“There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.”
- Ludwig von Mises

Read it and weep.

Von Mises was saying that there is no escape. There is no magic elixir, no panacea, no free lunch. When you borrow money, you have to pay it back. End of story.

The borrowing phase – a credit expansion – is pleasant enough. You feel rich and smart. You have money to spend. Your assets go up in price. Your stock rises. You even think you’ve discovered some miracle formula – some way to get rich without working or saving. It’s as simple as buying a house. Then, it goes up in price. So buy another one or two or three of them.

And then, alas, along comes the day when you have to pay back the money you’ve borrowed – the credit contraction. Now, you don’t feel so smart. Because, when everyone is trying to pay down debt, no one has money to bid up asset prices. Your house actually falls in price and you desperately try to get rid of those extra houses, hoping to get back what you have in them.

Yesterday, the Dow fell 277 points. It is a bear market, dear reader. That’s what stock markets do in a credit contraction. Assets, generally, become cheaper.

“Home sales dive” in South California, comes another report. Sales are off 42% from a year ago. Prices are down more than 10%. And it won’t end there.

Even the slicks on Wall Street are having trouble. The expansion stage of the credit cycle was pure molasses to them. But the contraction stage is bitter medicine. Today’s International Herald Tribune tells us that Citigroup has turned to the moneybags in Singapore for a $22 billion bailout. Over at Merrill Lynch, they already hit up the Singaporeans for $6.2 billion in December. They’re writing down some $8.4 billion in subprime debt, creating the biggest loss in the firm’s 93-year history. This month, they turned to Korea and Japan to fill a $6.6 billion hole.

Why go to Asia to raise money? Because that’s where the money is.

“Asians have trillions in dollar reserves,” Lord Rees Mogg explained over lunch yesterday. “They probably think they have enough of our money. Over the next few years, it looks as though the Western currencies and Western economies are going to be in trouble.”

As reported here yesterday, retail sector is showing signs of slower consumer buying. Even the luxury outlets – such as Tiffany and Ralph Lauren – have seen their stocks cut 20% to 50%.

What can be done about it?

As von Mises describes, above, the only alternatives are to stop the process of credit creation voluntarily or to continue to a “final and total catastrophe of the currency system.”

In the late ’70s, the Fed chose to abandon further credit creation. It was obvious that more money and credit was making consumer prices rise without causing genuine economic growth.

Now, three decades later, consumer inflation rates are still tolerable. It’s the threat of recession that seems insupportable. And so, between sooner or later, the choice is clearly later. Better to try to fight the little devil in front of us, they say; let someone else worry about that big devil Beelzebub.

Word on the street is that the Fed may act before its regularly-scheduled meeting later this month, and it may cut rates by a whopping 0.75%. Whether or not it will actually be able to stop the correction now in progress, we don’t know. But our Trade of the Decade just looks better and better. Buy gold on dips; sell stocks on rallies.

The feds can control only the quantity of paper money or the quality of it. If they lean down hard on the quantity side, pushing trillions of dollars worth of new cash and credit into the system in order to try to avoid a serious recession, the quality of the money will suffer. The Asians will be more eager than ever to dump the dollar; the greenback will fall, and gold will soar.

If, in the unlikely event that they were to voluntarily give up on credit expansion, reducing the quantity of dollars in order to protect the quality, they may be able to stop gold’s rise. In that case, a sharp recession would mean falling share prices. This is the trick that Paul Volcker pulled off in the early ’80s. The price of gold collapsed and stocks took off. But not before he had pushed up short-term lending rates to 20% and driven the economy into its worst recession since the ’30s and knocked down stocks so low you could buy the entire Dow for the price of one ounce of gold.

No matter what happens, we’ve got a long way to go before we reach that kind of turnaround point. And most likely – given the situation – it won’t come at all until we’ve been through Von Mises’ “crack-up” – the final and total catastrophe of the currency system.

Whee!

*** The European Central Bank is being cagey. Recently, Jean-Claude Trichet tried to explain himself. We do not have the same mandate as the U.S. Fed, he put forth. The Fed is meant to do two things at once: protect the value of the dollar and maintain a healthy, prosperous economy. Our mission at the ECB, he went on, is merely to protect the value of the currency.

Accordingly, the ECB has been reluctant to cut rates in order to help the economy. And consequently, the euro has gone up against the dollar and the pound.

In today’s news, the ECB warns that the U.S. Fed may not be able to continue cutting rates: “crashing dollar may stop Fed cuts,” says the headline.

Against gold and oil, the dollar has already crashed . You could buy an ounce of gold for just over $260 when George W. Bush first began using the White House toilet on a regular basis. That was not quite seven years ago. As of yesterday, you’d pay $902 for an ounce. Against gold, the buck has lost 60% of its value in less than two presidential terms. Against oil, it has taken a similar shellacking. Even against the euro, Europe’s Esperanto money, the greenback has been cut in half, more or less, over the same period of time.

And now the whole world is wise to America’s game. When the voters feel pinched, the feds give them more money. But the money they give them competes for value directly with the dollars the foreigners have saved. The Asians, for example, sweat and save and stick the dollars in their vaults. Now, they have trillions of them. But they wake up every morning and find their dollars are losing value. One day, a dollar buys one 800th of an ounce of gold. A few days later, it will only bring one 900th. One week, a dollar will buy one 90th of a barrel of oil. The next week, a barrel of oil costs $100.

So the ECB feels it is only fair to give warning. ‘Don’t expect us to keep protecting the quality of your money. If you keep putting it out, we’re going to sell it.’

Trichet is right about the theory. But he is probably wrong about the practice. Property prices on the fringe of Europe – in Ireland and Spain, notably – are falling faster than those in the United States. It won’t be long before the squeals of pain – in various foreign languages – reach the ECB too.

Spain and Ireland benefited hugely from the European Union. Suddenly, the Irish and the Spanish were able to borrow money at rates set by the Germans. They were low rates, the kind of rates the Germans, with the financial discipline and economic rigor, deserved. When such rates were on tap in Ireland, it set the whole country into major boom. Everyone wanted to buy property. And after a decade, Irish property was the most expensive in Europe, and the Irish, improbably, were Europe’s richest people. In Spain, the circumstances were different. But the effect was the same; Spain enjoyed a boom of the sort not seen in Iberia since the galleons came back from the New World with Inca gold.

But now what? Irish houses fell about 10% last year. We don’t have figures on Spanish property prices, but word on the Costa del Sol is that they are falling and so are the shares of the large builders who have been putting up apartments at a furious pace for the last 10 years. And the editors of International Living magazine tell me that they’re preparing a special feature article on Spanish real estate prices in the next issue. “If you’re looking for bargains,” they say, “that’s the place to look.”

What will Trichet do in the face of such America-like problems? Will he hold fast to his principles and refuse to cut rates? Or will he take a page of the Alan Greenspan Manual of Successful Central Banking and fall into line with his counterparts in Washington and London? Like them, will he favor the quantity side of the balance and let the quality go to Hell?

We don’t know. And we’d still rather hold euros than dollars, but the rate of increase in the European money supply is not much different from that of the dollar – about three or four times GDP increases. We prefer the yen to the euro and the euro to the dollar and the dollar to the pound; but we’d rather hold gold than any of them.

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