take as a given that central planners are as prone to error as a bear to honey. It also seems likely to us that it was a mistake for Alan Greenspan to cut rates so aggressively in ’02-’03 and leave them below the inflation rate for so long. The result was an orgy of spending and borrowing in the Anglo-Saxon economies…and an orgy of factory-building and capital formation in Asia. In both parts of the world, people missed their marks – overdoing it considerably.

And now there is Hell to pay.

As to how the bill will be settled, we are uncertain. There are two schools of thought.

On one hand are the deflationists, who see an economic meltdown, with lower prices…and a flight into U.S. Treasury bonds (and the dollar) for safety.

Below…we present a lively exchange between the two schools of thought. But here at The Daily Reckoning , we never liked schools. We played hooky at every opportunity…and learned what we could by keeping our eyes open. In fact, now we see a different world than either the inflationists or the deflationists…a world both rising prices…and falling prices…where inflation and deflation alternately bicker and make up…like a married couple.

We have described this tension as a “war” between the two forces – one, unstoppable…the other, irresistible. But the two are as likely to be friends as enemies. They may squabble and even come to blows…but they still sit down to tea with each other at 4PM. They can’t live with each other…and can’t live without each other.

Yesterday, for example, we saw them both walking along, holding hands. Stocks rose in the United States. But so did gold. And when they visited the treasury market, bond prices rose sharply as yields fell.

And then they paid a visit to the commodities markets and took prices down a peg. The dollar, too, they brought down.

In the months ahead, who knows? The two could fall out completely. If that happened, there could be a meltdown in the few things that are going up – commodities, treasuries, oil and even gold. Or there could be a meltup in the things that are going down – stocks and property.

We don’t know. As a financial analyst, this uncertainty worries us a bit. But as a moral philosopher, we take it for granted that there is more under heaven and earth than is contained in our philosophy. We’ll let Mr. Market tell his tale…and happily listen.

*** But let’s look at how our Trade of the Decade is going. With only two more years to go…not bad! Gold was about $260 at the beginning of the decade. It’s now nearly 4 times that number.

Stocks, as measured by the Dow, are only a bit below their peak set in 2000. But U.S. stocks generally are “officially” in a bear market, having lost 20% of their value from the peak. And measured in gold, stocks are down 72%. It took 43 ounces of gold to buy the Dow in early 2000. Now, it takes fewer than 12. Let’s see what the next 21 months bring.

And if you’ve been wary about getting in on our Trade of the Decade, we have a unique opportunity for you. You can get gold out of the ground and into your portfolio – for a penny per ounce. No joke…and no shovel required. Find out more here .

*** Our new friend, David Fuller of FullerMoney.com wonders whether this isn’t the time to do a little contrarian buying.

“In a contrarian play, I also think a bombed out bank such as UBS is interesting. Today, it has an estimated PER of 8.44, although I suspect earnings forecasts are too optimistic. However UBS also has a dividend of 7.58% which is covered 2.67 times according to Bloomberg. Perhaps there will be more shocks in the form of writedowns; perhaps more SWF support is required; I would not rule out a rights issue at some point.”

*** A milestone was reached last week. France’s last WWI veteran, Lazare Ponticelli, died at 110 years old. R.I.P. The Great War was probably the single most important event of the 20th century. It brought an end to bourgeois civilization. After it was over, Europe couldn’t return to the forward-looking bourgeois civilization it had before the war. Its art changed. Its architecture changed. Its manners. Its government. Its money.

And America changed too. The United States has tasted the fruit of empire. At first, she didn’t care for it. Woodrow Wilson got sick on it and never recovered. But gradually, then suddenly…after Japanese planes attacked Pearl Harbor 20 years later…she gave in to it…made a habit of it…and grew to like it.

*** Here is a message from a Dear Reader from Australia who makes the case for deflation. (His first comment is about the Fed’s latest bailout):

“I think Bill Bonner has the wrong end of the stick. The Fed is not pumping in anything – it is an asset swap with the banks and other financial institutions whereby the Fed takes the unwanted mortgage backed securities (at a suitable discount) in return for lending its own high quality Treasury notes. These will then be negotiable as collateral to raise money. It is a neat trick to liquefy the debt market but in the process the Fed is taking on the risk that other banks do not want to accept. It will hope that the discount to valuation will cover the failures. In time it may even profit. The question is this – since this is a term lending facility, will the Fed in managing its credit risk ever pull the trigger on a major bank and demand re-payment? Are we witnessing a de facto nationalization of the U.S. banks? See here for a better explanation .

“The point is that what the Fed is doing now is not inflationary – the money supply and cash in circulation has actually been falling. See James Hamilton’s (Professor of Economics at the University of California) explanation .

And as for buying gold:

“[The] view that gold will see a substantial re-valuation is correct but it may take a detour back to $400 or lower – simply because in the deflation to come, which will be brought on by an escalation of the current liquidity crisis, gold will be sold off to pay for margin calls. Gold will be re-valued in the future because it will most likely come back into service again as the standard against which all currencies will be measured. This accelerating crisis has been brought on by banks by-passing the prudential requirements through securitization of mortgages and by the use of massive leverage on the part of borrowers to magnify the gains made from the consequent asset inflation. Credit creation (money supply) has been on a tear for a decade or more because banks were able to keep the loans off their balance sheets through securitization. This process is now in the early stages of reversal.

“Most of what we read about in the financial columns today was brilliantly explained by Robert Prechter (of Elliottwave International) in his best seller of 2003 Conquer the Crash . As far as the equity markets are concerned, he was wrong in nominal terms because they continued to rise until last October. In terms of gold, the Dow, S&P500 and NASDAQ have all been falling since 1999. His explanation then of the likely unfolding of events is closer to what is happening right now than any other commentator present or past. Inflation is NOT the issue. The markets know it (why else would US bonds and Treasury notes be in such demand) and the Fed (as always) is following the 3 month US treasury bill down the lowering yield path. I believe that the US Treasury market is telling the real story.”

Until tomorrow,

Bill Bonner
The Daily Reckoning