Suddenly, economic pundits are debating two brow-furrowing questions: Should the Federal Reserve hang tough on interest rates to fend off higher price inflation? Or, should the Fed continue lowering interest rates to stabilize a slowing economy?

With the specter of inflation receding, the consensus is rallying behind the risks of recession. Many commentators argue that if the Fed doesn’t act quickly, the nation could even be plunged into a 1930s-style depression. Worse yet, we could be on the brink of the ultimate economic catastrophe — deflation!

Deflation – Bernanke’s Worst Nightmare

Deflation is defined as a fall in the general price levels. And it seems to be Mr. Bernanke’s worst nightmare. As he warned in a 2002 speech: “Sustained deflation can be highly destructive to a modern economy and should be strongly resisted.”

According to him, the sources of deflation are no mystery. “Deflation is in almost all cases a side effect of a collapse of aggregate demand – a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.” And falling prices, we’re told, open Pandora’s box. “[The] economic effects of a deflationary episode…are recession, rising unemployment, and financial stress.”

For the majority, monetary economics is a mystery wrapped in gobbledygook. From childhood to old age, we desire money, work for it, use it, save it, invest it and generally spend our lives agonizing over how to keep what we have and get more.

Yet the masses understand money’s origin about as well as they understand quantum mechanics. With general ignorance about the source and nature of money, any economist worth his salt can easily confuse the public about economic policy.

Deflation – Destructive? Nonsense!

Sustained deflation is highly destructive? Give me a break! Nothing is more nonsensical than to argue that falling prices, per se, are bad for the economy.

Was it a disaster when computer prices fell dramatically over the past four decades? Of course not. The lower the price, the better. The same is true for shirts, TVs, and rutabagas. Consumers win when competition and innovation increase output. And increased output results in deflation – as long as it remains undisturbed by monetary intervention.

Bernanke says that a collapse in aggregate demand causes deflation “in almost all cases.” Piffle! His “almost all cases” really refers primarily to the collapsing demand that apparently caused the Great Depression in the 1930s.

As Murray Rothbard pointed out in his classic America’s Great Depression, demand collapsed because of easy money. The new Federal Reserve had poured easy money into the financial system and created a speculative bubble that the economy simply couldn’t sustain.

In 1929, in a population of 120 million, 30 million families were involved with the stock market, and a million investors were classed as speculators. Of these, nearly two-thirds, or 600,000, were trading on margin, on borrowed funds. That is, they were trading with funds they either didn’t have or couldn’t easily earn.

Does that seem similar to the current real estate market? Millions of individuals have leveraged themselves into homes they can’t afford – all because the central bank created easy credit policies. Like the stock market bubble of the 1920s, the real estate bubble of the past two decades has reached its limit.

At the time, Keynes explained to the politicians that “falling demand” caused the Great Depression. It’s also the argument politicians used to justify massive government spending programs. Mr. Bernanke is following a well-worn path: First pump more credit into an already overheated economy and then, when the bubble bursts, do everything in your power to organize government rescue operations.

History Makes Bernanke a Liar

History also proves that Bernanke’s statement is a fraud when he said that deflation comes from a collapse in demand “in almost all cases.”

For three decades in the 19th Century, from 1865 to 1895, the general price level fell steadily, dropping by almost 50%. Did this sustained deflation “ravage” the American economy? Hardly. The real, inflation-adjusted, per-capita GNP nearly doubled over the same period! For 113 years, from 1800 until 1913, consumer prices in the U.S. fell 42%. That’s an average annual deflation rate of 0.5%. Meanwhile, expanding output created more wealth than ever before in history.

Why didn’t innovation and technological advances continue to drive prices downward in the 20th century as they had in the 19th? Because the politicians created the Federal Reserve.

Given the keys to unlimited credit creation, the Fed put the brakes on good, honest, beneficial deflation, and inflation took over. After falling for over a century, the price trend reversed, and from 1913 through this past November, consumer prices rose 2,048%!

Considering the fact that Mr. Bernanke is determined to fight the downturn with more infusions of “the hair of the dog that bit us,” the long-term danger ahead is inflation, not deflation.

Meanwhile, as Warren Buffett said in his 2006 annual report of Berkshire Hathaway, “Be fearful when others are greedy and greedy when others are fearful.” For the moment, the short-term is gripped by fear, so for us at The Sovereign Society, it is the time to be greedy.

JOHN PUGSLEY, Chairman

Nine months later, that same indicator correctly predicted a U.S. economic slowdown that morphed into the sub-prime mortgage monster by July 2007. What was the indicator? Bond yield inversion.

Historically, bond-yield inversion is an anomaly associated with an impending recession in the major industrialized economies. It occurs when short-term government bond yields trade higher than long-term interest rates. That usually suggests an economic recession or slowdown lies ahead.

More often than not, this indicator has accurately forecasted a U.S. recession in the post WW II period. And this indicator was right on the money predicting a bear market in U.S. stocks and credit starting last July.

What an Inverted Bond Yield Looks Like…

Starting in September 2006 until March 2007, benchmark two-year U.S. Treasury bonds started to yield more than respective 10-year Treasury bonds. That’s a classic inverted yield curve where short rates yield more than longer term rates.

At the time, no one seemed to be concerned about it (except me). In fact, many pundits on Wall Street dismissed this bond anomaly as a short-term phenomenon. They said this it was driven mainly by foreigners buying up quality short-term U.S. Treasury paper and thereby reducing the available supply in the marketplace. But they were wrong.

The Father of Yield-Curve Inversion

Professor Campbell Harvey of Duke University was one of the first to point out the relationship between yield inversion and economic recession. He published his dissertation in 1988 in the Journal of Financial Economics. In 1989, he published a follow up article in the Financial Analysts Journal.

Harvey’s prediction about the usefulness of the yield-curve was right on target. In 1991, after the 1990 recession, he noted that inversions of the yield-curve have preceded the last five U.S. recessions. That suggests the curve can accurately forecast the turning points of the business cycle.

Indeed, the yield-curve turned negative or inverted in late 2006 and successfully predicted the current U.S. economic slowdown. In some respects, the current slowdown has ballooned into the worst credit crisis since the Great Depression. I say that because not one, but several segments of the mortgage-backed market and other synthetic derivatives have clogged the financial system since last July.

Eight Countries Approaching or in
Actual Yield-Inversion

It’s true that no in-depth analysis or research has been conducted on the universality of yield-curve inversion abroad. But recent evidence suggests that once it hits the United States – the world’s largest credit market – it does spread to other industrialized economies.

As of mid-April, eight foreign markets are currently dogged by yield-curve inversion or approaching yield inversion.

Last year, the United Kingdom became the first G-7 economy after the United States to suffer yield-curve inversion for the better part of the year until last fall. For the record, the U.K. is now slowing sharply in 2008. Several British banks have come under pressure, one mortgage bank has failed and the housing market is unraveling.

Currently, six industrialized markets are mired in yield-curve inversion. These include Australia, New Zealand, Austria, Norway, Portugal and Switzerland. Two other markets now sport the same interest rates along the short and long end of the yield curve, including Denmark and Italy. This strongly suggests that an increasing number of mature economies are gradually being infected by America’s sub-prime slowdown as interest rates narrow.

Historically, the Anglo-Saxon economies have typically followed similar economic cycles. Expansions or contractions in economic activity have been simultaneous events that happen within months of each another.

This was the case in 1989-1990 when the United States suffered a recession and the United Kingdom, Australia and New Zealand soon followed suit. In the early 1980s, all three countries suffered the same economic hardships as the United States following a period of surging interest rates and inflation in the late 1970s. The same was true for most developed economies.

Decoupling or Re-coupling?

In the late 2000s, analysts have been quick to surmise that emerging markets and other economies in Europe have finally decoupled from the U.S. economic cycle. Although the emerging markets have shown incredible resilience since last July when sub-prime first bombed credit markets, other major or mature economies have not been as fortunate.

It looks like the United Kingdom is heading into a recession or a severe slowdown. The country’s credit markets have been bottled up for months, mortgages are turning sour and a leading mortgage bank collapsed last September (later rescued by The Bank of England).

British real estate is now contracting, especially in overheated London. The pound, though still relatively firm versus the beleaguered dollar, trades at an all-time low against the euro. The United Kingdom, in all likelihood, will join the United States and suffer a slowdown in 2008 or worse, a recession.

The majority of industrialized countries, including the European Union and Scandinavia, will increasingly share the same bond-yield inversion phenomenon that occurred in the United States 18 months ago. Over this period, benchmark 10-year Treasury yields have plummeted from 5.25% in late 2006 to 3.42% recently – a sizable gain for investors.

I expect yield-curve inversion and economic re-coupling to occur this year as the majority of mature economies suffer the same fate as the United States. Bond yields in Europe are poised to decline sharply despite the European Central Bank’s (ECB) adamant stand against inflation.

With more Eurozone bond markets inverting, it’s only a matter of time before central banks across the continent start hacking interest rates and the ECB abandons its inflation fight.

Bond-yield inversion is spreading. For European bond investors, this marks a good entry point to buy long-term government debt and investment-grade corporate paper ahead of a steeper yield curve by 2009 or 2010.

ERIC ROSEMAN, Investment Director

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Watch this video.

Laura Cadden: Traders and investors have been turning a concerned eye towards Japan. Housing sales in the Land of the Rising Sun crashed in 2007 and despite a long overdue increase in GDP growth last year, many believe that the country, once again, is at the edge of, or already in, a recession. Japanese business confidence is plummeting amid fears that the rising Yen will damage its crucial exports trade. The Nikkei has experienced its worst drop since 2001. Is it time for investors and traders to move their assets out of Japan? I’ve invited Martin Hutchinson of The Money Map Report to provide some insight.

So Martin, reading your analyses of late, you’re actually quite bullish on Japan.

Martin Hutchinson: Yes, I think the drop that we’ve had in the Japanese share market is because Japanese traders look at the world very differently to American traders. For example, when we had all the trouble last August the American markets went up seven or eight percent afterwards. It was crazy. You had sub-prime mortgages disappearing everywhere and the markets going up. Whereas Japan seems to have assumed that the American sub-prime mortgage industry is a big problem for Japan and therefore, their market’s down about 30%. I mean they’re everything in Japan because they’ve had such a lousy 15 years. Everything in Japan looks like a problem, everything in the U.S. looks like a bonanza. It’s madness. So you have to take that into account when you’re investing.

Laura Cadden: But yet, you feel that the economy is not in such dire straits?

Martin Hutchinson: Their growth rate’s a good deal better than the U.S. one. They’re running at about three-and-a-half percent at the moment and of course, they’ve got no population growth so that is a real three-and-a-half percent. The U.S has 0.6% growth in the last quarter and 1% population growth. In my book, that’s a recession. It’s minus .4% after population growth. So the Japanese are really pretty solid. The housing thing last year – it was a very nasty crash – but basically what they did was they changed the way of getting permission to build new houses and it took everybody about six months to work out how the new system worked. It was a god-awful bureaucratic mess. And so of course, meanwhile, no houses were constructed. But that wasn’t a real economic downturn, that was just bureaucracy gone mad.

Tired of reading? Watch the video.

Laura Cadden: Let’s discuss what the impact will be if there is a U.S. recession. A great part of Japan’s demand comes from U.S. consumers, correct?

Martin Hutchinson: Well, yes, but less than there used to be. China and Asia as whole is now a big part of their export market. Probably a more important problem for them is the Yen having zoomed up. It’s gone from 120 to the dollar to a peak somewhere in the high 90s. It could even go higher, I think. And that obviously makes it more difficult for them to export. But equally, because Japanese consumers haven’t spent so much as Americans, there’s a huge domestic market there that can absorb quite a lot of the growth. So you may want to look at companies that are involved in domestic Japanese business rather than purely its exports.

Laura Cadden: Now do you think that their economy is actually going to see an upswing any time soon?

Martin Hutchinson: Well, I think their economy’s going to continue growing pretty nicely and I think their stock market will eventually come out of its current funk and realize that however bad the problems are in the U.S., Japan’s on a different cycle. There isn’t a housing crash in Japan because they had one 15 years ago. And I think there’s every chance that the Japanese market may go down when everybody else goes down because traders are feeling suicidal for a month or two but when there’s some kind of recovery in the West, Japan will lead it and will give a much bigger upsurge.

Laura Cadden: Do you think it’s time for investors and traders to move in and snatch up bargains?

Martin Hutchinson: Yes, I think it’s a pretty good time. You can satisfy yourself with the idea that the market is now at about one-third of its level in 1990 and 1990 is a long time ago. And it’s down about 30% from its peak. I think you could easily find some bargains now in Japan.

Laura Cadden: What are you suggesting your readers look into?

Martin Hutchinson: I think there are three things that you can do. One is look at domestic Japanese companies. And the way you buy those is through the Japan Smaller Companies ETF (JSC:AMEX) and that’s basically looking at the smaller companies that are dealing the domestic market. They’re less effected by the Yen going crazy or the U.S. having a recession.

And then for the second one, I think there’s some very interesting technology companies in Japan, some of which are very well-known. But one that I’m very fond of, because it’s quite cheap at about 11 times earnings, is an outfit called Omron (OMRNY:OTC). This company is the world-leader in fuzzy logic control systems. And fuzzy logic is a sort of wonderful alternative mathematics that basically enables you to have more efficient vacuum cleaners and cement plants and things like that. They didn’t have Descartes and Aristotle in Japan and so they understand fuzzy logic in a way that don’t. And so here you’ve got this company that’s a world-leader in this bizarre alternative technology and it makes very nice money and it’s quite cheap.

And then the third thing, if you really want to be fashionable, is to go for Konami (KNM:NYSE) and that’s the video game producer. It’s about to come out with Metal Gear Solid IV in two months and my expert, whose near 16 years this month, tells me that Konami’s the best company in the business and frankly, with the sales of the Sony Playstation and the Nintendo Wii, and even the X-Box, all booming in the last year or so, you want to be in the guys that make the video titles for them and that’s Konami.