The Dow rose 40 points yesterday.

Remember our hypothesis: that the feds’ inflation will show itself much more prominently in gold and commodity markets than in the stock market, and that deflation will hurt stock and property prices more than it hurts the price of gold.

Yesterday didn’t prove anything. But it provided a nice illustration.

While stocks barely budged, gold, oil, and commodities all hit new record highs.

Gold is now so close to the $1,000 it can feel the body heat. It jumped $22 yesterday to end up over $988. The CRB also hit a world record and the price of oil closed over $104.

While gold, commodities and oil soar, price deflation in the housing market brings millions of Americans closer to sanity. They’re finally realizing that they can’t get rich by spending money they don’t have on things they don’t need.

Bankruptcy filings rose 18% in February. One of the big mortgage lenders, Thornburg (TMA), of Santa Fe, New Mexico, defaulted on a $320 million loan. Investors sold the stock. Just a week ago, it was a $12 stock. Now it’s a $3 stock.

Everything is getting ‘marked to meltdown,’ says the Wall Street Journal. Lenders approach a new loan as they might come upon the rim of an active volcano, worried that it might blow up in their faces at any minute. Yields on auction rate financing for municipalities and hospitals have almost doubled. And when the auctions fail, they can really explode. That’s why the Port Authority found itself paying a 20% rate on money it needed.

All of this is tempting the feds to intervene. Look at it from their point of view: if they do nothing and things get worse, they’ll be accused of inaction, or worse, insensitivity. Nothing is worse than inaction. The people curse it. The professionals loathe it. Doing nothing is always and everywhere detested by practically everyone. In marriage, it is grounds for annulment. In business, it is cause for dismissal. And in war it is a ticket to a court martial.

Of course, an economy is never inactive. It is always doing something – as millions and millions of people go about their business as best they can. When the feds ‘do something’ to an economy, it is not as if they were writing on an empty piece of paper. Instead, they are scratching out the verses written by private citizens and replacing them with their own clumsy doggerel and pushing the economy in some direction it doesn’t want to go. Sometimes they are successful – as, for example, at the beginning of this century, when a torrent of new cash and credit produced the world’s biggest housing bubble. But sometimes, Mr. Market insists on going where he wants to go.

After five rate cuts and one massive tax rebate program, the feds are wondering what to do now. The New York Times reports that Bush and Bernanke are “inching towards” a federal bailout of homeowners. Already, Bernanke has been urging bankers to forgive a portion of their mortgage loans. And Rep. Barney Frank, who wrote in the Financial Times recently that laissez-faire capitalism was all very wel as long as politicians got to tell the capitalists what to do, has proposed that the federal government buy distressed mortgages. George W. Bush, who will go along with anything, is said to be studying the legislation with the sharp eye of a Helen Keller.

A bailout is probably coming. But will it work?

More and more observers seem to be coming to the conclusion we reached – prematurely, it turned out – at the end of the ’90s.

Morgan Stanley’s Stephen Roach:

“The current recession has been set off by the simultaneous bursting of property and credit bubbles. The unwinding of these excesses is likely to exact a lasting toll on both homebuilders and American consumers. Those two economic sectors collectively peaked at 78 percent of gross domestic product, or fully six times the share of the sector that pushed the country into recession seven years ago.

“For asset-dependent, bubble-prone economies, a cyclical recovery – even when assisted by aggressive monetary and fiscal accommodation – isn’t a given. Over the past six years, income-short consumers made up for the weak increases in their paychecks by extracting equity from the housing bubble through cut-rate borrowing that was subsidized by the credit bubble. That game is now over.”

Roach goes on to compare America, circa 2008, to Japan at the end of the ’80s. Japan ran loose credit policies in the ’80s, which led to bubbles in stocks and property. America’s loose monetary policies of the ’90s led to a bubble in the stock market and then an even bigger bubble in housing in the ’00s. Faced with a meltdown in the ’90s, Japanese authorities knew they had to ‘do something’ and they did – they took the recommended doses of both fiscal and monetary policy. But the medicine didn’t work.

“The toughest, and potentially most relevant, lesson to take from Japan’s economy in the 1990s,” Roach continues, “was that the interplay between financial and real economic bubbles causes serious damage. An equally lethal interplay between the bursting of housing and credit bubbles is now at work in the United States.

“American authorities, especially Federal Reserve officials, harbor the mistaken belief that swift action can forestall a Japan-like collapse. The greater imperative is to avoid toxic asset bubbles in the first place. Steeped in denial and engulfed by election-year myopia, Washington remains oblivious of the dangers ahead.”

We’re not sure they’re oblivious to the dangers; we just doubt that they can do anything to make things better. On the other hand, we don’t doubt that what they will do will make things worse.

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