Gary Shilling meets me at the bar of the restaurant with a large plastic jar in his hands. Since developing a serious beekeeping hobby a few years ago, he has been giving his clients and associates a gift of honey from Shilling Apiaries. The label reads: “Our Honey is Sublime, Not Subprime!”

Who: A. Gary Shilling, President, A. Gary Shilling & Co.Where: Serenade, 6 Roosevelt Ave. Chatham, N.J., January 11, 2007On the Menu: Fresh honey, subprime glory and visions of unwinding derivatives contracts, crashing commodities and further housing declines.

Shilling is the one man who can afford to joke about the subprime residential mortgage mess, which has left so many finance professionals in tears. Back in January 2004, he is quick to point out, his newsletter, Insight, identified subprime mortgages as a weak link in the then-booming U.S. economy: “Subprime loans are probably the greatest financial problem facing the nation in the years ahead.”

Pretty prescient, wouldn’t you say?

Soon thereafter he was contacted by a guy then known as J.P., an obscure hedge fund manager, who thought Shilling’s bearish forecasts made a lot of sense. Well, by now that guy, John Paulson, has become a Wall Street legend. The funds he runs made $15 billion in 2007 by buying credit default swaps, an insurance instrument against default in collateralized debt obligations (CDOs) securitized by subprime mortgages. Paulson himself is believed to have had the largest payday in Wall Street history, making as much as $4 billion last year and promptly joining the Forbes list of 400 richest Americans.

Paulson & Co. bet the farm on the expectation that the mortgage bubble would burst. Shilling also put some of his own money into the scheme.

“I now wish I put all my money into it,” he wistfully says now. But the 600 percent return that he has raked up to date — along with the first hedge fund Paulson set up to short subprime mortgages — ain’t that bad either. Shilling still meets with Paulson and his fund managers regularly to assess the mortgage market and to strategize on how to profit from future developments.

Dr. Disinflation”This was one of my best calls,” admits Shilling.

Not that there weren’t others. During his career as a Wall Street economist, which began back in the 1960s, Shilling has developed a reputation as a professional contrarian. But he is not a contrarian just saying something to oppose the consensus. He has been right quite a few times — which is the reason why he has been a Forbes columnist and a weekly guest on CNBC’s “Kudlow and Co.”

I worked for Shilling in the mid-1980s. At the time he was known around the Street as Dr. Disinflation. Just when the second oil shock came about in 1979, Shilling began predicting the end of inflation and soon thereafter wrote a book called Is Inflation Ending? Are You Ready? It recommended that investors buy risk-free 30-year government bonds and, as he put it, “stocks that look like bonds” — shares of blue-chip corporations that pay steady dividends.

Few people paid much attention to his book and sales flopped. Inflation had just reached an all-time peak rising into the double digits, commodity prices were sky-high and shortages of goods and services seemed to be pervasive. Most people thought Shilling’s ideas were a laugh. Shilling also laughed — all the way to the bank. Having arrived to our lunch appointment with a sheaf of his newsletters in a folder, he shows that if you invested in a 30-year government bond, and adjusted your holdings to keep maturities stable at 30 years, your portfolio would have outperformed the Dow Jones Industrial Average by a long shot — even though over the past quarter of a century the stock market has seen its strongest rally in history.

But that was then, and now a long cyclical period of low inflation appears to be coming to an end. Commodity prices are at a record once more; gold — the traditional hedge against inflation — is above $900 per ounce and price indices are edging to levels not seen for a few years. Talking to Dr. Disinflation in today’s environment, I’m naturally temped to ask whether he believes that inflation is coming back.

Once Dr. Disinflation, always Dr. Disinflation. Shilling dismisses inflationary fears with a wave of his hand, as though shooing away a fly: “There would have been concern about inflation if commodity prices had been feeding into wages. They are not. Besides, the psychology is different today than it was in the 1970s. Back then, consumers were rushing out to spend their money almost as soon as they made it, buying up everything in sight. Now, they seem to be willing to wait for as long as it takes for the prices to come down.”

Fear of inflation is certainly unlikely to prevent the U.S. Federal Reserve from easing further. The only problem, notes Shilling, is that it may be facing a conundrum known in economics as “pushing on the string”. The Fed has cut interest rates, but the banking system remains clogged up and banks are still reluctant to lend to each other.

Nor will pumping liquidity into the system likely do the trick. Shilling’s measure of the liquidity crunch is not the money supply, but derivatives. Producing another chart, he shows that the growth in derivatives over the past decade or so has dwarfed conventional measures of money. The Bank for International Settlements estimates the notional value of derivatives at over $500 trillion.

“Derivatives are completely unregulated,” he says. “You and I could create a derivatives contract right here, around this table.”

The unwinding of derivatives contracts, which occurs with the decline in value of assets on which those derivatives are based, is what is really causing a liquidity crunch, asserts Shilling.

Commodities BubbleThis brings him back to commodities prices. Not only are they not going to stoke inflation, says Shilling, but he expects them to come down — and to do so with a bang. This, he believes, is the other shoe that is going to drop, and another opportunity to make a killing for savvy investors. Shilling was predicting a collapse in commodity prices at the start of 2007, the same time when he called for a sharp decline in housing prices as well.

Although he — and Paulson — have made a lot of money by shorting the subprime mortgage segment, Shilling believes that this has been only the tip of the iceberg. He points to trouble in the near-prime Alt-A pools of mortgages as a sign that the pricking of the housing bubble is far from over. In fact, he predicts that the nation’s house prices will fall 25 percent from their 2006 peaks. This is on average, mind you, with some markets, such as Florida and California, suffering an even greater debacle.

A bold prediction? Undoubtedly so, especially since Shilling himself admits that prior to the current protracted housing crisis, there have only been two instances of two consecutive months of year-on-year house price declines in recorded U.S. history.

And, even if he is correct, there is still the issue of timing. Paulson now looks like a genius, but his funds sustained losses for over a year and he could have easily gone bust had the subprime crisis not arrived, conveniently, when it did. Similarly, Shilling’s bearish forecasts at the start of 2007 would have left somebody shorting oil or the Dow with staggering losses in a year when both commodities and stocks set new record highs.

Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly “Global Economy” column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007.