The Wall St boom is over but it is an open question whether painful adjustments will be made by inflation or deflation.

We spent Saturday looking at penises. Big ones. Little ones. We had never seen so many.

“They used the erect penis as a symbol of fertility, abundance and good luck,” said Carla, our guide at Pompeii. “So, as you can see, it is everywhere here. Even sticking out of the walls.”

In front of us was a masculine protuberance poking out over a doorway. Another was carved into the stone of the roadway itself, pointing the way to a brothel. Others were on the walls, some of mythic size. One man had his pride and joy on the scales. Others used them in more traditional ways…

But today is Monday, a working day. So, we set to work and leave our discussion of 2000-year-old dongs for later.

First, we look at how last week ended.

Stocks rose a bit; the dollar fell; gold held steady – but at $889, well below $900.

These are the times that try our confidence. Stocks and gold are going in opposite directions – opposite, that is, to the direction we think they should be going. Stocks seem to want to go up. Gold has wanted to go down for a long time; now it is doing so.

But if our guess is right – ‘flation’ is inevitable in the financial system. And our guess is that this flation will show itself in rising prices for gold, commodities, and emerging markets…but lower (relative) prices for stocks, property and financial assets, generally.

Flation is inevitable because there are billions…no, probably trillions…of dollars worth of financial mistakes in need of correction and a world full of financial authorities trying to prevent it.

“A lot of people made a lot of mistakes,” says former Treasury Secretary, former CEO of Goldman, and now chief of Citigroup’s executive committee, Robert Rubin. Rubin made one himself, says today’s International Herald Tribune, by failing to rein in Citigroup’s excessive risk taking over the last five years.

But just because a lot of people made a lot of mistakes, it doesn’t prevent the authorities from making more. They’ve bailed out banks in Britain…and Wall Street brokers in America. The Fed has cut rates six times already…and is ready to cut a seventh time this week – bringing the key Fed lending rate to about half the level of consumer price inflation.

The result: money and credit flood the system…but many investors still drown.

Ours is not a common view. Most analysts think the authorities will either succeed or fail. If they fail, everything goes down. If they succeed, everything goes up.

Of course, no one really knows. We’ve never been in this financial situation before…so it is almost all guesswork. All we can do is to try to strip it down to the essentials to see if we can make sense of it.

“Is finance’s economic role ebbing?” asks a Wall Street Journalheadline.

Yes, is our answer. Wall Street made money by ‘financialising’ the economy. Businessmen, for example, ceased thinking about how to produce better products at better prices; instead, they became much more interested in mergers, acquisitions, stock options, asset shuffling, IPOs and buybacks. Some of these activities may have added value, but not many. But for Wall Street, these were the glory days. Billions in fees could be charged…and, as long as prices were rising, few people complained. But when prices began to go down, lenders looked at the collateral and discovered it wasn’t worth what they thought it was. The triple-A credits were marked down…banks teetered and had to beg for more capital…the government stepped in to protect the rich and, so they said, avoid a meltdown.

Wall Street also helped turn homeowners into speculators. Instead of buying houses to live in, people bought them – often with no money down - in the belief that they would go up in price. What is a no-money-down mortgage but an option to buy a house later? And now that house prices are going down, the mom-and-pop options are expiring worthless. Housing speculators are putting the keys in the letterbox, dumping cement down the toilet, and walking away.

“The bright new financial system,” said Paul Volcker a couple of weeks ago, “has failed the test of the marketplace.”

Volcker is right. Wall Street has peaked. The credit cycle has peaked along with it. Now it is time to make “painful but necessary adjustments,” he says.

Instead, the current leaders of the Fed seem inclined to try to avoid pain at all cost. This week, they are expected to announce another quarter point rate cut. The smart money considers another 25-bps cut in the bag. The smart money is not wondering what the Fed will do…but what it will say. If it signals the end of the rate cuts – what more will investors have to look forward to?

But here at the mobile Daily Reckoning headquarters in Rome, we’re still trying to look at the essentials. And the essential condition is this: the boom in the financial industry and things that depend on it is over. Now it is time for painful but necessary adjustments. The only question is how those adjustments will be made – by inflation or deflation, or – our guess – both.

*** First, news comes that Americans are hoarding food. The big discount stores are apparently rationing rice, for example.

“Sam’s Clubs, Costco limit bulk rice purchases,” said an AP story last week.

Today, the New York Times talks of a “recession diet,” in which shoppers try to switch to cheaper foods. And there is talk of a drought this year, further reducing the supply of available grains.

The LA Times mentions consumers “coping with soaring prices.” And the Boston Globe reports that drivers are trading in their gas-guzzling SUVs in favour of smaller cars. Maybe that is why Toyota is now the world’s leading automaker – selling more vehicles than General Motors.

Gasoline is at about $3.60 a gallon. Milk is even higher, at more than $4 a gallon. Consumers have no choice – they have to cut back. That, too, is one of the essential verities of today’s economy. Ours is a consumer economy in which consumers have less money to spend. .

*** Everyone should spend some time amid the ruins. It cultivates a sense of humility. “Look on my power,” the old stones of Pompeii seem to whisper…“and weep.”

The city of Pompeii sits on the coast of Italy, near Naples, about two hours’ train ride south of Rome. It also sits beneath a volcano – Vesuvius. It was this latter detail that brought it to an abrupt end…in 79 AD…and earned the city a notable place in history. In late August, Mt. Vesuvius began to rumble. The people looked up at the mountain and noticed a strange cloud over the peak – it was orange, and the shape of a typical pine tree from the area. Some Pompeiians took to boats to get away. Others went by land. Then, nothing happened. Pliny the Younger says his uncle returned to town, confident that it was nothing to worry about, and took a nap. Others came back to town to get valuables and other properties. Still others just seemed to go about their business.

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