LOS ANGELES, CA -- Jeffrey Gundlach leans back in his chair, and rolls what seems to be a puff of smoke around in his mouth. Actually he's not smoking a cigar, but Gundlach -- the chief investment officer of Trust Company of the West, and one of the best money-management brains on the planet -- often seems to be savoring the words that are about to emerge.

"Inflate," he says.

That simple? My question was, "President-Elect Obama calls you up and says, 'what should I do?'"

The paradox of unthrift

"I don't see what the alternative is -- any more than I did in February," Gundlach continues, a reference to a meeting we had in his office, when Gundlach predicted the S and P 500, then trading at $1200, would likely reach $400 in the absence of an aggressive Fed easing.

"The alternative they're pursuing is to bail out the victims of default one at a time, piecemeal, every day another crisis," he continues. According to Gundlach and others -- such as Tim Ryan, CEO of the Securities Industry and Financial Markets Association -- the prospect of $1 trillion or more being passed out in an orgy of secret Treasury Department deals and congressional pork-barreling, over agonizing months of political wrangling, may actually be contributing to the illiquidity in the securities markets.

The possibility of a bailout, down the line, encourages everyone who holds a deflated asset to hang on and hope for a turnaround later -- in much the same way many home-sellers hold out for months and years, awaiting the upturn. What's the worst that can happen? A default, which, for many -- both individual homeowners, and banks themselves -- is a not unattractive process. Better to start drowing, and be saved.

The impact of the bailout, especially as it now morphs into a $1 trillion superfund that might be spent on anything from insurance and auto companies, has been to lock in place a huge spread in the mortgage-backed securities market -- between the 20 cent bid price Merrill Lynch was forced to sell out for, and the 60 to 65 cent ask that financial institutions would like to receive.

In describing the Great Depression, John Maynard Keynes described the "paradox of thrift" in which hoarding assets, at a time of deflation, did not automatically self correct, but simply worsened the thirst for liquidity, as people removed cash from the economy. There may be an analogous paradox of the TARP bailout -- which stands for Troubled Asset Relief Program -- at work today.

"If you're going to spend a lot of money in that kind of process," Gundlach concludes, "you might be a lot better off just increasing the subsidy from Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE)," say from 800 basis points today to 1200 basis points. The process would be simpler, and, as well, would increase everyone's home equity and cash flow.

That in turn would give those who now have zero, or even substantially negative, equity in their home, an incentive not to simply give up -- mitigating the "culture of default" that is operating throughout the economy.

Monetary vs. fiscal bailouts

But if a recovery of nominal asset values is the proper end, there's an even simpler means, one used by governments in a net debtor position for more than 10,000 years. "We have to inflate," Gundlach repeats.

Of course, by inflation, Gundlach does not really mean a mindless, 1970s style expansion of liquidity without limit. When a banker like Gundlach advocates "inflation," he is being un-bankerishly saucy, as Gundlach is apt to do.

Instead, what he means is a one-time adjustment of prices, followed by, hopefully stability. "You need to reset the price level," he puts it. To do otherwise is like trying to get your computer to work properly when the screen has frozen up. Time to reboot.

Is $2.25 a gallon for gas, not to mention $750 gold, really a deflation? Both are substantially above their levels of several years ago. But then, so are prices for homes, commercial real estate, stocks, and most other assets. Do we really want to return to the price level for home values of, say, the year 2002?

At the same time, the movement of gas and gold is a sharp deflation from the peaks of close to $4 and $1000, respectively. At that time -- from last fall and into this spring -- the housing market correction had already begun, and a correction in equities appeared to have stabilized.

Investors simply assumed, and maybe thought they observed, that the Fed would do what was needed to protect asset values the housing market, which in turn underlies the global financial system. Commodities surged, and the stock market, after an appropriate early-2008 slump, actually stabilized.

Inflation and toothpaste

"You have to think in three dimensions," as Jude Wannisky once put it. In a modern economy, with widespread securities ownership, labor contracts that don't provide for falling nominal wages, and a derivative-based financial system, inflation and deflation are not simply two opposite and symmetrical processes.

A change in the price level, rather, is more like toothpaste. Inflation is pushing the toothpaste out of the tube. Deflation is an effort to push it back in. You don't want to push it back in. But that is what monetary authorities, despite the low historical level of interest rates, are attempting to do, egged on by many of the world's leading economists and financial journalists.

"In June, the Fed was still talking about inflation risk," Gundlach sighs. "Inflation risk?"

"Look," he continues, "if nobody wants to listen about the deflation, there's a simpler way to do it that might sound more appealing to people. You want to know what to do, Mr. President? Pay the Chinese. That's right. Just send them a couple trillion dollars."

"There's some country in Africa that has a one trillion unit note -- a trillion Zimbabwean dollars, or whatever it is. Just print up two or three of those, and send them to the Chinese. It's the classic debtor's solution, and we are a nation of insolvent debtors."

How to reflate

For policy-makers, the right way to execute a reverse-deflation -- and then stop -- is to perform a careful calculation based on wage rates, debt levels, exchange rates, and so on.

You reset the gold price to a healthy, high-employment level; adjust exchange rates accordingly; and then fix the global monetary system to gold, ending the ability of well-meaning elites to mismanage money one way or another. This is the policy adopted by the world at Bretton Woods, NH in the waning days of World War II.

For a thumbnail analysis, however, the true collapse in home values and equities began after gold began to fall below $1000, and oil and gasoline with it. It would seem that, at the least, prices need to return to those levels for there to be health in the housing and banking sectors. HIgher, if we want a margin for error.

"Bottom Line," of course, is wonderfully indifferent to whether policy-makers to their job, and more concerned with what Gundlach calls "a once-in-a-lifetime investment decision" -- when to turn your current shorts into a fully-invested long portfolio.

The Bottom Line

Having sold off a two-week Obama rally on November 4 and returned to an aggressive short position across the board, we're already advising clients to nibble at commodity stocks across the board. Commodities, unlike housing, are unencumbered by the prospect of a bailout, and will tend to respond promptly in the advent of a monetary easing -- just as they did from September to January, as the markets incorrectly anticipated a substantial Fed easing.

Once the commodities turn up, equity markets should follow. Today's thirst for liquidity will become a thirst for tangibles; the bid on mortgage-based securities will rise to meet the ask; and those neighbors down the street will finally sell their home, and at a reasonable, which is to say, market, price.

Watch the statements by policy-makers at the forthcoming monetary conference, and, more important, actions. The Fed is reportedly hesitant to go much further because, at the current Fed funds rate, "we're running out of bullets."

Which is why, when the Fed does cut again, it will signal the long-awaited capitulation, putting U.S. monetary policy in line with its real-world status as the world's greatest deadbeat. Paradoxically, that will be the time to cover your U.S. shorts, and buy.

(Gregory Fossedal is managing editor of Freedman's LLC. He is the author of numerous books on financial and political history, including "Our Finest Hour... Will Clayton, the Marshall Plan, and the Triumph of Democracy.")