“The first quarter will be ugly,” said an analyst at Deutschebank after looking at the latest report on the fourth quarter.

In the last three months of 2007, the U.S. economy neither grew nor shrank. Instead, it just came to a halt. The official report shows GDP rising at an annual rate of 0.6%. The previous three months showed growth of over 4%.

What is happening is what is supposed to happen and what we’ve been waiting to happen but so far hasn’t happened – the United States is entering a recession and is probably in one now.

New jobless claims are up more than expected, says one report. The economy is softening more than expected, says another. More bad news: mortgage rates are going up.

The feds, you’ll recall, are far more interested in fighting recession than they are in fighting inflation. That’s why the dollar is falling...about which, more in a minute. But in the battle between the feds and deflation, it appears that the feds are getting their derrieres kicked. And they’re losing the non-battle against inflation too. The cannon to the left of us and the cannon to the right of us volley and thunder no matter what the Fed does.

Yes, dear reader, as you sow, so shall ye reap. The feds sowed inflation – and now they’ve got a bumper yield of it. They planted a good crop of deflation too – by encouraging so many bubbles and so much debt. They’re going to fill the silos with that too.

And what can they do about it?

“The Fed is not really in control of the situation,” says Paul Volcker, former Fed chairman and the last man at America’s central bank to protect the dollar.

In trying to fight deflation rather than inflation, the Fed chose the wrong enemy, in our opinion. At least it could win the fight with inflation. Paul Volcker proved it was possible. The fight against deflation, on the other hand, is a losing proposition. When Mr. Market wants to deflate, there is not much a central bank to do to stop it; Paul Volcker’s Japanese counterparts proved that.

Has it come to that? Are we finally come to the grim harvest we predicted in this spot eight years ago? Are we now, at long last, faced with a long, slow slump a la Japan?

The United States “risks a lost decade like Japan,” says a headline in the London Telegraph .

“Is America heading for a Japan-style crisis?” asks a headline in our own MoneyWeek magazine.

The answer to this question is yes...and no. Yes, there are definitely parallels. Yes, the U.S. central bank is fighting the downturn just as Japan’s authorities fought its slump. And yes, they will probably make the situation worse, just as Japan’s policymakers did.

We mentioned yesterday that Western kibitzers blamed Japan’s authorities for not allowing the banks to fail. Japan’s big bank had lent hundreds of billions to Japanese industry in the boom years. Then, when the boom was over, the loans went bad. But the banks were ‘too big to fail,’ so the bad debt couldn’t be marked to market and the financial sector couldn’t move on.

In America, the big financial firms have plenty of debt too. Much of it is certainly bad. So far, many Wall Street lenders have fessed up to losses – totaling more than $100 billion. But there is much more still waiting to be discovered.

What’s more, America’s debt is not only broader and deeper than its Japanese equivalent; it is also more inscrutable. It’s not only the big players who have a lot of debt in the United States, in other words; the little guy has his share. And right now, U.S. authorities are looking for ways to keep the little guy from getting what he deserves – and, incidentally, protect the big lenders from further losses at taxpayer expense.

For example, there’s a proposal – originating with Goldman Sachs and put on the Congressional agenda by Rep. Barney Frank – for the government to buy up mortgage contracts. This would permit homeowners to hold onto their digs – even though they can’t really afford them. Nobody mentions it, but this proposal would also get Wall Street off the hook, putting the government in as a buyer of last resort, rather than allowing the mortgage contracts to be marked to market properly.

Meanwhile, there are trillions of dollars worth of derivative contracts outstanding. Here, the problem is not so much that the banks are hiding their losses, but that they don’t know what their losses are. Even Robert Rubin, formerly the head man at Goldman and the U.S. Treasury, says he didn’t really know much about CDOs either, until they began to blow up last summer. And then, two weeks ago, the world’s leading insurance company, with a trillion dollar balance sheet, and net income greater than the GDP of some sovereign nations, announced that it had made a mistake. It had “discovered a material weakness in its internal control over financial reporting and oversight relating to the fair value valuation of the super senior credit default swap portfolio.”

Anybody can make a mistake, of course. And whether AIG made a mistake when it first analyzed its swaps, or a mistake when it reconsidered its swaps, or will make another mistake when it rethinks them again is anyone’s guess. Our guess is that there are more “mistakes” to be uncovered because, as we will explain in some future Daily Reckoning ramble, the whole proud tower of modern financial business is based on a compounded series of frauds, subterfuges and mistakes-waiting-to-be-discovered. In retrospect, the $15 billion investors wiped from AIG’s market cap may turn out to be wishful thinking. The losses could go much, much higher and take many years to be discovered.

Nevertheless, there’s a whole ocean of difference between an island nation with huge savings, a thrifty population and an enormously positive trade balance, and a stretched-out empire, possibly in decline, running record deficits in its external trade and internal government finances, with an aging, over-paid, over-indebted workforce. The former can tolerate deflation. The latter hasn’t got the stomach for it.

*** The big news yesterday came from the currency markets and gold.

“Ben talks, dollar falls,” was the NY Post ’s take on it.

“Another day, another crisis for the dollar,” was how the Financial Times described it.

The crisis in the dollar is simple enough. Ben Bernanke has made it plain that the Fed has its guns trained on deflation. While it fires away, it takes incoming from inflation behind it. The currency markets expect another rate cut in Washington...while in Brussels, the European Central Bank turns its hard face to inflation. What’s a currency speculator to do? He trades his dollars for euros.

Yesterday, the euro hit another record high against the dollar, at over $1.52 cents.

But it’s not just the euro that is rising. Our Latin American correspondent, Horacio Pozzo, says you only have to look at the dollar index to see that the buck is falling against ALL major currencies.

Your poor editor is out of luck. Whether he spends his money in pounds or euros or pesos, he gets less for it practically every day. His lonely exile not only separates him from the land of his birth but the purchasing power he once enjoyed. When he was born, the dollar was not only a respectable currency, it was a desirable one. By 1948, it was already down to about half what it was worth at the turn of the century. But the worst was still ahead. Since then, it’s lost nearly another 90% of its value.

Not only is the buck retreating against other currencies, take a look at the commodities market and you see it losing ground against practically everything else. The CRB index is up to 566 – a new record.

And gold? What is happening with our old, yellow friend? How fare’s thee?

Not too badly, it turns out. Gold, too, is reacting...spectacularly . Yesterday, the price of an ounce of gold shot up more than $11 to bring the price to $973. Yes, you guessed it, a new record high. And this happened just days after an announcement that the IMF will sell some of its gold reserves in order to fund its operations.

Soon, the price of gold will hit the $1,000 mark. Then, you will see something unusual, something exciting, something remarkable. You will see the bull market in gold enter a third stage. At first, only the goldbugs bought the stuff. At $300 an ounce gold was a no-brainer. Then, a few savvy investors and sovereign governments began accumulating gold, gradually bidding it up. But now, as it heads over $1,000 – the bull market in gold is going public. It’s going to make headlines. People will start talking about it. Soon, ordinary people are going to start buying gold and then speculating on gold.

Yes, dear reader, gold fever is about to hit...the third stage of a bull market. How high will this fever take the gold price? We don’t know...$2,500 maybe. It could go into bubble territory too – perhaps up to $5,000. Anything could happen and probably will. Make sure you’re prepared.

But as we said yesterday, there’s only one thing that bothers us with this prediction – it’s too obvious.

What could go wrong? Could Ben Bernanke suddenly wake up as Paul Volcker? Or could deflation strike so hard it sucks inflation out of the system so fast the feds can’t put it back? Could gold stagnate around $1,000 or lower as the economy enters a deep, dark downturn, perhaps followed by a desperate push to get money into circulation, including dropping it from helicopters, as Bernanke once promised? Could the resulting hyperinflation render the dollar completely worthless?

We’re thinking...we’re thinking...

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