In a matter of weeks, the euro has been pounded into pulp while the dollar has regained much of its former glory. The mighty greenback has surged 6 percent in the last month alone.

Apparently, the early reports of the dollar�s demise have been greatly exaggerated. The euro, on the other hand, has been caught in the same recessionary-downdraft that is buffeting a number of other currencies, all of which are unwinding at the same time although unevenly.

Currency markets don�t move in straight lines. But don�t be fooled, most paper money is steadily losing value due to the unprecedented expansion of credit which started at the Federal Reserve. Investors are moving to cash and hunkering down; the stock and bond markets are just too risky and real estate is in a shambles.

As Greenspan�s massive equity bubble continues to lose gas, balance sheets will have to be mended and lending will slow to a crawl. At present, Germany�s slowdown and Spain�s housing crash are drawing most of the attention, but the spotlight is shifting fast. Next week it could be shining down on America�s failing banking system or poor corporate earnings reports in the US. Then it will be the dollar marching off to the gallows.

Europe�s troubles have put to rest to idea that other countries can �decouple� from the US and prosper without the help of the US consumer. That might be true in the long-term, but falling demand is already visible everywhere. Retail and auto sales are taking a thumping and 2009 is shaping up to be even tougher.

It�s looking more and more like the European Central Bank was faked-out by the early signs of inflation and missed the deflationary sledgehammer that was about to come crashing down. It was a rookie error by European Central Bank (ECB) chief Jean Claude Trichet and it could cost him his job. Raising interest rates while sliding into the jaws of recession is madness. Now all of Europe is headed for a hard landing and there�s no way to soften the blow. The ECB doesn�t have the same tools as the Fed; Trichet can�t simply backstop the whole system with green paper and T-Bills like Bernanke. He can either slash rates or sit on his hands and hope for the best.

The UK Telegraph�s Ambrose Evans-Pritchard sums up Europe�s woes in last week�s article ECB Slammed as Europe Crumbles: �The economies of Germany, France and Italy all contracted in the first quarter and may now be in full recession, shattering assumptions that Europe would prove able to shrug off the effects of the credit crunch. . . . The picture is darkening so fast in Spain that Prime Minister Jose Luis Zapatero canceled holidays and called his cabinet back to Madrid yesterday for the first emergency session of its kind since the Franco dictatorship.

�Growth has turned negative in Ireland, Denmark, Latvia, and Estonia, while grinding to a halt in Sweden and The Netherlands. Iceland contracted by a staggering 3.7pc. The grim data from Eurostat follows a recession warning in Britain, and shock news that the Japanese economy had shrunk 0.6pc in the second quarter. Almost the entire bloc of rich Organization for Economic Co-operation and Development (OECD) countries -- still two thirds of the world economy -- are now in the grip of a major downturn.�

Evans-Pritchard�s article reads like a chapter from the Book of Revelation; all that�s missing is the plague of locusts. The ECB is in a pickle and will have to allow the economy to cool off so the credit excesses can work themselves out. It�s like a pig passing through the belly of the boa; it takes time. As a result, deficits are expected to soar in the south (particularly Spain, Greece and Italy) while growth in the industrial north, Germany, will continue to shrink. Also, Spain, Ireland and England are undergoing the biggest housing meltdown in history after indulging in the same mortgage hanky-panky that took place in the US. Billions of dollars of low interest loans that were issued to unqualified mortgage applicants are gumming up the whole system and sending foreclosures skyrocketing. Now the losses have to be written down and thousands of unoccupied houses sold at auction. It�s a disaster.

The problem is so big that the future of the EU and the euro are now very much in doubt. Currency traders are expecting the ECB to lower rates (and weaken the euro) just as the futures� market is wagering that the Fed will raise rates to fight inflation. But don�t bet on it. Interest rates are going down not up, regardless of the Fed�s impressive PR campaign. Bernanke is just waiting for Trichet to make his move before he produces the Fed�s-scimitar and begins slashing rates. Keep in mind, the Federal Reserve is essentially the board of directors for the nation�s banks. If Bernanke is forced to choose between the people who depend on the dollar as a reliable store of value or bailing out the high-stakes gamblers who run the banks, the Fed chief will choose the banks 100 per cent of the time. In Vegas, that�s called a �sure thing.�

The perception that the dollar is getting stronger is mostly an illusion. Deflation is �dollar positive� because investors who flee from toxic assets naturally move into cash. But that doesn�t mean they have faith in the dollar, far from it. The fundamentals for the greenback get worse by the day. Fiscal and trade deficits are out of control, the national debt is tipping $10 trillion, foreign investment is drying up, and confidence in US leadership has never been lower. The dollar is on a timeline of roughly six to 18 months before it�s rolled into spools and sold as toilet paper. Paper currency is a country�s IOU and foreign central banks are wary of taking checks from a country that no longer wins wars or has the capacity to pay off its debts. That�s why, for the first time, there�s serious talk about the US losing its triple A rating on government debt. And it could happen sooner than anyone thinks. Every time the Fed uses the dollar to prop up the faltering banking system or provide limitless capital for defunct GSEs like Fannie Mae and Freddie Mac, the dollar comes under greater and greater pressure. At a certain point the dollar will crumble and the country will have to sell off its assets and industries to pay the bills. That�s when the private equity vultures and sovereign wealth funds will swoop down and scavenge anything of value for pennies on the dollar.

As the US housing market continues to collapse, trillions of dollars in equity and credit are disappearing in a deflationary bonfire. When a $400,000 home -- with no down payment and negative equity -- goes into foreclosure, $400,000 vanishes from the digital-pool of credit and has to be written down as a loss. So far, much of the losses have not yet been accounted for because the banks are using their own internal models for determining the value of their downgraded assets. Two weeks ago, Merrill Lynch sold $30 billion of mortgage-backed junk for 20 cents on the dollar. But they also financed the deal, which means that they really only got 5 cents on the dollar! This reflects the true �market value� of these assets. They are virtually worthless. Naturally, Merrill�s sale sent tremors through Wall Street where banks and other financial institutions are sitting on trillions of dollars of this garbage, marking it down at a few percentage points every reporting period rather than doing what Merrill did and putting it all behind them. As a result, the banks have less capital to lend, which means economic activity will continue to slow and the country will go into a deep recession. The point is, that the Federal Reserve now holds about $400 billion of this junk-paper on their balance sheets and the US Treasury is planning to take on hundreds of billions more (perhaps as much as $800 billion more under the new legislation!) to prop up Fannie Mae and Freddie Mac. The Bush administration is using the credibility of the dollar as collateral in its plan to bail out the most reckless, high-stakes Wall Street gamblers and their multi-trillion dollar Ponzi scheme that has blown up in their faces.

So, how does this affect the dollar?

The nation�s debts are entirely balanced atop its currency. The greenback is like a circus strongman holding a barbell precariously over his head; as the weight is increased, the sweat begins to appear on his brow while the veins in his neck and forehead begin to bulge. Finally, the knees buckle and the over-matched weightlifter crashes to the canvas in a heap. That�s the future of the dollar in a nutshell. It�s just a matter of time.

But how does that explain the sudden fall in gold prices; after all, gold is the logical alternative to paper money, right?

Wrong. Gold is �real money� all right, but it�s also a commodity. And when commodities are smashed by a deflationary tidal wave -- as they have been the last few weeks -- gold will follow them into the basement. In truth, gold has taken an even worse pasting than the euro, free-falling from $980 per ounce in mid-July to $786 at Friday�s market close -- $194 in a month. Goldbugs are so fanatically committed to their views about �real currency� and �fiat money,� that any correction in the market is seen as proof of government manipulation (even though they are right many times).

There�s plenty of evidence of meddling in the currency markets, just as one would expect. After all, the Western banking system, led by the Fed, operates as a cartel. The head honchos are about as committed to free markets as Bush is to democracy, which isn�t saying much. It�s all a public relations ruse that�s used to defend a de facto monopoly; the paper money scam. So, we shouldn�t be surprised when foreign central banks inexplicably purchase $28 billion of US government securities at the 11th hour (as they did last month) to conceal our massive trade imbalance and prop up the waning dollar. Don�t forget, it�s their chestnuts they�re keeping out of the fire, too.

But, that doesn�t mean the Fed has superhuman powers or that every time gold goes into a tailspin it�s because the black helicopters fired lasers into the currency markets. When the economy is in the grips of deflation; all asset-classes get dragged down, gold included. Many of the hedge funds and other big market players are selling their gold positions, recognizing that the commodities boom is over and it�s time to move on. That doesn�t mean that gold won�t rebound sharply when Bernanke slashes rates or if Bush blows up some new part of the globe. It simply means that in the short-term �cash is king.� Pension funds and hedge funds will continue to deleverage to reduce their credit exposure to put themselves in a better position to rollover their debt. That means that gold�s slide could last awhile. This doesn�t look like a conspiracy to me, but I have my tinfoil hat in hand just in case.

No one knows where the bottom is for gold, but one thing is certain it�s future looks a lot brighter than the dollar�s. The Bush administration has yet to demonstrate that it can enforce Dollar Hegemony via military intervention. That is a very big deal indeed. If the dollar isn�t backed by Middle East oil, then the $6 trillion stockpile of dollars and dollar-denominated assets that are languishing in foreign central banks and sovereign wealth funds, will continue to dwindle until the dollar�s position as �reserve currency� comes to an end.

That�s one doomsday scenario, but there is another one, too. If Bernanke and Paulson continue to pile all of the nation�s credit problems (bad paper) on top of the greenback, foreign capital will head for the exits and the dollar will crash. Either way, the dollar�s troubles are mounting and something�s got to give.