How do you know when you’re "through the looking glass?"

One terrific clue is when the price of gold - which normally moves up in response to monetary easing - instead plummets in reaction to one of the largest interest-rate reductions in U.S. Federal Reserve history.  Apparently, the 12% decline in gold prices last week [with half of that coming in a single day] resulted from the "hawkishness" shown by the Fed in only cutting rates by three quarters of a percentage point, instead of the full percentage point that many had expected and most had wanted.

That 12% decline - gold’s biggest weekly loss in 25 years - is a testament to how low the bar has been set that the Fed can slash rates in the face of a collapsing dollar and soaring commodity prices and still be viewed as hawkish on inflation.  Is it just me, or is central bank Chairman Ben S. Bernanke morphing into the Mad Hatter?

Despite the mildly tough language in its statement, it should be clear to all that the Fed sees inflation as the only politically acceptable "solution" to the problems it created. The conclusion that a three-quarter-point cut shows concern about inflation is half right.  The Fed is concerned, but only to the extent that the markets stay focused on bogus Consumer Price Index (CPI) numbers and fail to notice severe price increases throughout the economy.  The fact is that inflation will be with us for some time, and the knee jerk drop in gold is yet another excellent buying opportunity.

As the credit and financial crisis spirals out of control, and the Fed moved $30 billion of garbage Bear Stearns debt onto the public balance sheet, the proposals coming from other market leaders are taking similarly phantasmagorical turns.  Magazine publisher and perennial presidential candidate Steve Forbes, in an interview on CNBC-TV early last week, proposed that the government suspend "mark-to-market" rules for one year so that holders of unsellable mortgage-backed securities no longer have to recognize losses.

Remember, the dominos began to fall precisely when two Bear Stearns Cos. Inc. (BSC) hedge funds were forced to actually sell assets they had failed to properly mark-to-market.  Were the government to actually follow this advice it would destroy what little confidence remains in our financial system.  However, Forbes believes that the markets can be spared unnecessary pain if participants can simply pretend that their holdings are worth par value.  This amounts to a plea for accounting by "mutually beneficial mass delusion."

Later in the week, investors were cheered by the government’s decision to slash the surplus capital requirement of already overextended Fannie Mae (FNM) and Freddie Mac (FRE) by 33%, and by Wall Street’s success in convincing investors to dump $17.9 billion into the record U.S. initial public stock offering of Visa Inc. (V) [$19.65 billion if you factor in the over allotment provision] - which may qualify as the largest sucker bet in history.  But the most bizarre idea was introduced on the pages of The Wall Street Journal when veteran opinion page writer Holman Jenkins Jr. recommended that the government buy and "bulldoze" foreclosed homes in order to prop up the values of those that remain standing.  I’ll deal with these ideas in sequence.

After the government pushed through some earlier proposals that allow and encourage Fannie Mae and Freddie Mac to buy larger loans, the resultant reduction of capital requirements now pushes the government-sponsored lenders farther out on a well leveraged limb.  By allowing the accumulation of even more taxpayer-guaranteed debt, the moves will merely delay and exacerbate the housing problems and will increase the size of losses when these two government-sponsored enterprises ultimately fail.  In the meantime, by taking on more risk, the appeal of existing Fannie-and-Freddie-insured debt will erode further, driving up mortgage costs, and creating additional losses for leveraged owners of these securities.

In the early stages of the biggest credit crunch in U.S. history, buying shares in Visa, a company that derives its revenue based on transaction fees from credit-card purchases, qualifies as a particularly ill-timed investment.  Perhaps buyers of these shares didn’t get the memo, but the days of Americans using credit cards to buy products they cannot afford are about to come to an end.  For all its flaws, Wall Street does possess an extraordinary ability to apply lipstick on any pig.  For the formerly private owners of Visa, this is perhaps one of the best exit strategies ever engineered, on par with last year’s Hail Mary pass tossed up by top hedge-fund player The Blackstone Group LP (BX) last year [shares of Blackstone are now trading for half their IPO price].

Finally, in response to Jenkins’ proposals, there is no question that we built far too many homes during the housing bubble.  However, destroying them now will merely compound our losses.  The one benefit we have from excess construction is an ample supply of what will soon be highly affordable homes.  At the moment, foreclosed houses are only unwanted because their prices are still too high. Once prices drop sufficiently, there will be plenty of demand.  However, destroying existing homes reduces their value to zero [actually less due to demolition costs], and only exacerbates the losses to creditors and society.  Jenkins’ thinking is formed by the same perverse logic that led the Roosevelt Administration to destroy farm animals and crops during the 1930s because President Franklin D. Roosevelt wanted to prop up food prices.  As I wrote in my book, "Crash Proof: How to Profit from the Coming Economic Collapse," we must certainly be on the eve of our financial destruction - as we are clearly a nation that’s now mad as hatters.

[Editor’s Note: Money Morning Guest Columnist Peter D. Schiff is the president of Euro Pacific Capital Inc., a Darien, Conn.-based broker/dealer known for its foreign-markets expertise. A well-known financial author and commentator, Schiff is a regular Money Morningcontributor, and has most recently written about the fiction of the Bush Administration’s professed "strong dollar policy", the futility of "juicing" the economy, speculative bubbles and soaring gold prices. In mid-August, when analysts were touting beaten-down financial shares, Schiff said the stocks were "toxic," were destined "to get hit hard," and advised investors to "stay away." Investors who heeded that advice, and avoided such shares as Merrill Lynch, also avoided some stressful, subprime-induced losses. Check out Schiff’s first book, "Crash Proof: How to Profit from the Coming Economic Collapse," which was published by Wiley & Sons last February.]

News and Related Story Links:

• Wikipedia:

  The Mad Hatter.

• Wikipedia:

  Through the Looking Glass.

• Money Morning News:

  Congress Passes $168 Billion Stimulus Package.

• Money Morning News Analysis:

  Two Bear Stearns Hedge Funds Declare Bankruptcy, a Third Freezes Assets.

• Money Morning Financial Analysis:

  Commodities Fall Out of Favor as the Dollar Strengthens.

• Wikipedia:

  Hyperinflation

• Money Morning Commentary:

  Here’s Why the Steroid Stimulus Today Can Only Lead to Inflationary Pains Tomorrow.

• National Review Online (NRO):

  Bruce Bartlett Commentary: Bush and the Buck - A Weak-Dollar Policy is a Mistake.

• Money Morning Commentary:

  Until the Fed Feeds Us More Salad and Fewer Twinkies, Speculative Bubbles Will Remain a Risk

• Money Morning Economic Analysis:

  Slow Growing U.S. GDP Unchanged Sending Markets and Dollar Lower.

• The Wall Street Journal:

  Goldilocks Economy.

• Money Morning Financial Analysis:

  Despite its Billion-Dollar Loss in Blackstone Deal, China SWF CIC Sees the Bigger Picture.

• Money Morning News:

  Fannie Mae and Freddie Mac Poised to Boost U.S. Mortgage Market.

• Money Morning News:

  After its Record U.S. IPO, Visa’s Shares Post Double-Digit Gains for Second-Straight Day.

• Money Morning News Analysis:

  With Latest Rate Cut, Fed Tries to Find Balance Between Recession and Inflation

Profits Are Up 1,056.2% for This Wisconsin Company

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