Microsoft plays cool after DVD blow

By Martin J Young

The war over DVD formats came to an abrupt end this week when Japanese electronics giant Toshiba announced that it would no longer be developing, producing or marketing its HD-DVD technology. The move propels Sony’s Blu-ray format to victory as the new global standard in high definition DVD and eliminates the confusion amongst consumers who were in two minds over which format to adopt.

The battle has been seen by many as reminiscent of that in the 1980’s between Matsushita’s VHS format and Sony’s Betamax, the latter losing out and being relegated to a darkened room at the rear of many video rental outlets. This time though Sony emerged triumphant having successfully enticed a number of Hollywood studios to use its format for the release of new movies. The final blow for the failing format was said by Toshiba’s chief executive, Atsutoshi Nishida, to have been made when Warner Brothers chose to adopt Blu-ray.

A number of games consoles have also been in the fray with some using HD-DVD drives and some opting for the Blu-ray. Microsoft’s Xbox 360 seems to be the one that analysts predict will be hurt the most by adopting the Toshiba format. Sony had the winning hand from day one with its built-in Blu-ray drives in the PlayStation 3.

Many believe that consumers will now choose this console over the Xbox for future compatibility, although Microsoft responded by stating, "We do not believe the recent reports about HD DVD will have any material impact on the Xbox 360 platform or our position in the marketplace. We will wait until we hear from Toshiba before announcing any specific plans around the Xbox 360 HD DVD player."

The bones of the technology are in the programming that can be built into DVD-sized discs and offer higher resolution and sharper pictures than standard DVDs. The formats were incompatible with each other so it was widely assumed that one would emerge triumphant. Now that we have a winner we can expect to see a lot more of them in the market as the new technology is embraced and regular DVDs slowly get phased out and go the way of the VCD and VHS.

Internet
Following the rejection of Microsoft’s buyout offer for Internet stalwart Yahoo! the California based company has begun to offer severance plans to its employees. Yahoo workers will be eligible for payouts if they are fired or leave for "good reason"; the decisions appear to be making any possible move to purchase the company more expensive.

Yahoo has stated that the $31 per share bid by Microsoft substantially undervalues the company and has rejected the offer. Microsoft has responded by authorizing a proxy fight and is seeking to nominate a slate of directors to Yahoo’s board unless the Internet company is willing to enter into talks. Microsoft would hire a proxy solicitor to urge Yahoo investors to kick out board directors according to reports by The New York Times. The move will cost the Redmond-based software giant between $20 million and $30 million, a figure far more attractive than the prospect of a higher bid.

The proposed takeover appears on the surface to be moving into hostile territory, Microsoft know that it needs to make this deal productive if it is to have any hope of catching the market-dominating, runaway Internet advertising machine at Google.

Software
Microsoft has announced a new initiative this week that will give students around the world free access to development tools and software. The new software will assist students to write software applications, websites and design video games for the Xbox 360. Chairman Bill Gates stated that the concept should prevent learning barriers for students which would include high software licensing fees. Software has been made available to students before but the universities were made to register the programs limiting use to computer science students. This initiative will be available to all, the only drawback being that the products will only be Microsoft compatible!

Microsoft has also announced the official release of Service Pack 1 for Windows Vista this week. The release to web (RTW) download will be available on March 18 yet the software giant has stated that some users will still experience problems with drivers. These will be patched in an ongoing process through the automatic update feature of the operating system. The long-awaited software upgrade has not performed optimally in initial benchmarks, indicating that many of the annoyances of Vista will remain after the service pack is implemented.

As a result of this, the respect for Windows XP has increased and its third service pack is in process, but it is likely that this will be delivered via the Windows Update feature and not as a separate download.

More problems are expected with the Vista service pack as Microsoft has also confirmed that some third-party applications are either blocked or lose functionality when SP1 is installed. Programs from Trend Micro, Zonelabs, Bit Defender and Novell are expected to be affected and blocked by the service pack "for reliability reasons". Another glitch with SP1 was pulled this week; a file known simply as KB937287, which is a prerequisite for the service pack, caused some machines to enter an endless cycle of reboots. It seems that Vista still has a long way to go before confidence in it improves, despite what Microsoft claims.

Hardware
Gaming fans will have something to smile about this week as Nvidia prepares to launch its next "generation 9" series graphics cards. The 9600 GT will have Internet forums buzzing and is expected to weigh in at less than US$200, although there will be some confusion over the card as it remains on G94 architecture as opposed to its bigger "8 series" brother, the 8800 GT on G92. Meanwhile rival AMD has announced price drops on its HD 3800 series graphics cards indicating that it too may have something new in the pipeline.

Intel has launched an 8 core Skulltrail enthusiast platform this week, offering Ferrari performance for your PC. The dual socked board will seat two quad core Intel processors clocked at 3.2GHz and twin graphics card setups. Don’t expect much change from $15,000 for a high end and fully configured system.

Martin J Young is an Asia Times Online correspondent based in Thailand.

Sectors decouple, not markets

By R M Cutler

MONTREAL - A relatively broad-based advance on Asian exchanges is being cut short by new fears of a developed-world recession.

The original upward movement surprised investment professionals who had expected continued weakness on the basis of forecasts of economic slowdowns in the developed market economies of Western Europe and North America in particular. It began in Asia at the end of last week. Equities in the Japanese markets in particular advanced 3% on Wednesday, February 13, due primarily to growth in Japan's GDP. Manic-depressively, however, they slid back on the 14th and spent the Friday flat.

These movements, confirmed by the Mumbai-based BSE 30 Sensex, occurred only secondarily in response to developed-country (in particular US) economic data. They were driven by endogenous Asian macro-economic developments. The 2% decline in the Nikkei on Tuesday this week, for example, was caused by investors locking in profits from previous days, even as Japan Government Bonds tracked US treasuries to the downside.

The Nikkei may be moved by the Dow Jones averages, and sometimes it can create a feedback downdraft when esoteric parameters calculated and tracked by computer buy and sell programs exceptionally exceed the ranges for which quantitative analysts have programmed them. But also the ever-increasing program-driven trading can create counterintuitive moves.

This may be why, for example, the New York averages unaccountably began to drive higher around noon on Wednesday 20th, about two hours before the release of the Federal Open Market Committee minutes from January. It may be one reason why East Asian markets were buoyed, against expectations, several days over the past week when foreigners entered them late in the day to buy futures.

Throughout the week it was energy and raw materials - oil and metals in particular - that generally drove most world equity markets higher, and these sectors continued to rally even as others, such as financials, began to show signs of weakness towards the end of the current week. Specialists who a week ago were saying that they expected gold to consolidate from $910 down to the $830 round before moving higher, are ending the current week expecting it to rise from its present $940 to over $1,000 before falling. Platinum and palladium soared.

Oil and gas stocks across the broad, from exploration and production to integrated companies, advanced strongly, seemingly ignoring fears of a recession that would decrease demand.

Much ink has been spilt over the question of "decoupling" of Asian from American equity markets. One view holds that Asian demand can drive Asian markets in the event of a US recession. Another view is that if Europe is less badly hit than America, then Asia can withstand a US recession because demand for consumer goods produced in Asia will remain relatively strong. A third view is that other economies cannot decouple from trends in the US.

All these views make the error of taking a national view. Although central banks remain undeniably influential in their ability to affect short and medium evolution in national equity markets, it is economic sectors that drive the aggregate national equity index averages.

The Australian market, for example, began to decouple from the American one at the beginning of the present decade. The trends may be similar, and the volatility of the Australian All Ordinaries index may be slightly greater than that of the Standard & Poor's 500, but it is up about 80% since the beginning of 2001, while the S&P 500 is up only just over 20%.

If the Australian index is adjusted for appreciation of the Australian dollar over this time, then it is up 145% over the US market, ie, worth nearly two and a half times as much. The Canadian market is also up about 80% since the beginning of 2001 in absolute terms, and the Canadian dollar is up 50% over the US dollar since then, making the advance of the Toronto-based S&P/TSE Composite comparable to Australia's in currency-adjusted terms.

Can it be a coincidence that Australia and Canada were not only less heavily tech-laden than the US exchanges but also more heavily based in the "real economy" of energy and metals? Can it be a coincidence that, although financials in both countries have indeed taken hits with the subprime liquidity crisis, nevertheless the two countries are much less dependent upon performance by companies in the financial sector, as a percentage of aggregate corporate profits, than is the case in the United States?

National markets still matter, and governments can still be more important than their central banks. Witness, for example, the purchase by the Chinese state aluminum company Chinalco of 9% of Rio Tinto's listed shares on February 1, a move intended to prevent the Australian mining company BHP Billiton from acquiring the Rio Tinto group in what would have been the second largest takeover in history. But this is precisely in the natural resources sector, which rather makes the point that an integrated view of international sectors may in some cases supercede and give a more comprehensive perspective than national markets all taken together.

R M Cutler http://www.robertcutler.org is a Canadian international affairs analyst.

How about a Y?

By Chan Akya

I wrote in two previous articles about the destruction of the global financial system (In gold we trust, Asia Times Online, December 8, 2007) and the vast value destruction in G7 countries Dear dinosaurs, Asia Times Online, October 20, 2007). The plant that grows out of the soil is from the seed that was thrown in, and thus we should see all of G7’s grand errors come back and bite them in the posterior regions.

The behavior of Wall Street analysts and economists almost never ceases to amaze me. After first holding on for years to a charlatan-like view of "this time it's different" as a means to explaining the apparent miracle of uninterrupted growth for a very long time and inflation of asset prices ad nauseum, the group has now shifted its focus on what shape the ensuing recovery would take. Yes, I shook my head too when I realized these imbeciles had never acknowledged the errors in their forecasts nor do they still recognize the perils being imposed on the global economy by idiot central banks (see The Rogue and the pogue, Asia Times Online, January 26, 2008).

As always, this group over simplifies the task at hand, using some short-forms such as "V" or "U". One or two have gone to the extent of using an "L". Those fancy alphabet soups mean precisely nothing by themselves; all that market observers are trying to tell you is that the global economy will rebound quickly after hitting a bottom (V), linger in the bottom like a sea slug for a while and then miraculously rise up like a submarine-fired rocket (U), or most candidly among the three options, simply plunge and stay at the bottom for a while (L).

In the parlance of this group of market strategists and economists who between them couldn’t muster up the collective skills required to run a fast food franchise outlet, those three letters mean: "Please give me a bonus for 2008" (V), "Please let me keep my job for 2008" (U), and "Please don’t hurt me" (L). Put differently, these are the optimists, realists and pessimists respectively. And all three groups are wrong.

Revenge of the Y
I propose to add another letter of the alphabet into their web of misunderstanding; this may confuse some of the quacks among them, but at least a few should be able to paraphrase this article and publish it as their original thinking soon enough. The letter I have in mind is Y.

A Y-shaped recovery is much the same as a V, except there is an additional tangent from the bottom. What this means in practice is that while a few economies will recover quickly from the current mess, many others will fall by the wayside and slowly (or quickly, it doesn’t really matter) achieve irrelevance to global markets.

It may come as no surprise to readers that I expect Asia to form the upward trajectory in this scenario while much of G7 falls into the steep downward tangent envisaged by the tangent below the "V". Before anyone starts muttering stuff about how unprecedented all this would be, perhaps they should spend some time thinking about the world economy of barely three hundred years ago. At the time, two economies between them had 50% of global GDP - these two were China and India. What happens for the next couple of decades will simply represent a return of the pendulum to produce the same outcome.

Getting into the details would require readers to understand first the question of "why a Y" and secondly, "how".

First the question of why a Y. The Achilles’ heel of G7 economies is the financial system, which has now gone into a full-fledged deleveraging mode. Consider the following news items from the last week or so:

1. The failure of the US market for cities and townships to raise money used to pay for things like schools and hospitals (through auction rate securities, see Wealth destruction gathers pace, Asia Times Online, February 20, 2008), because US banks couldn’t find the measly few billion in capital required to support that system. This brings back memories of the aftermath of Hurricane Katrina - when a somnolent US Federal government failed to provide basic necessities to its afflicted citizens, only multiplied by a few hundred times. What this also showed is that the shortage of capital has become the chief constraint in the US financial system, and it is unfortunately not something that either the government or the Fed can do anything about.

2. Great Britain nationalized its failed lender Northern Rock after evaluating all alternatives (see Rocking the land of Poppins, Asia Times Online, September 22, 2007) and finding them overly expensive for taxpayers. In the process, the country has breached fiscal constraints and will now have to tax its citizens in an attempt to recover its financial footing; this will come at the significant cost of economic growth for years if not decades to come.

3. Market reports have cited the impending demise of a large US investment bank that has frozen part of the global derivative market as all banks attempt to quantify their exposures to the "weakest link" in their individual chains. Surprising losses reported this week by two European banks - Credit Suisse and BNP Paribas - that had previously been seen to avoid a bulk of the US problems only accentuated market fears of further write-offs.

4. Two high-profile failures in Germany - IKB and Sachsen LB - continue to haunt the European financial system as Germany has failed to find a buyer and also set the stage for other potential embarrassments such as bigger Landesbanks and commercial bank losses in the near future.

5. I really could go on and on.

To put things in perspective, all of these incidents above, with the exception of Northern Rock, are among the world’s top 100 banks. Readers may respond with - alright, we know that the global financial system is broken, but so what. The banks take losses and move on.

Well, not really. Any recovery is contingent on the emergence of alternative economic uses for assets that were previously mispriced. Think about that - when the dotcom bubble ended, the world still had Internet technology and millions of miles of optic fiber cable. That in turn created the boom in outsourcing, as well as the acceleration of price competition that sparked a global search for cheaper manufacturers that benefited Asia.

Meanwhile, what G7 had left behind was the lifestyle afforded by decades of wealth accretion from the rest of the world, even as their unit labor inputs declined sharply. The US is merely the most obvious example of this malaise, but similar trends can be seen in other countries such as the UK and Italy as well. In essence, the production systems of G7 have become extremely dependent on capital intensive processes, which are in turn dependent on the flow of financing.

This is what kills Achilles - hurting the heel (ie the weakest link in global financing leverage, in this case the US subprime sector) opens up the gush of blood straight from the heart (ie the massive storm of losses engulfing banks). The assets that caused the loss are houses in various suburban locations across various American cities. There is no productive value for these houses, and having cheap houses without any jobs around the region won't help change population dynamics. Unable to offload these dead assets, banks cannot lend any more to companies, and without those borrowings, G7 factories will simply wilt away and die.

After the question of "Why a Y", the question of "how" is relatively easy and has been answered above - just reverse the course for Asia and you can see the makings of a recovery. As noted above, the beneficiaries of recent real technology transfers - factories, call centers and the like - were all in emerging markets and particularly Asian countries such as China and India.

These two countries have leveraged growth into building infrastructure that can eventually support self-sustaining economies. While many other Asian countries have also benefited from these trends in the last few years, they lack the strategic depth required to make it on their own domestic consumption. This is why I believe that differentiation would become a key factor in Asian markets this year (see Storm warning for Asia, Asia Times Online, January 4, 2008).

Between them, China and India have vast ability to increase consumption and improve their living standards to what prevails in the rest of the world. One of the first things to do would be to acquire the resources required for further growth but otherwise desist from investments in the US and European financial systems, allowing banks in these countries to crumble under the weight of their own bad loans.

There are those who point out that at US$3.5 trillion between them, China and India are too small to matter against economic colossus like the US at US$11 trillion and Europe at a similar level. That view is wrong because it uses historical currency values that over-estimate the intrinsic worth of G7 economies, or more to the point diminish the GDP sizes of Asian countries.

Much like the US dollar’s bluff has been called, other "reserve" currencies such as the euro and pound sterling will fall by the wayside. The Swiss franc will survive, if only because the need for a country with a secretive banking system that helps finance one’s mistresses will never disappear, but I digress.

To achieve this separation from the continuing economic decline of the US and Europe though, China and India must cut the umbilical cord of currency pegs to the rest of the world. They must float their currencies, take the bite off the export apple but allow domestic consumption to take over as the primary driving force. Without that happening, we are going to end up looking at another letter altogether: a prolonged decline in global GDP size, or an I.

Inflation targeting

By Henry C K Liu

(See also PART 1: Fed helpless in its own crisis)
PART 2: A failure of central banking)

Milton Friedman, the 1976 Nobel laureate in economics, identified through an exhaustive analysis of historical data the potential role of monetary policy as a key factor in shaping the course of inflation and business cycles, with the counterfactual conclusion that the Great Depression of the 1930s could have been avoided with appropriate US Federal Reserve monetary easing to counteract destructive market forces.

Friedman’s counterfactual conjecture, though not provable, has been accepted by central bankers as a magic monetary formula to rid capitalism of the curse of business cycles. It underpins Greenspan-led Fed’s "when in doubt, ease" approach of the past two decades which had led to serial debt bubbles, each one bigger than the previous one.

Macroeconomists, including current Fed chairman Ben Bernanke, focus their attention on the structure, systemic performance and behavioral interactions of the component parts of the economy. While they defend the merits of market fundamentalism, most neoclassical macroeconomists subscribe to the debt-deflation view of the Great Depression in which the collateral used to secure loans or, as in the current situation, the backing behind their derivative instruments will eventually decrease in value, creating losses to borrowers, lenders and investors, leading to the need to restructure the loan terms or even loan recalls.

When that happens, macroeconomists believe that government intervention is necessary to keep the market from failing.

The term debt-deflation was coined by Irving Fisher in 1933 and refers to the way debt and deflation destabilize each other. De-stability arises because the relation runs both ways: deflation causes financial distress, and financial distress in turn exacerbates deflation. This debt-deflation cycle is highly toxic in a debt-infested economy.

Hyman Minsky in The Financial-Instability Hypothesis: Capitalist processes and the behavior of the economy (1982) elaborated the debt-deflation concept to incorporate its effect on the asset market. He recognized that distress selling reduces asset prices, causing losses to agents with maturing debts. This reinforces more distress selling and reduces consumption and investment spending, which deepens deflation.

Bernanke wrote in 1983 that debt-deflation generates wide-spread bankruptcy, impairing the process of credit intermediation. The resultant credit contraction depresses aggregate demand. Yet in a later paper: Should Central Banks Respond to Movements in Asset Prices? (2002) coauthored with Mark Gertler, Bernanke concludes that inflation-targeting central banks need not respond to asset prices, except insofar as they affect the inflation forecast. The paper refers to a 1982 paper by Oliver Blanchard and Mark Watson: Bubbles, Rational Expectations, and Financial Markets, with the general conclusion that bubbles, in many markets, are consistent with rationality, that phenomena such as runaway asset prices and market crashes are consistent with rational bubbles.

Interventionism
Friedman’s conjecture on the effect of monetary policy on economic cycles drew on the ideas of neoclassical welfare economist Arthus Cecil Pigou (1877-1959) who asserted that governments can, via a mixture of taxes and subsidies, correct market failures such as debt-deflation by "internalizing the externalities" without direct intervention in markets. Pigou also proposes "sin taxes" on cigarettes and alcohol and environmental pollution.

However, Pigou’s Theory of Unemployment (1933) was challenged conceptually three years after publication by his personal friend John Maynard Keynes in the latter’s highly influential classic: General Theory of Employment, Interest and Money (1936). Keynes advocated direct government interventionist policies through countercyclical fiscal and monetary measures of demand management, ie full employment.

Macroeconomists are also influenced by the work of Irving Fisher (1867-1947): Nature of Capital and Income (1906) and elaborated on in The Rate of Interest (1907 and 1930), and his theory of the price level according to the Quantity Theory of Money as express by an equation of exchange: MV=PT ; where M=stock of money, P=price level, T=amount of transactions carried out using money, and V= the velocity of circulation of money. Fisher’s most significant theoretical contribution is the insight that total investment equals total savings (I=S), a truism that all debt bubbles violate.

The 1990s appeared to be a replay of many aspects of the 1920s when consumers and businesses relied on cheap and easy credit in a deregulated market to fuel an extended debt-driven boom which became toxic when an inevitable debt crisis caused asset price deflation. Federal Reserve banking regulations to prevent panics were ineffective and widespread debt defaults led to the contraction of the money supply. In the face of bad loans and worsening future prospects, banks abruptly became belatedly conservative in their lending while they scrambled to seek additional capital reserves which intensified deflationary pressures. The vicious cycle caused an accelerating downward spiral, turning an abrupt recession into a severe depression.

Legal limit on credit
Bernanke points out in his Essays on the Great Depression (Princeton University Press, 2000) that Friedman argues in his influential Monetary History of the United States that the Great Depression was caused by monetary contraction which was the consequence of the Fed’s failure to address the escalating crises in the banking system by adding needed liquidity. One of the reasons for the Fed’s inaction was that it had reached the legal limit on the amount of credit it could issue in the form of a gold-backed specie dollar by the gold in its possession. Today, the Fed has no such limitation on a fiat dollar, a condition that permits Bernanke to suggest the metaphor of dropping money from helicopters on the market to fight deflation caused by a liquidity crunch. Free from a gold-backed dollar, the Fed is now armed with a printing machine the ink for which is hyperinflation to fight deflation.

Yet in the popular press, Friedman was known also for his advocacy of a deregulated free market as the best option for sustaining economic growth, which raises the question of the need for central banking intervention to replace specie money of constant value with fiat currency of flexible elasticity. A free money market under a central banking regime is an oxymoron. Betting on Fed interest moves is the biggest speculative force in the market. Friedman apparently did not extend his love for free trade to the money market. The Friedman compromise was to manage the structural contradiction with a proposed steady expansion of the money supply at around 2%.

Still, Friedman’s love of free markets does not change that fact that totally free markets always lead to market failure. Free markets need regulation to remain free. Free market capitalism, the faith-based mantra of Larry Kudlow notwithstanding, is not the best path to prosperity; it is the shortest path to market failure.

Unregulated markets in goods have a structural tendency towards monopolistic market power to reduce price competition and to inch towards rising inflation. On the other side of the coin, unregulated money markets can lead to liquidity crises that cause deflation. The fundamental contradiction about central banking is that the central bank is both a market regulator and a market participant. It sets the rules of the money market game while it pretends to help the market to remain free by distorting the very same rules through the use of its monopolistic market power as a market participant not driven by profit motive.

The Fed is a believer of free markets who at the same time does not trust free markets. The response by ingenious market participants to the Fed’s schizophrenia is to set up a parallel game in the arena of structured finance in which the Fed is increasingly reduced to the role of a mere passive spectator.

Rational expectations
Robert Lucas, the 1995 Nobel laureate economist, also made fundamental contributions to the study of money, inflation, and business cycles, through the application of modern mathematics. Lucas formed what came to be known as the "rational expectations" theory.

In essence, the theory asserts that expectations about the future can influence economic decisions by individuals, households and companies. Using complex mathematical models, Lucas showed statistically that individual market participants would anticipate and thus could easily counteract and undermine the impact of government economic policies and regulations. Rational expectations theory was embraced by the Reagan White House during its first term, but the doctrine worked against the Reagan "voodoo economics" instead of with it.

Inflation targeting
In a debt bubble, an escalating rate of inflation to devalue the accumulated debt is needed to sustain the bubble. Thus conventional wisdom moves toward the view that the overriding purpose of monetary policy is to keep market expectations of price inflation anchored at a relatively benign rate to ward off hyperinflation. This approach is known in policy circles as inflation targeting, on which Fed chairman Ben Bernanke is an acknowledged academic authority and for which he had been a forceful advocate before coming to the Fed.

In May 2003, Pimco, the nation’s largest bond fund headed by Bill Gross, having earlier pronounced a critical view on the unrealistically low yield of General Electric bonds in the face of expected inflation, came out in support of inflation targeting. Fed economist Thomas Laubach, a recognized inflation targeting advocate, estimates in a paper that every additional $100 million increase in projected Federal annual fiscal budget deficit adds one quarter percentage point to the yield on 10-year Treasury bonds, albeit that this estimate has been rendered inoperative since the 1990s by dollar hegemony through which the US trade deficit is used to finance the US capital account surplus, reducing the impact of US fiscal deficits on long-term dollar interest rates. Global wage arbitrage also kept US inflation uncharacteristically low, albeit at a price hollowing the US manufacturing core.

Laubach was part of the Princeton gang that included John Taylor of the celebrated Taylor Rule, and Bernanke, the money printer of late at the Fed. (Inflation Targeting: Lessons from the International Experience by Ben S Bernanke, Thomas Laubach, Frederic S Mishkin and Adam S Posen; Princeton University Press 2001). The Fed’s long-held position is that Federal budget deficits raise long-term interest rates, over which Fed monetary policy as currently constituted has little control.

The Taylor Rule
Economist John Taylor was the editor for Monetary Policy Rules (National Bureau of Economic Research Studies in Income and Wealth - University of Chicago Press 1999) in which he put forth the Taylor Rule.

The Taylor Rule states: if inflation is one percentage point above the Fed’s goal, short-term interest rate should rise by 1.5 percentage points to contain it. And if an economy’s total output is one percentage point below its full capacity, rates should fall by half a percentage point to compensate for it. The rule was designed to provide "recommendations" for how a central bank should set short-term interest rates as economic conditions change to achieve both its short-run goal for stabilizing the economy and its long-run goal for fighting inflation.

Specifically, the rule states that the real short-term interest rate (that is, the interest rate adjusted for inflation) should be determined according to three factors: (1) where actual inflation is relative to the targeted level that the Fed wishes to achieve, (2) how far economic activity is above or below its "full employment" level, and (3) what the level of the short-term interest rate is that would be consistent with full employment.

The rule "recommends" a relatively high interest rate (a tight monetary policy) when inflation is above its target (normally below 2%) or when the economy is above its full employment level (normally defined as 4% unemployment, but this figure has risen in recent years to 6%), and a relatively low interest rate (a loose monetary policy) in the opposite situations. Under stagflation, when inflation may be above the Fed target when the economy is below full employment, the rule provides guidance to policy makers on how to balance these competing considerations in setting an appropriate level for the interest rate. The answer is a neutral interest rate. Yet as a practical matter, the only way to counter stagflation is to lean on the anti-inflation bias as Paul Volcker did during the Carter years because a neutral interest rate may extend stagflation longer than necessary.

Although the Fed does not explicitly follow the rule, analyses show that the rule does a fairly accurate job of describing how monetary policy actually has been conducted during the past decade under chairman Greenspan. This is in fact one of the criticisms of the Taylor Rule in that it tends to reflect Fed action rather than to guide it. On the question of whether the Fed should have leaned against accelerating home prices during 2003-2005, Taylor rule simulations suggest that the Fed should perhaps have been thinking of itself as one important cause of that phenomenon in the first place.

The mystery of neutral interest rates
Journalist Greg Ip of the Wall Street Journal reported on December 5, 2005 that in a written response to a letter from Rep Jim Saxton (R- NJ), chairman of the Joint Economic Committee of Congress, about the meaning of a neutral interest rate as invoked by Fed chairman Greenspan’s testimony, Greenspan said that definitions of "neutral" vary, as do methods of calculating them and that neutral levels change with economic conditions.

Thus the concept of a neutral rate is made useless by practical difficulties. This of course was a standard Greenspan position of all economic concepts as the wizard of bubbleland always drove by the seat of his pants, doing the opposite of his obscure official pronouncements. With the Fed widely expected to raise the Fed funds rate target to 4.25% the following week in a continuation of the traditional policy of "measured pace", up from its low of 1% in June 2004, and with the 10-year yield at 4.5%, the yield curve was approaching flat and an inversion soon if the Fed, as expected, continued its interest rate raising policy. Historically, a flat yield curve signals future slow growth and an inverse yield curve signals future recession.

But Greenpsan, invoking rational expectations theory, dismissed the historical pattern by arguing that lenders were likely to accept low long-term rates because of their expectation of future low inflation, and this would stimulate future economic activities. So stop worrying about the inverse yield curve. It was an attitude that continued when an inverse yield curve emerged again in the early 2000s.

There is no denying that the US economy, as well as the global economy, had been plagued with persistent overcapacity. And if low inflation, as defined by the Fed, is the result of slow wage increases, where in the world can the future expansion of demand come from? Many analysts, particularly in the bond markets, have sharply criticized the Fed for keeping interest rates too low for too long and ignoring signs of incipient and insipid inflation.

In his Monday, December 5, 2005 Congressional testimony, Greenspan reiterated his view that recent price increases were mainly a result of "transitory factors", such as rising oil prices. True to his Keynesian past, Greenspan also pointed out that corporate profit had been so high that businesses had ample room to offer higher wages without raising prices to consumers. But of course, supply-side economics requires corporate profits to boost return on capital rather than boost demand by raising wages. And management never voluntarily raises wages without being pressured to by labor strikes, let alone for the good of the economy. To management, the only thing good for the economy is corporate profit.

The surprisingly tentative tone of Greenspan’s residual Keynesian outlook contrasted with the more extended attempt in his testimony on the following Tuesday to buttress his view that core inflation, which excludes volatile areas like food and energy prices, was likely to remain below 2% through the end of the next year. But despite his optimism about inflation remaining under wraps, Greenspan cautioned investors against thinking that the Fed might feel less constrained in unwinding its cheap-money policies of the past three years from 2001 to 2004.

In the June 30, 2004 Congressional hearing, Greenspan carefully dodged an opening question from Senator Richard C Shelby, Republican of Alabama and the chairman of the Senate Banking Committee, on whether the Fed would raise the federal funds rate another quarter-point at its August 2004 meeting. Greenspan also refused to be pinned down on what was in many ways the most basic question: What constituted a "neutral" interest rate that Greenspan claimed he tried to follow that neither provoked inflation nor slowed down the economy?

Many economists have suggested that a neutral fed funds rate - the rate charged on overnight loans between banks and the key policy tool the Fed relies on to guide the economy - is between 4% and 5%. That would have been a big increase from the June 30, 2004 fed funds rate level of 1.25%.

Like the famous description of pornography from Supreme Court Justice Potter Stewart, Greenspan said people would know the rate when it arrived. "You can tell whether you're below or above, but until you're there, you're not quite sure you are there," he said. "And we know at this stage, at one and a quarter percent federal funds rate, that we are below neutral. When we arrive at neutral, we will know it."

Economists have highlighted numerous difficulties in estimating the neutral federal funds rate in real time, including data and model uncertainty, which can result in estimates that are off by a couple of percentage points. These difficulties add to the challenge of conducting monetary policy, especially when the fed funds target is near the neutral rate, because policymakers must make their decisions without the benefit of reliable data. Therefore, policymakers will be especially attentive at this stage to incoming data. And, until research finds a solution to the difficulties of estimating the neutral rate, the conduct of policy will remain both a science and an art.

Expectations undermine inflation targeting
The problem is that according to "rational expectations" theory, market expectations can undermine the Fed’s inflation targeting policy to push tolerance for inflation increasingly higher until it reaches hyperinflation. Inflation targeting advocates therefore argue that inflation targeting should encompass a dual objective of holding down inflation as well as preventing deflation.

The financial press, grasping at straws in the wind to anticipate Fed policy, highlighted Fed chairman Bernanke’s January 10, 2008 speech at the Women in Housing and Finance and Exchequer Club Joint Luncheon in Washington, DC, on financial markets, the economic outlook, and monetary policy, as signal of the Fed standing "ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks".

Yet Bernanke also said: "Any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead we will be closely monitoring the inflation situation, particularly as regards to inflation expectations."

Thus the Fed is restrained in its interest rate action not only by actual incoming inflation data but also by data on inflation expectations. This means that when the market expects the Fed to cut interest rates, it actually limits the ability of the Fed to cut rates.

After the Fed’s January 2008 unprecedented and drastic interest rate cuts, the market has been anticipating that the European Central Bank (ECB) would need to follow the Fed’s lead to lower euro rates significantly. Yet while the ECB faces a similar dilemma as the Fed with regard to simultaneous vigorous inflation and slowing growth, the ECB is limited by its singular mandate of restraining inflation, unlike the Fed’s dual mandate of price stability and support for growth and employment. Jean-Claude Trichet, head of the ECB, testified in front of the European Parliament that inflation remains the ECB’s prime focus to "solidly anchor inflation expectations".

The euro zone economies are saddled with a less flexible structure of wage volatility that cannot adjust quickly to price changes as in the US because most European wage contracts are indexed to inflation but not to deflation. Unlike their US counterparts, European companies cannot layoff workers as easily, or adopt a two-tier wage and benefit regime for new workers.

Market expectation is focused on the inevitability of a euro-zone slowdown from the financial market turmoil that had originated from the US in August 2007 and on the prospect of euro interest rate reduction in the face of asset price correction despite a strong euro against the dollar. Yet European politics will not allow political leaders to be complacent about a strong euro buoyant by a flight from a deteriorating dollar while euro economies face a decline from global depression caused by a slowdown in the US economy. In the current global trade regime, the depreciation of the dollar will bring down the value of all other currencies. Exchange rate fluctuations only reflect temporary differentials in the rate of decline in the purchasing power of different currencies. Even as the euro falls against the dollar, it continues to lose real purchasing power.

Democrat Congress wants employment targeting
As early as February 19, 2007, half a year before the August emergence of the credit crisis, Representative Barney Frank of the 4th Congressional District of Massachusetts, the Democratic chairman of the House Financial Services Committee, told The Financial Times it would be a "terrible mistake" for the Fed to adopt inflation targeting to guide its interest rate decisions. Frank, whose committee is the House counterpart of the Senate committee charged with oversight of the US central bank, said such targeting "would come at the expense of equal consideration of the [the Fed’s] other main goal, that is employment".

By that Frank meant inflation targeting could be used to keep inflation down at the expense of full employment. His comments came as Fed policymakers entered the final stages of a far-reaching strategy review that included detailed debate over the merits of adopting an inflation target. What Frank opposed was the prospect that the Fed would fight inflation by keeping interest rate above that needed to produce low unemployment.

Fed chairman Bernanke believes that the central bank would be better off with a relatively flexible inflation target - one that would be achieved on average, rather than within a specific time frame, giving maximum latitude to respond to exogenous output shocks. Critics point out that this could lead to the Fed alternatively overshooting and undershooting in the short term, creating undesirable volatility in the market. This is because incoming economic data are known to be unreliable and need subsequent revision.

Further, in order to make any such policy change, Bernanke would need at least the tacit consent of key figures in Congress. Frank’s unequivocal statements against inflation targeting as it impacts even short-term unemployment suggest this consent will still be difficult to secure even after generally favorable congressional hearings. Frank told The Financial Times that Bernanke "has a statutory mandate for stable prices and low unemployment. If you target one of them, and not the other, it seems to me that will inevitably be favored". The reality could be that neither stable prices nor low unemployment can be achieved by short-term flexible inflation targeting.

Advocates of an inflation target at the Fed say it is important to distinguish between the relatively rigid form of targeting as used by the Bank of England and the relatively flexible form favored by Bernanke. Frank, however, said he would not support even a flexible target "without equal attention to unemployment also". What Frank wants is a low unemployment target to link to a low inflation target. The fear is stagflation with high unemployment accompanied by high inflation.

Inflation expectation around the world
Inflation expectation has been rising everywhere in the world, driven in part by rational expectation on the part of market participants. Beyond price data on oil and food, US core inflation in the 2.2 - 2.3% range since April 2006 has been above the central bank’s stated comfort level of 1.6% to 1.9% for some time. Further, the "core rate" is designed to sooth the financial markets and to distract market participants from the reality of rising inflation. The core rate does not exist anywhere in the real economy. It is a fictional notion designed to disguise inflation to justify perpetual real negative interest rates. And negative real interest rates have an upward spiral effect on inflation trends.

And in the euro-zone, even a rising euro has not stopped inflation from rising to 3% in November 2007, largely due to rising price of dollar-denominated imports, such as oil, outpacing the rise in exchange value of the euro. Evidence of second-round inflationary effects are already visible, with Europeans workers, most vocal in France and Germany, demanding wage increases to compensate for a loss of purchasing power beyond the acceptable range of accepted inflation and productivity targets. Members of the British police held a mass protest over pay in central London on January 23, 2008, angered by a 2.5% pay rise being backdated to only December 1, 2007 for member officers in England, Wales and Northern Ireland.

Long-term inflation expectations in the euro-zone, as expressed by interest rate futures, are running at nearly 2.5%, a robust 25 basis points above official ECB target of "close to but below 2%". Forecasters expect euro-zone inflation to slow in 2008 but nobody is predicting that it will fall below target, let alone turn negative for the rest of the year, particularly if the dollar continues to decline in purchasing power. Responding to a declining dollar, oil and other key commodities prices denominated in dollars can be expected to rise in adjustment, causing inflationary pressure worldwide.

Global inflation outlook for 2008 does not justify an accommodating monetary policy stance for any central bank. Risk of a recession in the US looms larger by the day from the collapse of the debt bubble, yet monetary policy is not an effective tool to prevent that prospect. A debt bubble will eventually have to burst to allow overblown asset prices to self-correct. If a central bank, as Greenspan claims, should not and cannot intervene on asset prices on the way up, but starts to target them on the way down, it fuels inflationary expectations. Low interest rates had caused the price bubble; and resorting to lowering interest rates to keep prices up after the bubble burst risks hyperinflation.

If higher inflation to the level needed to sustain the expanding debt bubble is tolerated, serious convulsions in global bond markets and the foreign exchange market and serious disruption to the global flows of funds can be expected. If high inflation is not tolerated, a violent burst of the debt bubble may be the outcome. While the market pushes the Fed to allow inflation to moderate price correction, it is far from clear that the damage to the global economy from inflation will be less than that from market price correction.

Inflation expectations in emerging markets
Measuring inflation expectations in emerging markets requires different methods since competition for export market share has neutralized wage-price spirals common for the developed economies. This is so despite the fact that food and energy account for a much larger share of total spending in poorer countries than in rich ones, making it harder for workers to absorb price increases without demanding higher wages to compensate. The core rate of inflation, excluding food and energy, is moderate in most parts of the world and strikingly low in some of the fastest-growing economies in the world, including Saudi Arabia and even China, where core inflation was just 1.1% in October, 2007. Headline inflation in China was 6.5% in August, 2007 with food prices leading the rise.

The food prices increase was exacerbated by an outbreak of porcine reproductive and respiratory syndrome ("blue-ear" disease) that has affected pig supplies, pushing the year-on-year increase in meat and poultry product prices to 49% in August 2007. Pork alone accounts for around 4% of the basket used for the consumer price index, so movements in its price have a direct feed-through into inflation. The cost of eggs rose by 23.6% year on year in August, moderating from a peak of 34.8% in June. Vegetable prices were up 22.5% over a year ago. Aquatic-product prices are also gaining momentum. Food accounted for 37% of the average total spending of a Chinese urban household in 2005.

The Fed and global stagflation
While inflation expectations remain locked at moderate rates, food and energy prices will continue rising at above-average rates because of an anticipated decline in the purchasing power of the dollar, causing overall inflation to escalate globally as the global economy slows. The Fed is betting on its aggressive rate cutting moves to turn 1970s'-style stagflation into mere inflation.

Until the end of 2007, many financial executives, market participants, influential commentators and government policymakers had insisted publicly that last summer’s credit squeeze would prove short-lived and containable. Suddenly, in the course of a few weeks, bankers and regulators have been forced to face reality and to admit that the shock that began in August was merely the first sign of widespread financial collapse that would take years to unwind.

Market confidence fell abruptly off a cliff, with banks became wary of lending to each other while investors stopped buying new securitized debt instruments. Borrowing costs in the money markets rose dramatically to put pressure on corporate borrowers, private equity acquisition and commercial real estate finance.

Fear has spread to the entire global market, partly due to lack of transparency behind the credit crisis that began in the US. Projected losses continue to rise with no end in sight. The problem is made worse by the self-inflicted loss of credibility on the part of top government officials and leading financial executives.

For example, Bernanke first suggested that the subprime mortgage crisis would result in a manageable $50 billion in losses. Less than three months later, he tripled the projected loss to $150 billion while still denying any threat of systemic contagion. Speaking after the February 9 meeting of Group of Seven finance ministers, Peer Steinbrck of Germany said the G7 now feared that write-offs of losses on securities linked to US subprime mortgages could reach $400 billion, sharply higher than the $150 billion credit losses that the Fed, Wall Street banks and other institutions have revealed in recent weeks. The latest panic-stricken Fed interest rate cuts are telling market participants to expect losses that could amount to trillions.

AIG, the world’s biggest insurance company by assets, sent tremors through the markets on February 12 when the insurance company raised its estimate of losses in October and November from insuring mortgage-related instruments from about $1 billion to $5 billion. AIG shares tumbled 11%, wiping $14 billion off its market value. AIG has written $78 billion of credit default swaps on CDOs, which protect the purchaser from a CDO’s failure to pay. The primary providers of the hedges are bond insurers such as MBIA and Ambac, whose ability to pay claims is causing deep anxiety in global markets. These have written about $125 billion of protection on "senior tranches" of CDOs. Catherine Seifert, analyst at Standard & Poor’s, was quoted in the Financial Times saying that AIG would "have an extremely difficult time regaining investor confidence".

How many times can public figures be shown wrong by subsequent unfolding events before losing total credibility? The overused truism is now flooding the media: that credibility is like virginity - much easier to lose than to get it back. Like the resourceful pimp who promotes the virgin-like freshness of his prostitute by claiming that it is only her second sexual encounter, the "good fundamentals" of the economy is touted over and over again by influential public figures in the face of deepening systemic collapse and dwindling confidence. Gratuitous advice that the market was temporarily oversold and that every decline session presents a "buying opportunity" continues to be standard pronouncement by those who are in the position to know better.

The faith-based Larry Kudlow & Company program on CNBC, where participants are asked to declare with solemn piety: "I believe free market capitalism is the best route to prosperity" as an article of faith, is increasingly attracting viewers for its entertainment value rather than for the quality of its analysis, particularly when the host continues to repeat with a straight face his tiresome mantra that the Goldilocks economy is alive and well in the face of serious systemic financial disaster.

Back in the real world, Goldman Sachs analysts estimate that the total final loss on US subprime mortgages would exceed 80% of its March 2007 face value of $1.3 trillion, even if the meltdown does not spread throughout the $20 trillion total residential mortgage outstanding and beyond the housing sector into commercial real estate and corporate finance.

The bulk of this loss will ultimately be borne by pension funds whence the average worker around the world expects to receive money to fund his/her retirement needs. Market forces can resolve the financial crisis with a sharp and quick price correction from bubble levels but the politically sensitive Fed and Treasury are trying to engineering a "soft landing" by extending the debt bubble, the penalty for which would be a decade or more of stagflation. Pathetically, supply-side market fundamentalists are clamoring for more government bail out of the market, with "damn the economy" frenzy. It is the equivalent of the God-fearing faithful asking the Devil for help in easing the ordeal of faith.

Dollar hegemony and loose monetary policy
The benefits of a loose monetary policy are by now proving to be dramatically short of what their advocates have claimed. A protracted policy bias towards low interest rates led the economy into its current debt quagmire, particularly when the unearned profit of the debt-driven boom has gone to a select manipulating few, leaving the masses with debts unsustainable by income. More low interest rates will perhaps help the wayward financial institutions delay inevitable insolvency but will not get the economy out of its debt crisis without pain. The argument that subprime mortgages helped expand homeownership is false. Such mortgages only put buyers into homes they cannot otherwise afford by distorting the happy American dream into an unneeded financial nightmare.

Easy money has been one of the most tempting monetary fallacies for all governments all through civilization. It has brought down the mightiest of empires, from Rome to Dynastic China. But the one basic requirement for sustaining the value of money is that must not be easy to come by without equivalent input of value. In the current international architecture based on fiat money, governments of trading nations justify inflationary monetary policy with the need to lower currency exchange rates to compete for market share in international trade. Inflation is driven by global trade.

The Bernanke Fed seems to have followed Greenspan’s pattern of adopting traditional gradualism only when interest rates are on the way up to retrain inflation, but always abandoning gradualism on the way down to stimulate growth, thus introducing a long-term structural bias in favor of inflation. The Fed then frequently finds itself behind the curve in fighting inflation expectation and overshooting to combat deflation expectation. This unbalanced proclivity has contributed to the long-term decline of the purchasing power of the dollar on top of the fiscal and current account twin deficits. Yet the US has been the privileged beneficiary of this easy fiat money fallacy through dollar hegemony since 1971 when President Nixon abandoned the Bretton Woods fixed exchange rate regime based on a gold-backed dollar. And this fallacy of the benefits of easy fiat money is about to be exposed by hard data for even the printer of the fiat dollar.

The Age of Worker Capitalism
There was a time in the past under industrial capitalism when in a class war between capitalists and workers, moderate inflation could help workers keep their jobs by keeping the economy expanding and make it easier for them to pay off their debts to capitalists. But nowadays, under finance capitalism, when capital comes mostly not from capitalists but from enforced savings held by worker pension funds, inflation robs workers of their retirement resources while stagflation lays them off from their current jobs.

Capital has been manipulated as a notional value on which derivative transactions are calculated and profit and loss are realized. Finance capitalism, through income disparity condoned by a supply-side ideology of keeping profit for the rich in the name of capital formation and letting the working poor be taken care of through trickling down from the rich, has constructed a financial infrastructure that channels profits to a few and assigns losses to the many. The inequity is mind-boggling. At least the capitalists of industrial capitalism used their own money. In finance capitalism, the retirement funds of workers are manipulated by financiers to exploit workers.

In April 2002, the term dollar hegemony was put forth by me in Asia Times OnLine in a critical analysis of a post-Cold-War geopolitical phenomenon in which the US dollar, a fiat currency, continues to assume the status of primary reserve currency in the international finance architecture that finances global trade. Architecture is an art the aesthetics of which is based on moral goodness, of which the current international finance architecture is visibly deficient.

Thus dollar hegemony is objectionable not only because the dollar, as a fiat currency, usurps a role it does not deserve, thus distorting the effects of trade, but also because its impact on the world community is devoid of moral goodness, because it destroys the ability of sovereign governments beside the US to use sovereign credit to finance the development their domestic economies, and forces them to export to earn dollar reserves to maintain the exchange value of their own currencies. Exporting economies are forced to accumulate dollars that cannot be spent domestically without severe monetary penalty and must reinvest these dollars back into the dollar economy.

The Bretton Woods II theory fallacy
In 2003, economists Michael Dooley, David Folkerts-Landau and Peter Garber proposed what has since become known as the Bretton Woods II theory. The theory turns dollar hegemony from the destructive monetary scam that it is into an assenting fantasy by applauding it as a happy win-win arrangement in which newly industrialized countries peg their currencies to the fiat dollar at an undervalued exchange rate in pursuit of export-led growth; and in return, they reinvest their trade surplus dollars back into the US, which acts as an economic anchor and consumer of last resort. This warped theory fed the illusion that the US trade deficit can be reversed by merely forcing trade surplus partners to upward revalue their currencies. The 1985 Plaza Accord succeeded in pushing the Japanese yen up against the dollar and threw Japan into a two-decade-long recession without reversing the US trade deficit.

By 2006, the US was running a current account deficit in excess of 6% of its gross domestic product, a level that would normally be considered excessive and unsustainable while the capital- starved exporting economies in Asia were holding large amounts of US debt. The Bretton Woods II theory says that this state of affairs is both desirable and sustainable, a dubious claim clearly disproved by facts by now.

There may still be some who argue that dollar hegemony is desirable but no one can deny it is clearly unsustainable. If this currency abuse is practiced by any other government, the International Monetary Fund (IMF), a creation of the Bretton Woods regime, would impose austere "conditionalities" on its fiscal budget to restore the exchange value of the currency. With dollar hegemony, the US, the nation with the longest continuous current account deficit in history and the world largest debtor, is exempt from such IMF imposed austerity discipline on its fiscal budget.

The net result of the injurious effects of dollar hegemony is the emergence of anti-trade protectionism even within the US, the supposedly lead beneficiary of the Bretton Woods II regime, particularly the segment of the US population that has unevenly borne the pain of free trade. For the exporting economies, there are growing signs that political leaders are beginning to realize that export-led growth is not the panacea that neoliberal market fundamentalism has made it out to be. Exporting for dollars that cannot be invested at home has left all exporting economies starved for capital for domestic development, with serious disparity of income and wealth, and political instability resulting from unbalance development. While much of domestic politics in the exporting countries is distorted by uneven power held by special interests of the export sector, a collapse in global trade will shift the balance of political power back towards the domestic sector.

The circular fund flow from US current account deficit back into US capital account surplus appeared to have come to a sudden halt in the summer of 2007. The US Treasury International Capital System (TICS) data show a massive drop in net foreign purchases of US long-term securities since the end of June, dropping from $99.9 billion to $19.5 billion in July and to a negative $70.6 billion in August, bouncing back to a positive $26.4 billion in September. All the while, US current account deficit has been running about $80 billion a month.

What dollar hegemony does over time is to feed the US debt bubble and steadily weaken the value of the dollar while it hollows out the US industrial core, as US policymakers in both the Clinton and Bush administrations tirelessly assert that a strong dollar is the national interest. Whenever the dollar debt bubble burst in the last two decades, as it again did in August 2007, the Fed was forced into the fad of a monetary easing mode, ie lowering dollar interest rates not just temporarily but keeping it low for long periods. The effect has been to force the purchasing power of the dollar to fall, which then induced other central banks to let their currencies fall as well to protect their competitive export market shares and to preserve the value of their dollar holdings in local currency terms. A competitive currency devaluation war will eventually unravel dollar hegemony in a disorderly fashion into a spiral of global hyperinflation. That eventuality appears to be at hand in 2008.

The collapse of dollar hegemony can accelerate the emergence of an Asian regional currency regime, along the lines of what happened in Europe after the collapse of the Bretton Woods regime in 1971. There has been a lot of talk for a long time about Asian monetary union, with little progress so far. See my July 12, 2002 article, The case for an Asian Monetary Fund, in Asia Times Online.

Prisoners' dilemma for foreign central banks
The dollar’s fall in exchange value relative to the euro is costly for all central banks holding large amounts of dollar-denominated financial assets whose economies also import from the euro-zone, even when dollar-denominated commodities continue to appreciate in price.

By holding and continuing to accumulate large amounts of dollars from trade surpluses, these central banks have a powerful incentive to ensure that their dollar holdings retain their purchasing power and exchange value in relation to their own currencies. Yet if these foreign central banks perceive the US Fed as powerless to halt the fall of the dollar by its unwillingness to keep dollar interest rates appropriately high, because the Fed prefers a robust market to a strong economy, they would have an equally powerful incentive to sell off their dollars while there is still a market for them or to compete to buy hard assets that would cause prices to rise. Both of these moves will lead to dollar hyperinflation.

This situation creates a well-known "prisoners’ dilemma" for central banks with massive dollar holdings. Collectively, these central banks have a compelling incentive to hold on to their dollars to avoid a massive sell off that hurts everyone, so as to maintain the dollar’s value on world currency markets for the common good. Yet individually, each central bank has an incentive to sell dollars and diversify its holdings into other currencies or hard assets before the market collapses from other central banks selling ahead of the others to gain individual advantage. This fear of defection from a common interest leads to a classic prisoners’ dilemma, and the risk that these dollar-holding central banks will simultaneously try to diversify their currency portfolios poses the greatest threat toward a run on the dollar.

The Western oil companies have been playing this game of the prisoners’ dilemma against OPEC members for decades to induce individual producers to cheat for advantage by selling more than its share of the allotted quota, causing Saudi Arabia, the lead producer, to keep oil prices up by cutting its own production below its allotted quota to minimize the effect of individual defection. The Saudi’s role as swing producers held the cartel together. The US, unlike Saudi Arabia, has thus far shown no inclination of cutting down the production of fiat dollars.

The Triffin Dilemma of 1960
The Triffin dilemma, named after Belgian-American economist Robert Triffin who first identified it in 1960, is the problem of fundamental currency imbalances in the Bretton Woods regime. With dollars flowing overseas through the Marshall Plan, US military spending and US citizens buying foreign goods and US tourists spending aboard, the amount of euro-dollars in circulation soon exceeded the amount of gold backing them. By the early 1960s, an ounce of gold could be exchanged for $40 in London, even though the official price in the US remained $35 by law. This difference showed that the market knew the dollar was overvalued and that time for gold-backed dollar was running out.

The solution was to reduce the amount of dollars in circulation by cutting the US balance of payments deficit and raising dollar interest rates to attract dollars back into the country. But these moves would drag the US economy into recession, a prospect President John F Kennedy found politically unacceptable. This was posed as the famous Triffin dilemma to Congress as an explanation of why the Bretton Woods regime had inevitably to collapse. Triffin noted that there was a fundamental liquidity dilemma when one country’s national fiat currency was used as a global reserve currency for trade. The very structural advantage would cause that country to lose any resolve to maintain the value of its fiat currency.

As the post-war world economy grew, more dollars were needed to finance it. To supply global dollar liquidity, the US must run a deficit, as no other government can produce dollars. But to maintain credibility of its currency, the US must not run a deficit. That was the fundamental dilemma. In the end, the US opted to continue to run a balance of payments deficit, which led to the loss of credibility and the collapse of the Bretton Woods regime in 1971.

However, if the United States stopped running balance of payments deficits, the global economy would lose its largest source to monetary reserves. The resulting shortage of liquidity could pull the world economy into a contracting spiral, leading to economic, social and political instability.

How long will central banks subsidize dollar hegemony?
Some argue that it is not the business of central banks to maximize the return on their exchange reserve portfolio, but to protect and enhance the stability of domestic financial markets and, in the case of central banks of large economies, global financial stability. In other words, foreign central banks that hold massive dollar reserves from trade surpluses are expected to pay the price of exchange rate losses to sustain the current international global financial infrastructure based on the fiat dollar.

Yet the profit made from the exchange rate losses sustained by the foreign central banks went disproportionately to the international financial elite, causing income disparity everywhere that held back consumption demand, which became a critical structural problem when the global economy moved into an overcapacity mode.

Whether and for how much longer this counter salutary arrangement can be sustained depends on the degree and rate of decline of the dollar and the disproportionately low purchasing power of workers in the US and the rest of the world. Foreign central banks may become convinced that the US has neither the intention nor the resolve to keep the dollar strong beyond rhetoric, nor the ideology to let domestic and foreign workers have a larger share of global corporate earnings. When that happens, the incentive for foreign central banks to hold onto the dollar in hope of an eventual reversal of its declining value may vanish very suddenly either as a result of financial logic or political pressure.

Shortly after the outbreak of the credit crisis of August 2007, as supposedly low-risk instruments became victims of unanticipated risk swelling from below, the monetary policy establishment began looking for a scapegoat and found it in the failure of the rating agencies to account properly for the complexity of the securitized instruments, relying overly on faulty mathematical models to override conventional prudent risk management.

It is true that rating agencies operate under a conflict of interest, their fees being paid by the issuers of the debt instrument they rate. Yet the underlying logic of the rating agencies’ permissive blessing rested on a reasoned assumption: that the explosive growth in credit derivatives and collateralized debt obligations (CDO) of recent years around the world had been enabled, if not caused, by US-led monetary policy under the leadership of Alan Greenspan at the Fed and Robert Rubin at the Treasury, and that this monetary of easy money would continue. Dollar hegemony, though unavoidably presenting a long-term threat to the US-controlled international finance architecture, was as close to a free lunch in monetary economics as one can get.

Destructiveness of dollar hegemony
Dollar hegemony allowed the US to soak up the world’s wealth with persistent negative real interest rates to finance US spending. After Clinton, the Bush tax cuts, with the help of Greenspan’s loose monetary policy, sustained the global debt bubble with reflation, the act of stimulating the economy artificially by increasing the money supply during stagnant growth and by regressive tax reduction during periods of rising fiscal deficits.

Global broad marketing of securitized debt instruments has shifted credit monitoring from direct lender knowledge of the credit history of individual borrowers to aggregate credit rating based on statistical probabilities constructed from theoretical borrower profiles and behavior patterns, much like the fundamental assumption of the rational economic man by neoclassical economics. More and more mortgages were written on the assumption of home prices continuing to rise, thus reducing concern for borrower credit rating to near zero. The safety of mortgage-back securities depended entirely on expected rising prices of homes and not on the credit worthiness of the borrower. In fact, a subprime borrower is more likely to refinance regularly to siphon rising home value into bank profits than a prime borrower.

As house prices stopped rising and began to fall, irresponsible borrower behavior surprised the risk models. Many borrowers stopped mortgage payments not because they were cash strapped but because they did not want to feed a mortgage that would soon exceed the market value of their houses. The abnormally rapid rise of distressed mortgages upset the statistical credit hierarchy of the mathematical models and caused a sudden credit squeeze. As the credit squeeze persisted, ratings agencies were being forced to downgrade hundreds of thousands of debt securities, after failing to foresee the on-coming waves of defaults initialized by subprime borrowers.

For example, on the last Wednesday night in January 2008 alone, Standard & Poor’s reportedly downgraded more than 8,000 residential mortgage-related securities with a market value of $534 billion. These downgrades in turn triggered bitter recriminations, amid a wave of losses at asset management firms and banks. The Financial Times quotes Wes Edens, head of Fortress Investment Group, a leading fund with over $40 billion in assets under management: "Much of the money lost has been held by people who held AAA securities [that were downgraded]. That has caused a tremendous loss of confidence."

At the root of the rating collapse was the reliance on risk management models that assume human behavior to remain unchanged in times of financial distress as during times of financial euphoria. Delinquency rates on home mortgages jumped much more abruptly than historical trends, with many subprime borrowers stopping payment on their home mortgages before halting payments on their credit cards or automotive loans - turning the traditional delinquency pattern on its head. As a result, mortgage lenders face losses at a much earlier stage in a credit crisis than in the past and within much shorter time frames.

This is partly because many subprime mortgagees were first-time homeowners who had little or no equity in their new homes and did not particularly consider keeping their new home as a top priority, rendering the assumed risk profiles inoperative when house prices fell. Unlike home buyers of previous times who bought a house to have a home, many in this new group of house buyers in the debt bubble tend to view their houses as vehicles of investment driven by financial calculation with little or no emotional attachment. Many bought and sold a house every year, each time moving into a bigger house the payments for which had no relationship to their income.

Bank data show that a large number of current mortgage defaults are not linked to temporary cash flow shortfalls but to borrowers having bought houses at prices their income could not carry. These borrowers depend on refinancing at rising home value to handle their mortgage payments. Mortgage delinquencies started to surge as soon as house prices started to fall, which prevented overstretched households with unaffordable loans from refinancing their way out of trouble. These buyers were a key factor in turbo-charging the rise in home prices during the debt-driven boom; they are a key factor in turbo-charging in the rise of defaults when the boom busts.

Borrowers with high loan-to-value mortgages or negative equity had no incentive to maintain payments when house prices started to fall below the value of the mortgage even if they were able to. No one likes to feed a dead horse.

Borrowers appear to favor their cars more than their houses in which they had no equity stake. IMF data show delinquency rates on prime loans made in 2006 and 2007, too late to benefit from house price gains before the debt bubble burst, rose more quickly than delinquencies on similar prime loans made in 2003 or 2004.

With a presidential election on the horizon, official attention has been focused on the problem of payment "resets", which allegedly pushed subprime borrowers with loans at initial, ultra-low "teaser" rates to default. The Bush administration brokered a plan to freeze resets while Treasury officials privately admitted that the scheme is not a silver bullet because recent mortgage data show a surprisingly weak correlation between rate resets and delinquencies. The main factor remains borrower attitude and behavior distorted by massive debt with reduced punitive consequence for the borrower from default.

Debt bubble destroys US national character
The debt bubble fed by dollar hegemony had hollowed out more than just America’s industrial core; it has also hollowed out America’s moral core and filled it with unprincipled greed. The American idea of home ownership as a symbol of a free society in which any citizen can earn with honest hard work and financial discipline a home for his/her family has been punctured and replaced by a vile fantasy that a home can be bought with no equity, with unrealistic interest and amortization payment schedules based not on the buyer’s current and expected future income, but on rising home prices made possible by the deliberate easy money policy of the Federal Reserve, supposedly the nation’s keeper of the value of its currency.

Some market cheerleaders continued to argue for months after August 2007 that the US jobs market could stay healthy to keep the credit crisis from spreading to the general economy. But job growth in recent decades has been concentrated in the financial service sector, which cannot continue in a distressed financial system. By the end of 2007, even the most optimistic analysts had to acknowledge that December consumer spending decline signaled that the US is slipping into recession that can result in a protracted period of rising unemployment. "The problems in the credit markets are spreading to the consumer sector - the next area of concern is auto loans and credit cards," says John Thain, newly appointed chief executive of Merrill Lynch who replaced the discharged chief after the giant brokerage disclosed massive losses from subprime mortgage related investments.

Since the repeal of Glass Steagall in 1999, mega-banks have been able to re-enact the same kinds of structural conflicts of interest that were endemic in the 1920s - lending to speculators, packaging and securitizing debts, marketing structured financial instruments backed by bank credit line and extracting lucrative fees at every step along the way in blatant conflict of interests. Much of these debt instruments are even more complex and opaque to bank examiners than their counterparts were in the go-go 1920s. Much of it is virtual obligation tied to the solvency of other instruments supercharged by complex computer model of assumed variables and relationships. Structured finance, instead of preserving liquidity and hedging unit risk, turns out to be the detonator of systemic risk and liquidity draught, exacerbated by explosively high leverage. The problem is multiplied by the lack of transparency.

The rise in prices destroyed the purchasing power of wages and government revenues, and the government responded to this by printing money to replace the lost revenues but left most wages relatively fixed. This was the beginning of a vicious circle. Each increase in the quantity of money in circulation brought about a further inflation of prices, reducing the purchasing power of incomes and government revenues, and leading to more printing of money. In the extreme, the monetary system simply collapses while the economy remains technically robust.

Hyperinflation is a state of mind
This is the way that hyperinflation takes root: by a self-reinforcing vicious cycle of printing money, leading to inflation, leading to printing more money, and so on. Hyperinflation is not defined by merely a super high rate of inflation, but the general acceptance of the compounded inflationary effect of a vicious cycle of debt. This is one reason why incipient inflation is feared, that even a little inflation one year will lead to more next year, and so on, building exponentially by compound interest.

There is a general knee-jerk market psychology associating rising asset prices with economic health and falling asset prices with economic distress. Yet some economies have experienced steady price rises up to 50 to 100% per year without falling into a cycle of hyperinflation, if such rises are anchored by real economic growth. And there has never been a hyperinflation cycle that could not have been avoided or broken by a simple government determination to stop the expansion of the money supply for speculation purposes.

John Maynard Keynes, who advocated deficit financing to counter cyclical depression, warned about the danger of inflation: "By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

The key point is that a monetary system can only function if the value of the monetary unit is relatively stable so that any increase in the quantity of money reflects a corresponding increase in real wealth. Monetary elasticity should not be confused with tolerance for inflation. Hyperinflation is not just prices rising at an extremely high rate. It means that inflation is out of control and price levels are detached from the value of underlying assets. Most of all, hyperinflation can only exist if society loses faith in itself and accepts further resistance of it as a lost cause.

War is the mother of all inflation. Modem democratic governments always find it easier to borrow than to level taxes needed to pay for war. To pay back the mounting national debt, the temptation for inflation is irresistible. As the wave of inflation of the 60s and 70s, which began around 1965, was triggered by the enormous cost of the Vietnam War, the current wave of inflation is tied to the two wars in Afghanistan and Iraq and the homeland security costs related to the global war on terrorism. As with the Vietnam War, which failed both to contain the spread of communism in the Southeastern nation and to strengthen the US economy, the current war on terrorism will only drag down the US economy without improving US national security.

Rubinomics exports inflation to emerging economies
At least the inflation of the Vietnam War was partly caused by the social dividend of Lyndon B Johnson’s Great Society spending, albeit paid for with the inflation equivalent of a 20% capital tax on all savings held as cash, bonds, insurance and on pension payments and other fixed income. Today, under the dynamics of "Rubinomics", the US through dollar hegemony exports inflation to all emerging economies that export to the US.

The Federal Reserve for the past two decades has not been able to check inflation, even as it succeeded in slowing down the US economy, but global prices have continued to rise, pushed by the demands of the emerging economies. The reason is that the world’s growing population is consuming food, energy and basic commodities faster than our market economy can produce them, ironically because full production capacity cannot be tapped due to insufficient worker income to support unmet consumption. Inflation has developed momentum with excess money that has flowed to those who will not spend it, not to invest it.

The market has lost faith that governments will have the political courage to adopt needed policies to remodel the antiquated plumbing of systemic cash flow needed to keep the economy growing without debt or inflation. Current market forces react to fixated inflation expectations which in turn exacerbate inflation pressure in a self-fulfilling prophecy. The world must stop looking to the flawed institution of central banking to bail it out of a monumental debt crisis with more debt.

The current crisis presents an opportunity for a catharsis to reform the greed-infected global economy away from senseless and wasteful competition, toward cooperative enterprise to rebuild a new world community based on human values, to achieve equality without conformity, with compassion for the less fortunate and respect for diversity. The wind of change is sweeping the world.

Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com.

Wealth destruction gathers pace

By Julian Delasantellis

In the Old Testament story of Exodus, the liberation of the Hebrews from slavery in Egypt, those Israelites with the sign of the blood of the lamb on their doorposts were spared God’s wrath; those Egyptians without it were not. Today, it is now apparent that the market for what is called "auction rate securities" will not be spared the wrath of the fearful God of credit market crisis now wielding a terrible swift sword over the world’s capital markets.

In this, auction rate securities take their place alongside the subprime mortgage market, the collateralized debt obligation market, the market for asset backed commercial paper, structured investment vehicles, mortgage insurers, and undoubtedly many more to come, laid low and to waste as the unfolding judgment day continues and intensifies for the great credit creation boom of the past 10 years.

If it is true that idle hands do the devil’s work, then the skyscrapers of Wall Street’s great houses of investment banking must surely be among the holiest places on earth, for lately they have been very busy indeed.

At its core, investment banking is a very simple enterprise. On the one side are lenders, those currently with money who are willing to collect some measure of remuneration for deferring their current consumption to some point in the future. On the other side are the borrowers, those who need and want money now and are willing to pay interest to get their hands on it. Investment banks bring the two groups together, and in doing so are richly rewarded in the process.

But in the same manner in which the average American shopper now has more consumer choices available to him in the cat food aisle than the average Soviet consumer would have had in the whole store, the top in their class Wharton MBAs and Massachusetts Institute of Technology math PhDs ( those with lesser grades had to settle for less important work, like working for NASA) have fashioned a dizzyingly diverse credit market architecture, called financial engineering, in which the transfer of money from lenders to borrowers could occur as readily and as seamlessly as possible.

Do you have money to lend for a long period of time, say 20 years, but don’t want to get stuck lending at a low fixed rate in case inflation and/or interest rates rise? That’s OK, financial engineering’s solution to that is adjustable rate borrowing. Do you have money to lend, and you don’t want to have to worry about whether it will get paid back, but you want to earn a higher rate of interest than safe but low yielding US Treasuries? The solution to that is insured corporate borrowing, whether it to be companies, students borrowing to pay their way through college, car loans and the most recent next big thing from 2003-06, real estate lending to prospective borrowers with less than stellar credit scores, now known with infamy as subprime borrowing.

However, as I told my son as the tow truck returned the first car his mother and I bought for him belching smoke like a Russian steel mill, for engines to work they must have lubricating oil, and the lubricating oil for the financial markets is money. For borrowers to borrow the lenders must have money to lend, more importantly, they must have the willingness to lend.

In olden days generating money to lend was accomplished the old fashioned way - somebody earned more money than they spent, and lent the rest.

So old school
With the Keynesian macroeconomic revolution of the mid-20th century, national governments took up some of the role of monetary management once entirely left to the markets, establishing in all the world’s major economies central banks to lend money into the economy when the private sources of capital were either unable or unwilling to do so. The successful working of this public/private arrangement funded the great postwar economic boom that followed World War II, but as government management of economic affairs, like the reputation of government’s role in society in general, came into disrepute with the economic and social calamities of the 1970s, the private sector came to see the big drawback of relying on central banks to create money.

Like they say on American home-repair TV shows, if you want something done, do it yourself. Central banks will create only what they consider is the appropriate level of liquidity, of money, in the economy. What if you want more money than the central banks are willing to create? In that case, the banks had the idea, essentially, to print their own.

The core mechanism here was to initiate a process of daisy chain leveraging, continually collateralizing each previous iteration of borrowing and lending in order to fund whole new successive levels of greater borrowing and lending.

Enter the math nerds, armed with their pocket protectors. Their job was to create, to be the "financial engineers" for such bewilderingly complex successive sets of these debt instruments that none of the lenders or borrowers getting into them could honestly say that they really understood what they were being sold. In the final analysis, the investment houses pitched these new products, called "financial derivatives" because their ultimate value and worth was "derived" from the value of other instruments, on the basis of the perceived credibility and honesty of the investment houses themselves.

The banks were selling off their hundred-year or more reputations for honesty and probity in order, as was the true spirit of the time, to get rich fast, and, whatever they may say now, while they were doing so they loved every minute of it.

And so was fueled the first great economic boom of the 21st century. Core economic theory states that too much money seeking to buy too few goods produces inflation, but with Chinese production holding down the prices of everything from tennis rackets to tubas the impact of the added monetary firepower never really made it into the inflation and cost of living statistics.

Where it was felt, however, was in the market for real estate in America and in much of the rest of the Anglo-Saxon world. Chinese manufacturing became skilled in producing the goods that Americans wanted to buy, but it couldn’t produce those monstrous six-bedroom 4,000-square-foot New England colonial/Southwest adobe fusion styled houses (Americans left that task for the illegal immigrants it imported from Mexico; see "Exurbia: Built on paradox and hypocrisy, Asia Times Online, March 29, 2007) that sprawled across the landscape like kudzu, and more importantly China couldn’t produce new vacant land that the houses would sit upon.

The buyers with the financially engineered cash burning holes in their pockets bid real estate prices up, and that set up what was then seen as a virtuous (these days it’s seen more as a vicious) circle of real estate appreciation. Rising prices tempted, then forced, other buyers into the market, hoping to hop onto a trend for a quick and easy killing. More importantly, the mortgages on the properties with the rapidly rising prices were bundled up and collected into packages of bond-like derivative securities called collateralized mortgage obligations.

With home prices rising so rapidly, investors snapped these up quick. Why shouldn’t they have? The securities would maintain their value, and continue to pay a very nice rate of interest, as long as the mortgage borrowers, the people living inside their homes, paid back their loans on time. There was every expectation that they would, for not to do so would mean being foreclosed out of ownership of what was seen as modern suburban goldmines.

Everybody knew that, in the long term, annual home price rises of 20% or more in the hottest local markets couldn’t last, that they were unsustainable. Still, like denizens of a Roman orgy in Pompeii seeing Vesuvius start to belch and rumble, the insane pleasures of the present were just too exquisite to entertain any thoughts of the catastrophe soon to be bearing down upon them.

About a year ago now, the tide turned. House prices had risen so far so fast that the most vulnerable borrowers, the subprimes, could not afford the payments when their low, initial "teaser" rates reset to the higher rates and monthly payments they would carry for the full terms of the mortgages. They defaulted on these mortgages, and that caused the value of the mortgage derivative bonds containing their mortgages to fall sharply in value.

You can think of the subprime mortgages as the high-tide mark of the great credit creation bubble on a warm summer’s day. As the water, the amount of liquidity in the system, recedes, more and more sea life is exposed to the sun’s hot rays - it withers and dies. As the subprime mortgage paper failed, the other derivative instruments, whose value depended on the subprime mortgage paper holding its value, were then uncovered, and were shown in the final analysis not to have anywhere near the intrinsic worth they were valued at.

From collateralized mortgage obligations through collateralized debt obligations, asset backed commercial paper, structured investment vehicles, all the way to the mortgage and bond insurers, they all depended for their value on another derivative at the next link back on the daisy chain. Like dominoes falling, like a video of a building being built run in reverse, brick by brick, the great wealth creation edifice of this decade is being pulled down.

Last week, it was the turn of what is called auction rate securities. At a US Senate hearing, New York Senator Charles Schumer asked why the Port Authority of New York, the operator of most of New York City’s transportation infrastructure, was now being forced to pay annual interest rates of 20% on a rollover of its debt, as opposed to the 3-4% it usually paid. It could not be that the Port Authority had suddenly become a poor credit risk; check out the webcams of the Authority’s toll bridges, tunnels and airports - they’re all as busy as ever.

The problem was that, instead of utilizing the standard, tried and true markets for government agency debt, the Port Authority was using the market for auction rate securities.

The finance MBA definition of auction rate securities states that they are something of a strange hybrid of long-term fixed- and short-term floating rate debt, but what you really need to know to understand what’s going on is that they are just another derivative product produced by the math PhDs and marketed by the investment houses. The failed offering by the Port Authority was but one of 1,000 auctions of these securities that last week sunk like a stone; the big brokerage houses such as Goldman Sachs and Merrill Lynch, the companies that had created, peddled and promised to stand behind the auctions, were, when they were most needed, nowhere to be found.

Everything is interconnected. What is going on here is that, as the crisis destroys wealth with every sector of the credit markets it ravages, less liquidity is available to fund every succeeding sector in the rest of the credit markets-they’re falling too.

When people think of interest rates they think of the US Federal Reserve, but what the Federal Reserve acts upon and directly controls is but a very small, and highly misleading, picture of the overall health of the credit markets. For instance, since September, the interest rate that the Federal Reserve most directly controls, the Federal Funds target rate, has declined by 225 basis points, from 5.25% to 3%. Over that same period, the interest rate for corporate bonds issued by companies rated by Moody’s as Baa, not the best, but still respectable, has actually risen, from 6.59% to 6.95%, with over half of that rise coming just this past week.

The Fed, along with the world’s other major central banks, is providing liquidity to the markets by the bucketful; too bad that just about none of that money is getting to where it’s really needed - the corporate sector. It’s being safely ensconced in short-term risk free government Treasury securities, a very prudent bet with fear pervasive that loans to the private sector will be defaulted upon and never paid back. The prospect of the US$600 and up soon to be deposited in American consumers’ hands by means of the recently passed stimulus package is apparently impressing these markets about as much as if during the World War I somebody had suggested attacking dreadnoughts with slingshots.

In and of itself, the market for auction rate securities is not large, "only" $330 billion out of the estimated total nominal world value of the entire derivatives market of over $500 trillion. (By comparison, only 22 of the 183 countries listed by the World Bank had a gross domestic product greater than $330 billion, and the estimated $500 trillion value of world derivatives is more than seven times that of total world GDP. If the derivatives markets stumbles or falls, it could take a lot of the world economy with it.)

The point here is that an avalanche of credit and wealth destruction has been created and continues to gain ever greater and greater momentum as it rolls down the hill. In another few weeks or so, another victim will be inundated and lost (my money’s on credit default swaps and the bond insurers such as MBIA as the next to go), then more after that.

They say that this year Americans are voting for change. Unless some countervailing force can soon be mobilized and employed to resuscitate and return confidence to the credit markets, by 2009 the country will indeed look very changed, no matter who’s in the White House.

Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.