The Fed hit the markets with a half-point rate cut. The S&P shot up more than any time since the invasion of Iraq in March ’03. And now we read in the paper that Goldman’s (GS) earnings in the last quarter rose 79%...and Abu Dhabi sank $18 billion into giant buyout firm, Carlyle.

Investors must think that the Fed’s intervention in the credit markets will be as effective as the Bush Administration’s intervention in Mesopotamia. And they’re probably right!

In neither case does a campaign of shock and awe bring guaranteed results. Some problems just don’t lend themselves to meddling from outsiders.

In the case of the U.S. economy, the Fed’s rate cut offers borrowers more credit at lower cost. But it is not as if the U.S. economy has been short of credit. Total credit in the United States rose from 150% of GDP in 1971, when the dollar was cut loose from gold, to about 340% of GDP today. That, dear reader, is a credit expansion! It is what has made the U.S. economy what it is today...and it is why a cut in the Fed funds rate may not be as effective as investors hope.

The financial authorities are correct – what the U.S. economy (and by extension, the world economy) needs is more spending. Spending is what makes the money world go ’round. But who’s got money to spend?

The rich, of course. The luxury market has been extremely profitable for many years. But reports coming in to our Daily Reckoning headquarters tell us that even the rich are becoming hesitant to part with cash. They’re waiting to see how their hedge funds do...or what happens to the U.S. economy. Million-dollar houses are taking longer to sell, according to our sources. Other markets for the rich – watches, cars, boats – are not quite as sans soucis and extravagant as they were three months ago.

But the rich don’t need credit in order to spend. They have real money.

Unfortunately, it’s the not-so-rich that drive an economy; there are so many more of them. As long as credit is expanding, ordinary people have more money to throw around. Inevitably, they reach a point when they can’t go on. The people from whom they borrowed begin to ask for their money back. Bills mount up. Sooner or later, the debtor can’t make his monthly payments.

Then, when the Fed comes along and offers lower rates, he’s likely to think twice. He may want to borrow more money...but he can’t afford it.

“Housing costs push working class to the edge,” comes the headline from the Financial Times.

His real problem is not a lack of credit; it’s a lack of spending power. He doesn’t have enough income to continue borrowing. High housing costs, high energy costs, high food costs...what’s a poor working stiff to do?

“Ghost towns,” is how the New York TIMES describes some new housing developments. While low rates lured consumers to buy houses they couldn’t afford...the buying lured builders to build them. Now they sit empty...waiting for the day when willing sellers once again can come to terms with able buyers.

For the moment, the buyers aren’t able to buy at present prices...and the sellers aren’t willing to drop prices to a level where they can. The housing market, unlike the wheat market, takes time to clear. Our guess is that the adjustment will take several years.

The dollar went down again yesterday. It is probably going to drop to $1.50 to the euro (EUR) within the next 12 months.

A Dear Reader asks: 

“I realize many of the arguments for inflation as being good for gold. Where I have trouble is making a case for gold rising during deflation. The fact that gold rose in value in the 1930’s I believe is not relevant. The U.S.A. is off the gold standard and cannot arbitrarily change the price of gold.

“So, how does deflation increase peoples’ desire to hold gold?”

The case for gold is obvious when consumer prices are rising. Gold tends to rise along with them...and then races ahead, as people turn to gold to protect themselves from inflation.

How about when prices are falling? Isn’t it better to hold onto to cash – even paper currency – rather than gold? Well, yes...and no. Falling prices mean that the currency itself is becoming more valuable. As long as that is happening, gold is not needed for protection – at least, not against falling currency.

But when prices fall, typically, they do not fall alone. Instead, they come plunging down along with businesses, junk bonds, hedge funds, stocks, careers, property values, retirement plans and credits of all sorts. People become worried about the quality...that is, the real value...of their assets. They look for something solid to hold onto...a way to protect their assets from markdowns, defaults and bankruptcies. Gold, the only credit that is not also someone else’s debit, is a good way to avoid depression-style losses. You don’t have to worry about someone making his monthly payments, or a business paying its quarterly dividend or making good on its bond coupons. Gold pays no dividends or interest. But investment returns go negative in a deflationary slump; as we pointed out yesterday, the ‘cost’ of holding gold goes down...and then turns, relatively, positive.

Another thing that happens when economies face deflation is that monetary authorities tend to panic. Pretty soon...up is down...down is up. A genuine consumer price deflation in America or Britain would be so painful our central banks, and our political leaders, couldn’t stand it. Consumers have too much debt. How they’d howl!

This summer, equity prices fell less than 10%. Still, within days, it sent central banks scrambling to get more credit into the system. Imagine what would happen if stocks went down 20%...or 50%! Ben Bernanke said he would drop paper money out of helicopters, if that were what it took to avoid consumer price deflation. We don’t have to tell you want would happen to the value of the currency. Even before the helicopters took off, it would be in freefall...with gold rising on the other side.

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.