The rally may end any day, but it didn’t end yesterday. Stocks rose 127 points, as measured by the Dow. Oil closed at $66. Gold rose $2.50.

We said we were doing some serious thinking this week. Maybe it is the season. But more and more, our thoughts become grayer. Less black. Less white. Less hard. Less soft.

A few years ago, it looked to us as though the world financial system had gone to war. We cheerfully awaited the victory parade. We figured Mr. Market would whup the feds good and hard. It hasn’t happened so far.

On one side, are the forces of a natural market correction… following a long, long period of expansion. The easier money gets, the more people tend to mis-spend and mis-invest it. Then, inevitably, their mistakes must be corrected. That’s what bear markets and recessions are for.

But the feds don’t like bear markets or recessions. And at least since Keynes outlined his general theory back in the early 20 th century, they’ve believed that they don’t have to put up with them. Keynes took a page from the Old Testament. Government should act like an enlightened Egyptian Pharaoh, he didn’t say, but should have. It should run surpluses in the fat years and deficits in the lean years… thus flattening out the pattern of boom and bust.

Pharaoh was no dope. He stored up grain for 7 years, when the harvests were bountiful. Then, when the 7 lean years came, he released the grain to the people. Problem solved.

Keynes believed that modern government could do the same thing. But Pharaoh was not running a democracy. He had no voters to answer to. So, if he wanted to store grain in the fat years, he could do so.

In theory, the US government could do the same. But in fact it never runs significant surpluses. There are too many people who want too much bread and too many circuses. And you don’t win votes by denying the voters what they want. So, in practice, the feds run deficits even in the fat years! Last year, before the downturn really started to bite, the US federal government ran the biggest deficit in history – nearly half a trillion dollars.

Now, let’s imagine how that would work for a bad Pharaoh. He would give out grain in the fat years. This would encourage farmers to produce less grain. Then, when the lean years came, Pharaoh would have no grain to give out… and the farmers would have less grain stored up themselves, since they grew less during the boom years. The famine would be worse than ever.

Then, if we can imagine that Egypt was trading with China at the time, perhaps Pharaoh could borrow grain from the Zhou dynasty to help ease the peoples’ pain. Perhaps he could mortgage the pyramids. Whatever, he – and the Egyptian people – would have been in much better position if he had done as Joseph told him in the first place… lay up stores in good times, draw then down in bad times. How difficult is that?

But Bernanke didn’t see the famine coming. Neither did Geithner. Or Greenspan. Or any of the other savants Pharaoh interpret his dreams . None of them expected hard times. None of them warned the public. None of them encouraged the government to save money for the recession. Nassim Taleb asks why Bernanke was reappointed after he clearly failed the most critical test. But heck… the federal government is an equal opportunity employer. Employees aren’t let go just become they’re incompetent.

Anyway, getting back to our thoughts…

… it looked like a battle to us – between the forces of inflation (the feds)… and the forces of deflation (the market). But battles usually have clear winners. One side is master of the field; the other retreats. One side is victorious; the other is defeated.

Alas, some wars produce no hozannahs of success… and no wailing widows of failure. Some end in draws… or in confusion… or in disgrace and bankruptcy for both sides.

Like the bad Pharaoh, the feds saved nothing. Now, they have to try to work their Keynesian magic on credit. This puts them in a weak position; like a government that wages war on borrowed money. They can continue their campaign only as long as lenders allow them. They can’t wage the war as effectively as they’d like. Then again, maybe they can’t lose it as spectacularly as they might.

For the moment, their credit is still good. The bond market foresees an inflation rate of less than 2%. Bankers, taking money from the government, are happy to lend it back to them.

But the forces of the correction are giving up little ground. While stocks rally, the real economy remains in a funk.

“Sharp drop in start-ups,” is a news headline from yesterday. New business start-ups are a major source of new jobs. Bad omen.

Even glamour publisher Conde Nast is forced to make cut-backs. It has told employees that they may not spend more than $1,000 a night when they are travelling.

A Pimco economist says savings rates are still going up… and may exceed 8%. This represents hundreds of billions of dollars taken out of the consumer economy. Oddly, while it makes the slump worse, it also helps finance the government’s battle against it. Savers buy US debt (albeit indirectly).

So, the battle is still going on… and the outcome is still in doubt.

*** Racehorse prices are in freefall, says a report out yesterday. But collectible cars are still doing well.

Yesterday, we saw someone drive by in a huge, gaudy pink Cadillac from the 1960s. It had magnificent fins and enough chrome to stagger a blind man. In it were a middle-aged man and woman, looking very comfortable and proud. They were travelling in style… in a rolling sculpture.

Old cars are not only holding their values, they’re still going up. But not all old cars. Detroit’s muscle cars have been falling in price for the last three years. Not very green?

*** And here’s a report we received over the internet, from Aaron Trask:

“Everyone is right to fret about inflation but the “deflation scare” isn’t over yet, says Charles Nenner, founder of the Charles Nenner Research Center.

“Renowned for his cycle work, Nenner sees deflation remaining dominant until year-end and inflation not picking up for another 18 months. But that will be the start of a 30-year (yes, year) upcycle for inflation says Nenner, who spent 12 years as a market-timing consultant for Goldman Sachs.

“The investing implications of this scenario are clear: Nenner is bullish on gold for the long-term and even more bullish on gold mining stocks, which he says are currently cheap relative to bullion. After a secular decline, Treasury yields are set to rise, with Nenner predicting the 10-year yield will reach 5.50% by Spring 2013, a 45% rise from Friday’s close of 3.78%.

“What’s less clear is the timing of this trade. Nenner believes the “deflation trade” is about to reassert itself in the short-term, meaning strength in the dollar and Treasuries, and weakness in commodities and equities, as we’ll discuss in more detail in a forthcoming segment.

“For those who believe the dollar is doomed, Nenner notes “all currencies are bad.” In other words, currency trading will be a game of relative bets vs. a one-way trade against the greenback, as so many expect.”

Until tomorrow,

Bill Bonner

Source: The Battle Continues