How our spirits soared over the weekend. “Gold at $898,” said one headline. “Hillary Dies,” said another.

We allowed ourselves a brief daydream. What if some strange virus attacked presidential contenders...and laid them out like dead rats in front of a terrier? Huckabee, Romney, Obama, Giuliani – the whole lot of them!

And then we read on. It was Sir Edmund Hillary who croaked, not the leading contender for the Democratic nomination.

But gold’s rise was real . It came, better than we predicted, along with a big drop in the Dow. Gold up; Dow down. That has been our mantra for the past eight years. But, for most of the time, we have been only half right – only right about gold, that is. On a floodtide of new money and credit, the Dow has floated, like an empty beer can in bilge water.

But now Mr. Market seems to have punched a hole in the stock market’s boat. While the feds desperately pump more money into the system, stocks sink anyway. Friday, the Dow lost 246 points.

What’s going on?

The force of inflation may be unstoppable; that’s why gold is reaching towards $900. But deflation will not go away. And it keeps sucking the juice out of the financial system.

“This is not merely a subprime crisis,” writes Wolfgang Munchau in the Financial Times .

It if were just a subprime crisis it would be over already, he says. Nor is it going away anytime soon. Because “other pockets of the credit market are also vulnerable,” namely credit cards and credit default swaps.

And now we turn to that great economist from the Sovereign State of Massachusetts, Barney Frank, for an update.

The FT gave him space to tell us that what America needs now is a little more of what he and other members of Congress have to offer – more meddling! As expected, the politicians are pointing their fingers at Mr. Market . “He’s a failure,” they say. “What we need is more government.”

Mr. Frank bemoans “income inequality.” He must think it is a bad thing that some people earn more than others. Because now that some people earn even more than they did before, while most people earn less, he says we should do something about it. Ever confident in the wisdom of the same yahoos who elected him, he thinks, “the American people will decide that we should enact policies that seek to curb growing inequality.”

We only bring it up to point out that even Frank has noticed what we have been saying for years: that in the last six years, when the United States was supposed to be enjoying a boom, “average earnings for the vast majority of workers have fallen in real terms.”

The boom was a fraud, we say. Pass a law, says Frank,

Since the lumpen American earned no more income, and since his consumption spending went up, he had to get money from somewhere. That was no problem as long as house prices were rising. But when they stopped rising, he turned to credit cards. And now, with unemployment rising, the credit card companies are bound to discover what the subprime mortgage holders discovered, that their credits aren’t worth quite as much as they thought.

Meanwhile, credit default swaps are a $45 trillion industry. People buy swaps to protect against bond defaults. But, as we’ve pointed out, when credit is expanding, bonds rarely default. If a company gets into trouble and can’t pay its obligations, lenders rush to the rescue with more money. It’s when you come to the end of a credit expansion that the troubles arise.

Bill Gross, who runs the largest bond investment fund in the world, PIMCO, estimates the size of the coming crisis in swaps at about $250 billion – or about the same size as the subprime problem. His estimates, however, assume that a recession would not cut too deep or last too long. It could be much worse. Bond defaults could cause a global financial meltdown, Munchau points out. When credit was expanding, offering default protection seemed like a no-brainer; the insurer got bad for offering insurance against something that never happened. Naturally, a lot of no-brain investors came to the wrong conclusion – that they would NEVER have to pay off on their insurance obligations. But now the credit cycle has turned; credit is contracting, not expanding. And now, bonds are beginning to go bad. And so, the investor who bought a swap to protect himself turns to his insurer. Uh-oh. Here’s where it really starts to go bad. Because, real trouble rarely comes in the door alone. Typically, he comes with his drinking buddies and low-life friends.

If the economy softens substantially, or stays soft for a long time, many companies will default on their bonds. When that happens, not only will the defaulter default, but so might the insurer, and then, the insured too. In other words, all three could go broke.

A trillion here, a trillion there and pretty soon you’re talking about real money.
And a real credit crisis...

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