The fog of war – that is, in the “war” between inflation and deflation – is lifting. We’re beginning to see more clearly which way the battle is going.

“America’s giant mortgage companies nationalized,” is how Le Monde treated Monday’s big story. “The biggest bailout in history...” it went on.

But what does it mean when the world’s most free-market government nationalizes its largest finance industry? It means a couple things:

First, that the days of “laissez-faire ”, even ersatz laissez-faire , are over. No more deregulation. No more tax cuts. No more free trade agreements.

Second, that the feds are running scared. They are in retreat. The battle between a natural market correction...and an unnatural, inflationary boom...is going against them.

We were right all along – or almost right; when the dot.com bubble burst it marked the beginning of the end – the end of the bull market on Wall Street...the end of the credit expansion that began in ’82...and the peak of American power and influence in the world.

The decline since then has been delayed and disguised – by a flood of new liquidity from the feds. But now, there’s no stopping it. And it’s much worse than it would have been eight years ago...since Americans became more and more used to spending money they didn’t have; they have more debt than ever. And because the Chinese and other foreigners became more and more used to selling things to people who couldn’t pay for them; now their new apartment buildings are empty and their new factories are quiet. And now, the downturn is global...and it will be longer, and harder, than practically anyone imagines.

This just in: “Top China developer’s sales fall sharply.” Maybe it was the distraction of the Olympics, but China’s biggest listed property developer, Vanke, said sales fell 35% last month.

And this too: Yesterday, gold fell more than $30 – to $757. The euro rose to $1.40. Oil is rising this morning, on fears of Hurricane Ike, but it closed yesterday at $102. Our guess is that it will sink to the $70 range.

*** And here’s Le Monde again:

“Good news, finally...almost everywhere, inflation remains under control and in retreat.”

Wrong. Wrong. Wrong. Inflation may be in retreat. But it’s not good news. It means the whole world is sinking into a slump – not just the United States and Britain.

And that’s what the feds are afraid of. Sec. Paulson justified the takeover of Mac and Mae on the grounds that the markets and the taxpayers needed “protection from a systemic risk.”

What was the risk? That both Freddie and Fannie would go broke, that houses would fall to what they were really worth, and that – when the federally-chartered agencies stopped paying their debt to foreign lenders – the whole world financial system would melt down. Driven by fear...Paulson took the bold action...

And now...for the next act:

The U.S. economy has grown during these last two decades. But it has grown only because consumers have been willing to go deeper into the debt. This was not good growth. It was not healthy growth. But at least it was growth.

You get growth by spending money. If the consumer spends – it is growth in retail, consumer items, services, and so forth. If business spends – you get more jobs, more capital equipment, more buildings, trucks, computer programs, etc.

But what if neither consumers nor business is willing to spend?

Sunday’s government takeover of the U.S. mortgage finance industry looked like a godsend to many investors – and to Le Monde . The government made it clear – if it weren’t already obvious – that it wasn’t going to abandon its two federally-sired mortgage twins, Fannie and Freddie. More importantly, it signaled that the feds were ready to spend.

Bill Gross’s PIMCO made $1.7 billion by betting on the bonds of Fannie, Freddie and other agencies. You could have made some money too. We explained the “Paulson Doctrine” in these pages – which guaranteed the bonds would eventually be saved – several weeks ago. The Paulson Doctrine maintains that the feds will let the shareholders take losses – but not the bondholders. Why? Because the largest bondholders are foreign countries – notably China. And America desperately needs more credit from these large, overseas financiers. Foreigners hold trillions of U.S. dollars and U.S. dollar-denominated debt. If they begin to fear the government is not behind it, they’ll dump it fast – which would be the end of the current dollar-based monetary system.

So, the move to bring Fannie and Freddie under direct government control was widely seen as a plus for everyone. Foreign lenders know the game is still rigged – so their money is safe. Homeowners think they’ll be able to continue living at someone else’s expense. And investors hallucinate that the government has “done something” to put this mess behind us.

But we have a question: Where do the federales get the money? The slump – though it has barely begun – has already clipped corporate and individual tax receipts. Plus, social welfare programs are becoming more expensive.

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