Big drop in the Dow yesterday...down 370 points. Gold fell hard too...minus $19.10 – to $890.

Everything falling...sinking....declining...dying downwards – deflation...deflation...deflation...

What is happening?

We explained yesterday that the great boom of the last quarter century was a bust for Americans. And we explained why:

1. Because Americans made a critical mistake – misled by their own financial authorities, by the reckless saving of Asians (in dollars!) and by their own misguided belief in capitalism. Result: they spent too much, borrowed too much, and saved too little.

2. Because Asians (and other foreigners) entered the world economy. Aided by modern communications and government policies designed to encourage globalized commerce, this huge new supply of cheap labor lowered wage rates in the United States.

But we did not mention a key point. Americans misunderstood the nature of capitalism itself. It is not an “economic system” that makes people automatically richer. It is a moral system, a system that rewards virtue and punishes error. You don’t get richer because of Free Enterprise. Indeed, as the economic history of the last quarter century shows, you can get poorer. The market system merely provides the setting in which you get what you deserve. You could get rich, if you were to do the right thing: work hard, save your money, innovate, take chances, forgo consumption. But do the wrong thing, and you will pay for it.

We received this note from a Dear Reader today:

“My sister and her husband were the ideal success stories. She is in management at the state utility, my brother in law was an engineer at the local nuclear power plant and later got his law degree at about age 46; working and studying simultaneously, commuting out of state, resulting in an early heart attack due to stress and smoking.

“They had a beautiful 3,000 sq ft home with a pool, built in cherry wood finishes and top- of-the-line vehicles. After they sold their home to move to an ocean view, 1 bedroom property (that they gutted down to nothing and put in over $150,000), they realized that they owed more than the current house was worth.

“Here are two professionals with advanced degrees, one in business, the other in engineering and law working and studying all their lives with nothing to show for it. They now owe more than what they have is worth. My sister is sadly saying that now she won't be able to retire. She is 55 years old, has worked hard getting up at 5am every morning, traveling one hour to her job. Traveling for the utility, working almost every weekend, taking extra courses, years and years of work and she has...nothing...absolutely nothing.”

That is why trying to keep the party going is such a huge mistake. Why encourage people to do the wrong thing? Why keep the bar open any longer? Providing more money and more credit and bigger government deficits only creates more drunks. It merely compounds the error, with more people fumbling for their car keys when the party is finally over. What good could possibly come from more consumer spending now? More credit card debt? Bigger houses, bigger mortgages, more new houses available for sale? Higher house prices? Higher stock prices?

Americans are already living beyond their means. What is the point of more stimulus? What could it stimulate them to do, but live even further beyond their means?

“Bill, you just don’t understand the wonders of modern macro-economics,” comes the response. “The authorities are simply doing what they should be doing; they’re putting more spending power into the economy to offset what appears to be a cyclical downturn. That way, they’ll be able to prevent a more serious slump. We don’t want to fall into a Japanese style trap, do we?”

Apparently the feds are geniuses. They’ve figured out how to harness capitalism, how to take out the downside, how to eliminate mistakes. They think they’ve taken Mr. Market off the mean streets and out of the wild slums. They think they have him behind bars; they think he’ll do what he is told. Now, thanks to their adroit management, we no longer have to worry about slumps, crashes or recessions. If Americans spend too much...no worries...the feds will just give them more and more cash and credit, forever and ever, amen.

Mr. Market can be an agreeable fellow. He’ll go along with a good gag, for a while. But he eventually gets tired of it. Eventually, he finds a way to break out. And it looks like he is now on the loose. And he’s armed.

Yesterday’s big drop in the Dow came as a consequence of a report from the service industry. Sales are falling more than forecast. But what would you expect? Capitalism rewards virtue and punishes error. It was surely an error for Americans (and British and a few other Anglo-Saxon tribes) to spend so much and save so little. Now, they’re getting whacked for it.

GMAC says it lost $734 million as its home loans “went sour,” according to yesterday’s news.

And now comes a front-page story in the International Herald Tribune.

“Reality check: Americans turn thrifty.”

This is the story we’ve been following for the last year. Without new money from rising house prices, Americans are stuck. They have no choice. They have to cut back. Not even the checks from a generous Uncle Sam will be enough to offset a housing decline.

The feds may not know which way the wind is blowing, but consumers are beginning to notice the plastic bags in the air. For years, they had the breeze at their backs. Now, it is in their faces. They can’t help but realize that they made a mistake. And they’re beginning to correct it.

Look for consumer spending to fall and savings to rise.

*** The good and the great, the world’s biggest humbugs and brightest worthies gathered in Davos, Switzerland last week. Even Bono was there.

They look at the big picture, of course. And they try to think of ways to make the picture a little brighter. But do you think the world is actually improved by a bunch of people drinking champagne and wondering how they can make things better -- by meddling with other peoples’ plans? If so, you do not work here at The Daily Reckoning. Our view is different. In our view, the baker does not bake for reasons of altruism or idealism. He bakes to earn his own bread. And as Adam Smith pointed out more than 200 years ago, it is thanks to his efforts to improve his OWN life that the whole world gets better. Or, as Goethe put it: “Let everyone sweep in front of his own door, and the whole world will be clean.”

Still you can’t blame the policy makers, the movers, the shakers and the late-night party makers for having a good time, as long as they don’t actually do something.

Water was the big subject at this year’s confab. And here, we give the tip of the hat to Mr. Ban Ki-Moon, UN General Secretary. First, he noted, with no show of humor or awareness, that the response so far to the UN’s initiative on water sustainability had been merely “a drop in the bucket.”

Then, he went on to say that he hoped this year’s session at Davos would be as big a success at last year’s, and that “what we did for climate change last year, we want to do for water and development in 2008.”

What did Davos do for climate change last year? How did it change the climate? Did all those rich and famous people, flying all those miles in business and first, in those carbon-consuming jet airplanes, staying in those fancy, well-heated alpine hotels and feasting on delicacies flown in from all parts of the globe – did they do any good for the world’s climate? We doubt it. But we think Mr. Ban Ki-Moon is right. This year’s Davos conference will be an equal success.

Meanwhile, we note that the idea of capitalism – the phony idea that it produces wealth automatically, that is – is alive and well among the world’s elite.

First, a team of researchers asked the ‘elite’ in 18 countries which institution they trusted. They answer: business. Not government. Not the media. Money has upstaged politics, as we pointed out earlier.

Then, Bill Gates – the world’s foremost entrepreneur and richest capitalist – spoke to the group.

“In markets where profits are not possible, recognition is a proxy; where profits are possible recognition is an added incentive,” he said.

He was proposing something he called “creative capitalism.” How that is different from any other kind of capitalism, we don’t know. In any business, there are different kinds of rewards. Some people like to run art galleries – even at a loss – because they like art. Others want to be in the film industry, because it is glamorous. And who wants to own slum properties and collect rent from drug addicts? Only people who want a high rate of return and don’t care much about prestige or personal safety.

It is discouraging to read accounts of Gates’ speech. The man seems to have spent too much time in front of a computer terminal. He said he wanted to “find a way to make the aspects of capitalism that serve wealthier people serve poorer people too.”

Either the world’s number 1 capitalist doesn’t know much about capitalism. Or he is just another humbugger, like all the rest. He should know that capitalism serves no on in particular. It only serves those who make use of it, those who save, those who invent, those who work and improvise.

It is a moral system, as we mentioned above, serving the thrifty, the quick, the smart. It is indifferent to how rich people are, to their skin color, to the language they speak and to the flag they salute.

Capitalism is always creative...and always destructive too.

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