Whither goes the money? Are bad debts written off balance sheets as easily as they were once written on them? Does the money just go up to money heaven, back into the "thin air" from whence the Fed first drew it out?

We were wondering yesterday about the debt bubble. Can debt levels continue to rise forever? And what happens when a debtor cannot pay? No harm done, right?

Our head aches and our knees wobble at the thought of it. Even without thinking, we know it can't be so. Nature has her limits, her penalties and her dirty tricks. In debt, as in dollars, quality and quantity vary inversely. The more debt a man takes on, the more he has to struggle to keep up with it. The quality of his IOU declines. "Will he really be able to make good on his commitments?" lenders ask themselves.

Logically, if not consistently, lenders demand higher rates of interest. Higher rates increase the weight of debt throughout the economy. A man who must borrow to continue living in the style to which he has become accustomed must shoulder more debt at higher rates - making him even less able to pay. At the margin, debtors begin to buckle at the knees. Credits go bad. Bankruptcy courts and workout companies start hiring extra hands. That is what we see happening in Britain and America today.

But, apart from the overburdened lender, is anyone really worse off? The credit may have been created "out of thin air" by central banks...doesn't it vanish just as painlessly? Alas, no.

When a lender doles out a million pounds to a borrower, both of them now feel they have money to burn. Imagine next that the borrower takes an extravagant vacation around the world. The money does not vanish into thin air. Instead, it goes into travel expenses: jet fuel, swanky hotel rooms, pricey bar tabs. It goes not up to heaven, but down to earth, where it is used up, and vanishes forever, like a lover's last kiss or a smoked cigarette. And it does not vanish without a trace. You are left with a bitter aftertaste and the burnt-out stubs.

First, the borrower goes broke. Then, when the lender goes to collect, he finds that he is broke, too. And somewhere in Sri Lanka or San Martin is a hotel proprietor standing in front of a brand new wing of rooms. He wonders what's happened to his free-spending customers. What happened to the sound of ice cubes at cocktail hour and the smell of foie gras at lunch? He worries about how he'll pay the mortgage he took out to pay for his new addition.

As the credit cycle continues to turn down, there are fewer people with money in their pockets, and more capital investments that don't really make sense anymore. In short, the money doesn't ascend into money heaven at all. Instead, it becomes a steel ball and chain clamped to the ankles of investors, businessmen and consumers...one they'll drag around for years. Not only have the borrower and the lender no more money to spend, but now the hotel owner has thrown away his money on that suite of luxury rooms that no one wants. He'll either have to eat into his own income or capital to keep the thing going...or go bust, too.

Fraud begets fraud...swindle begets swindle...error begets error and the whole cycle soon becomes woebegotten. In America today, the Fed's phony new money - created out of thin air - feeds phony house price increases that turns into phony consumer demand that coaxes businessmen in China to make bad capital investments. When the cycle tops, almost everyone everywhere will feel the pain, because the funny money drew out real resources - oil, labor, steel - that might have been put to better use.

Don't get us wrong; we love the Fed as much as everyone else. In the Soviet Union, resources were misallocated by force. In the Fed's empire, they are misallocated by fraud. This is undoubtedly a big improvement; for one thing, it is much more entertaining.

Bill Bonner, back in London with more thoughts ...

*** A quick note from our currency counselor, Chuck Butler:

"2006 will be a more difficult environment to define clear U.S. dollar trends, according to Morgan Stanley economist, Stephen Jen.

"He points out that the technical picture is beginning to point toward U.S. dollar shorter-term strength against the euro in the completion of a wave 'B' move, which would then signal a larger wave 'C' weakening of the U.S. dollar.

"OK. So, we've got short-term dollar strength, followed by a larger move down in the dollar. I would prefer to eliminate the short-term dollar strength, but I can't always get what I want!"

*** We checked the chart. Gold looks as though it "should" correct to about $500. The trouble is, markets don't always do what they "should" do. Often they do the opposite.

And while long suffering readers of The Daily Reckoning were probably breathing a sigh of relief on Mr. Greenspan's retirement from the Fed and congratulating themselves that they wouldn't have to read any more of him, we came across this remarkable headline on page 45 of the Wednesday Times of London: "Terror threat responsible for high gold price - Greenspan."

The former chairman may have left his post behind, but he also left his mark. And he hasn't yet left the public limelight. In his first private sector speech since being let off the leash of officialdom, the ex-maestro, and erstwhile most powerful man in the world, "blamed the threat of terrorism for the soaring gold price." According to the article, Mr. Greenspan earned $120,000 for his one-hour speech.

A rush of questions came over us. Why would he say such a thing? Is the threat of terrorism twice as high as it was on 9/11? Did the threat of terrorism go up 25% last year?

Is the man now managing his own investments (they were in a trust while he was in office)? Could he be short gold and just trying to drive the price down to cover his trade? Or is it possible that he is still on some leash? Or...is the 79-year-old going out of his mind?

We may never know the answer, but while the price of gold tumbled on Wednesday, Thursday brought no follow-through. Gold was stable. Here at The Reckoning, we watch...and wait.

*** We pity poor Ben Bernanke. We have a feeling he doesn't know quite what he's gotten himself into. Greenspan was wily, cynical, and opportunistic. He had been an objectivist, and an acolyte of Ayn Rand. He knew how the Fed worked and he knew how to look out for Number One.

But Bernanke, from what we can tell, is a believer. He earnestly believes he can regulate the economy by jiggling rates. He thinks running a central bank is a matter of skill and judgment. Greenspan knew it was just luck and treachery. The former chairman must have blessed his predecessor every day of his reign for providing him with such a delightful economic balance sheet to run down. The present chairman is likely to curse his predecessor every day of his - when he finally figures out what it is that Mr. Greenspan has really accomplished.

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