Big news yesterday: gold dropped $36.50 – to $828.

Oh la la...and our “Trade of the Decade” – long gold, short stocks – still has a year and a half to go. Looks like we should have ended this trade a few months ago, when gold was pushing up to $1,000.

What’s going on?

Well, it appears that the feds are losing the battle. We have the ‘stag’...but no ‘flation.’ All over the world, in almost every sector of the economy, prices are falling. Inflation is on the run – or so it appears today.

Housing prices are on the decline in America, Britain, Australia, Ireland, and Spain. We don’t know about other markets. They are said to be still rising in Brazil and other emerging markets. But we wouldn’t bet on it.

Commodity prices have been going down for about two months. After hitting a high of $147, oil has slipped all the way down to $114.

Stock markets are down all over the world. Most indices are off 15% to 20% for the year, except for China, which has been cut in half.

Even the dollar is showing signs of deflation – it’s going up! Not only are the things it buys becoming cheaper, it is also gaining ground against its archenemy, the euro. Yesterday, the euro fell below $1.50.

“The inflation rate is going to come down,” said an economist at Lehman Bros. Most economists agree. And so do investors. TIPS are U.S. Treasury notes that are adjusted to inflation. Investors pay a premium for them in order to get the protection of the feds’ inflation adjustment.

Thus, the yield spread between these notes and regular 10-year Treasuries is a good measure of how much inflation investors expect. And currently, the yield has dropped to its lowest point in nearly five years.

What is the reason for this stunning defeat of inflation? How come the central banks and financial authorities aren’t better at what they do best? The latest numbers we have show them trying hard.

Money supplies worldwide are increasing at about 20% per year – five times faster than the rate of economic growth. According to theory, if the supply of money increases faster than supplies of goods and services inflation will result. Is the theory wrong? Or is something else is going on?

Yes, something else is going on. The world economy is cooling off. After running so hot for so long, a chill wind is blowing. It began almost exactly a year ago – on August 9, 2007 – when the subprime story broke. First, the homeowners got in trouble. And then, the builders. And then the lenders. And then the investors who lent to the lenders. The problem mounted up the financial ladder like a crusader scaling the walls of Constantinople.

For a long time, it looked as though the go-go economies of the Far East...and the commodity producers...would be able to hold them off. The world economy had “decoupled,” it was said – with the emerging economies continuing to grow while the old economies of Europe and North America were in a slump. With this huge new demand in front of them, commodities markets continued to move higher...even as stock markets and housing sank.

But now, it looks as though nothing will be spared. Everything is going down. Gold, stocks, property, copper, inflation, GDP growth rates, consumer spending, car sales, student financing, employment, house sales, housing prices – everything.

And against all this...the dollar is going up.

But what does it mean? Well, no one knows.

Expansions are typically inflationary. Contractions are typically deflationary. But we knew that. What we didn’t know was whether there would be enough juice in the emerging markets to keep the world economy growing...

...and whether the feds could effectively re-inflate – with their bailouts, handouts, and monetary cop-outs. The answer to those questions seems to be ‘no.’ But the matter is far from settled. No economist has ever seen a world money system such as the one we have now. No one knows how it will react to the stress of a major contraction.

So, we’ll hold onto our gold a bit longer...and wait to see what happens next.

*** Greenspan’s “Age of Froth” is over, sayeth the columnists. The Bubble King is no longer at the Fed. And the bubbles seem to have come to an end. Now the headlines are depressing; the losses are mounting; and the lawyers are circling.

At least, that’s the word on the street.

“Economic Slump in US to Worsen as Consumers Get Squeezed,” says a headline at Bloomberg.

They’re probably right about that. The longest-running increase in consumer spending, which began in 1992, is coming to an end. And the unemployment rate is expected to reach 6% before the end of the year.

Consumers – with lower income, less credit, and falling house prices – must feel like they’ve been caught in a vise. They’ll wiggle and complain; but what can they do but cut back? And a cut back in consumer spending marks the end of the booming consumer-driven, credit spiked economy of the last 16 years.

But does it also mark the end of the bubbles? Of the sturm and drang in the financial markets? Is the dollar now as good as gold – or better – now that the froth is gone?

Our intuition tells us that it ain’t quite so. The feds are still inflating – or trying to. Speculators are still speculating. People still believe in the dollar...and in the dollar-based monetary system – even though it’s the very same system that has created so many problems for so many people. And even now, after 10 years of negative real returns, most investors still believe in “stocks for the long run.”

We anticipate a major change in consumer/investor attitudes – but it hasn’t come yet. Consumers – especially baby boomers – must stop spending and begin saving. And since they are so far behind, they must begin saving as if their retirements depended on it – which they do.

And investors need to change their way of looking at things too. You can’t have another great bull market in stocks until investors have given up on them. Speaking more broadly, you’re not likely to have another big run of profit from investments until investors stop looking for them...

These changes of attitude don’t come easily...or painlessly.

Another sign of the times: “prime” borrowers are defaulting on their home loans at increasingly high rates. Last month, reports CNN.com, JP Morgan Chase CEO “called prime mortgages ‘terrible’ and suggested that losses connected to prime may triple. For the second quarter, the bank reported net charges of $104 million for prime rate delinquencies, more than double the $50 million recorded three months earlier.”

WaMu reports similarly disturbing losses and it is clear that this latest trend is doing nothing to help the already struggling housing sector on the road to recovery.

*** But let us imagine that the bubbles are over...what would the world economy and the world’s markets look like?

A few years ago, along with Addison, we wrote a book called Financial Reckoning Day .

Our guess was that the United States would follow Japan into a long, slow, soft slump. Prices would fall. Consumers would stop consuming. Families would begin saving again. Investors would be wary of the stock market. And speculators would go broke.

We were wrong. Instead, the Greenspan Fed set its key borrowing rate at 1% and left it there for over a year. Anyone who wanted to borrow money could get it – on the easiest terms ever.

No credit?

No problem! This money giveaway set the world on the most reckless period of borrowing and speculation the planet had ever seen.

But we are at the end – or near the end – of that period now. And what if the great slump that we saw coming in 2001-2002...came six years late? And what if it weren’t limited to the United States, but gripped the whole, globalized world economy?

What if prices fell across the board? What if consumers in the West stopped consuming...putting workers in the East out of jobs? And what if the world didn’t really need so much oil, or so much copper, or so much other ‘stuff’ after all?

What if the whole world entered a long, slow, soft Japan-like slump?

It’s just a possibility, dear reader...just a possibility. We tend to prepare for the worst...because if the worst doesn’t occur, at least you’ve made some money in the process.

Until tomorrow,

Bill Bonner