--The US$700 billion Paulson plan is barely three days hold.

This is now a test of whether ordinary investors and savers believe the financial system is on the verge of a collapse.

--That's it, plain and simple.

The action in the money markets last week made it clear that investors have lost nearly all confidence in the share market and in the regulators of the financial system. They are moving to cash.

--If the Paulson plan fails to restore confidence, the next logical move by governments is to close markets altogether. Think about it. First, the regulators ban short selling. This squeezes the bears to cover and sends markets soaring, at least for a bit. But if it doesn't work, the only real intervention left is to close the market altogether and take a bit of a holiday.

--But for now, we'll have to see how markets reaction.

--The policy goal is obvious: halt falling share prices by shooting the bears in the head. The intended consequence was achieved in London on Friday, where shares were up 9%. But look out for the unintended consequences.

--It's not just bears who short. Hedge funds, by definition, hedge long positions by going short to cover their exposure. Remove their ability to hedge and you invalidate the logic of the trade. In other words, if hedge funds can't go short, they might not go long either.

--The result? After a huge short-covering rally, we suspect some stocks will go no bid. After all, who's going to want to go long in this environment (especially if you can't hedge your risk)? Markets are only markets when traders and investors are willing take up opposite views of what's going on. This is what makes markets, the willingness to take the other side of the trade.

--By eliminating the ability to take the short side of the trade, the regulators insure a short-covering rally in the short term. But in the long term? They've actually made the market even riskier. You have one remaining choice: long only, or out of the market altogether.

--We reckon a lot of people will chose to liquidate their longs and get into cash, rather than being long only at a time like this. The irony then, is that the ban on short selling may actually instigate the market meltdown it's designed to prevent. Perverse, but perhaps true.

--Institutional investors do have the alternative of hedging their longs in the options markets. Look for increased volume on put options. But this trade is rather obvious too, and the premiums on put options would be steep at this point. Again, the sensible (as well as panicked) position is the same: it is better to be out of the markets than in them.

--Frankly we're not sure what would reverse this sentiment. But it's not our job to engineer sentiment, only to read it. Right now, confidence is on a knife's edge. And quite unintentionally, Aussie regulators may have done precisely the thing to kick off a week of full-scale liquidation in global share markets.

--None of this would matter if the Paulson plan announced on Friday put a firm book-end on the crisis. But it hasn't done anything like that. So what has it done?

--If you haven't heard already, Paulson's plan gives him authority to set up a US$700 billion slush fund. He'd be free to directly buy the mortgage-related securities from U.S. commercial and investment banks that are currently locking up the credit markets.

--It also gives him a fund of around US$400 billion to disperse in the money market and halt investors redemptions of these near-cash investments. The money market is a huge source of short-term funding for the banks and corporations, and thus indispensable to un-freezing the credit markets.

--There are so many practical problems with the plan that one hardly knows where to begin. And that does not even include the political/philosophical problem.

That "problem" is that the Treasury Secretary is asking for complete authority (with legal immunity) in solving the crisis. Though not public yet, both the Wall Street Journal and Bloomberg report that the draft legislation makes the Treasury Secretary's action non-reviewable or by any other Federal agency or U.S. court.

--Is this not a coup, of sorts? Will the U.S. Treasury Secretary be granted authority by Congress to spend over US$1.4 trillion without review by a single elected representative or Federal agency? Can Congress constitutionally grant him that authority?

--Legal scholars will debate. Perhaps legal action will be taken. In the meantime, keep an eye on the currency and commodity markets. The U.S. dollar will be absolutely smashed should this plan go through. In fact, for the first time since we went bearish on the dollar in 2002, we believe the viability of the currency itself has been put into play this weekend with the Paulson plan.

--That is, we've always believed the dollar is headed to its intrinsic value (zero). But the Fed's have always managed to prolong the day of reckoning with half measures and market manipulation. This week, we get the distinct feeling they may fail. It all depends on the Plan.

--And what about that plan? Will it work? That depends on what you think it's designed to do. If it's designed to stabilise stock markets, you'll have to wait until after the wave of short-covering transactions are executed to see what traders really think.

--But Paulson has said his target is the credit market, not the share market. And so "work" in that sense is simpler to understand (if harder to achieve). The plan "works" if it gets all the garbage mortgage- related securities off the bank balance sheets and on the Federal (taxpayer balance sheet).

--Here Paulson and his insane clown posse in Congress chooses to save the banks at the expense of the dollar. The result for Americans is more inflation and a lower standard of living. But at least the banks don't go out of business. We don't make light of what that would mean. It would not be pretty. But let's be honest about the choice being made by the U.S. government.

--Still, there are more questions than answers to the plan. Where will the money come from? Will Treasury have to sell US$1 trillion in new debt? If so, at what interest rate? Hello Japan and China, are you there?

--More questions. What price will Paulson pay for the toxic sludge?

If investors in the market are not willing to buy this stuff at steep discounts (50% to 80% off its book value), then why should the government? Yet if the government buys the assets at a discount, it forces the banks to take more losses, losses that could wipe out their remaining capital.

--A plan that forces financial firms to take losses that wipe out their capital, while loading the U.S. taxpayer up with liabilities is no plan at all (although we admit it's just the sort of thing you'd expect from these clowns at this point). Either way, if you reason it out, you reach the conclusion that Paulson will have to pay the banks what they say the assets are on the books for.

--It sounds insane that the government would pay the banks hundreds of billions of dollars for assets that are worth, quite clearly, much less. But this is the real problem for Paulson in sorting the banks out. There is a market value for the mortgage backed assets and the intrinsic value.

--The market value of the assets is significantly lower than what the banks are carrying them at. And then there is the intrinsic value: what you can actually sell the securities for. The trouble is that the intrinsic value of these securities is unknown because it's tied to the value of U.S. houses. And that value, the median value anyway, is still falling.

--So how can Paulson possibly justifying paying book value (or more) for assets whose market value is currently much lower, and whose intrinsic value is still falling?

--That's simple. If the government doesn't buy these assets up, no one will. And if they don't get them off the bank balance sheets this week, more banks will fail.

--If investors get wind of these failures (as they did last week) they will lose confidence in the system and move to cash. This accelerates the drawdown in bank capital (as it did with Indy Mac). And it puts the retail banks (who rely on deposits for capital) in play as well. It's not just the investment banks that would be exposed any longer.

--This loss of confidence in near-cash securities happened last week. And by all accounts, it left the markets within a breath of full meltdown. This weekend's New York Post reports that, "According to traders, who spoke on the condition of anonymity, money market funds were inundated with $500 billion in sell orders prior to the opening. The total money-market capitalization was roughly $4 trillion that morning."

--"The panicked selling was directly linked to the seizing up of the credit markets - including a $52 billion constriction in commercial paper - and the rumours of additional money market funds 'breaking the buck,' or dropping below $1 net asset value."

--"The Fed's dramatic $105 billion liquidity injection on Thursday (pre-market) was just enough to keep key institutional accounts from following through on the sell orders and starting a stampede of cash that could have brought large tracts of the US economy to a halt. "

--The plan seems destined to fail by almost any reckoning. For one, it relies on Congress actually doing something in a timely manner. For once, Congress could do the American people a favour and do nothing. That is the most patriotic action it could take at the moment.

--But we reckon there are enough terrified Senators and Representatives who will rubber stamp what looks like an extra-legal transfer of authority to Paulson. Yet it won't really solve the fundamental problems. Why?

--Paulson's plan assumes that once the toxic assets are removed from bank balance sheets (without doing so at an asset sale price that wipes out the bank's remaining capital) the banks will be free to lend to one another and to anyone else again. That's a huge assumption.

--We'd expect banks, provided they can get rid of their garbage to the Treasury, to hoard cash, not expand lending. The only way to prevent this natural reaction is to give the Treasury a preferred equity stake in the firms, or negotiate terms of the bailout that include an expansion in lending once the dodgy assets are gone.

--In other words, the plan only works if the banks go right back into the housing market and re-finance everyone into a long-term loan that keeps them in their house. Do you think that will happen? Wouldn't it just put shareholder capital right back into the firing line?

--There are other problems, too. If house prices keep falling, the government will own depreciating assets (assets it was forced to over- pay for to begin with). Nothing in the plan prevents house prices from falling (nor could it). The money will never be repaid.

--And by the way, how many American homeowners will look at this and conclude they can quit paying on their mortgage altogether now because neither the bank nor the Federal government is going to foreclose on them? We reckon it's a lot, which is trouble for that whole raft of Alt-A loans currently putrefying on the balance sheets of various hedge funds, pension funds, commercial banks, investment banks, and, perhaps, your local council.

--The plan also assumes (or accepts) that the huge increase in Federal borrowing will not lead to massive inflation. Perhaps this is the only way out short of outright destruction of the financial system. But the path of hyperinflation is a long road to ruin for the rest of us.

--The plan also assumes that the investment banking model itself-buying long-term assets with short-term debt-is sound. It just needs rebooting so that sounder investment decisions can be made. After all, Wall Street must be thinking, isn't the destruction of three out of five investment banks a high enough price to pay for our misdeeds?

--And herein lies the core of the entire public policy and market response to the credit crisis. No one is willing to admit that entire Greenspan-induced credit bubble was the world's largest mis-allocation of capital and resources ever.

--America has its housing boom. Everyone got rich for awhile. People with no jobs, no income, and no assets got houses that went up value. Mortgage brokers, appraisers, and real estate agents made money on commissions.

--Wall Street, Fannie Mae, and Freddie Mae packaged it all up. The credit ratings agencies (for a fee, of course) said it was as good as triple A. AIG and others insured it. It was sold to investors and fund managers, who were delighted to get a risk-free yield greater than you could find in government bonds.

--And now it has all been exposed as just another credit bubble, albeit massive in scope and unique in the sense that it connected Main Street to Wall Street in a novel way. Both have to lose.

--Only instead of taking the losses and acknowledging the poor decisions made from the bottom to the top of the U.S. economy, we want to liquidate the bad investments without taking any losses. Wall Street wants the capital back that it wasted and Americans want to stay in the homes they couldn't afford in the first place.

--We want all of the gain and none of the pain. And we aim to pay for the liquidation by doing what Americans have been doing for the last fifty years: passing the buck and charging it to the next generation.

--Create new debt, float more bonds, and use future income and productivity and wealth to pay off today's reckless, immoral decisions. If the younger generation of Americans understood it better, they wouldn't be getting behind Obama. They'd be reading Jefferson, Paine, and Franklin and talking about a revolution.

--What's more desirable?

A revolution?

A systemic failure?

Hyperinflation on the road to serfdom?

None of them are appealing.

--Given the age we live in, the likeliest outcome is the one that causes the least pain now and requires the smallest sacrifice. That would be more borrowing and inflation. Is that a result we can be proud of? Will Americans really stand for it? Or will they be relieved by it, and get the inflation, socialism, and authoritarian government they've been creeping towards for years?

--Those are political questions for Americans. For Australian investors, the key question now is how the market responds to the short-selling ban. If foreign investors cannot hedge their longs to companies like BHP and Rio Tinto, we wonder if they will bother to be long at all in the current environment. Share prices will tell the tale.

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And now over to Bill Bonner in Courtomer, FR:

"I've never seen anything like it," said Capital & Crisis' Chris Mayer.

The Dow rose more than 400 points. Gold was up $46 at the close of the day. The dollar is falling...oil is holding steady.

We're hosting a meeting of financial analysts here at our conference center in Normandy. Last night, after dinner, we all gathered around a computer screen - amazed, aghast and appalled.

"I can't believe it..." "Incredible..." "What will they think of next?"

From England came word that the financial regulators had banned short selling of financial stocks. What did they think...that they could keep prices up by decree?

But the Americans did the same thing, only dumber. The SEC issued an emergency edict prohibiting "abusive" short selling. What the heck is that, we wondered?

Maybe it's when you sell a company when the share price has already fallen more than 10%... Like kicking a man when he's down; it's not very sporting.

The feds announced a program of coordinated intervention...with $250 billion to be made available to the financial industry to cover its bad debts...

And get this...CNBC: "Bad Debt Plan May Cost up to a Half a Trillion Dollars."

Where do the feds get that kind of money? Ha...ha...ha...

But we're not the only ones... Russia is new to the ways of late, degenerate capitalism. But it's getting the hang of it fast. It too is manipulating markets with a $20 billion injection "to boost the stock market."

And then, there's this item from Bloomberg :

The latest crises "expose the flaws" and "tarnish the image" of the U.S. economy.

They're missing the point completely.

It is not "flaws" that are being exposed - it's the whole consumer economic model and the whole generation of jackass economists who created it.

They rejected the insights of classical economics. Instead of encouraging saving and capital formation, they thought they could nurture growth by luring consumers to spend more money.

"Tarnish the image?" No, this crisis will eventually destroy the image altogether, not tarnish it.

But let us return to the story as we've been telling it. There's a war going on...a battle between a natural market correction...and an artificial attempt to avoid it. On the one hand, Mr. Market wants to correct the excesses of the boom/bubble period that began in 1982. On the other, Misters Bernanke and Paulson want to prevent him. Mr. Market takes down asset prices. Mr. Market Manipulators push them back up.

We know who the ultimate victor will be. Mr. Market never loses. One way or another, real prices must come down. That's just the way it works.

Night follows day...whether you like it or not. Stocks, bonds, property, art become expensive...and then they become cheap. Recently, they've been expensive...soon, they will be cheap.

As recently as a few months ago, it looked like the feds might be able to hold off a correction. Government-caused inflation was pushing up prices all over the world. Oil hit $147. Gold shot over $1000. Investors were getting rich in Chinese stocks and London property. Consumer price inflation was rising everywhere. Back then, it looked like consumers would be the big casualties of this war. They were facing much higher prices...with declining incomes.

But then, financial institutions began to take incoming...and pretty soon...the whole battalion of investors, worldwide, were getting beaten back.

Stock market investors suffered flesh wounds in the United States; the Dow is down about 17%.

In China, investors have practically had their heads blown off; the Shanghai index has lost 67%.

Commodity investors got whacked too. Oil is down a third from its high. Yesterday, it closed at $97. Gold lost a quarter of its value, from the high. And investors in many of the safest, surest and smartest companies on earth - investment banks, mortgage lenders, and other financial institutions - have been wiped out.

But this week reminds us that the war isn't over. The feds still have some ammunition left.

The Fed has 200 basis points left to zero; it can cut rates further.

The government can intervene directly in markets; it can seize companies; it can lend to anyone at half the rate of inflation; it can send out checks... In fact, judging on recent evidence, it can do anything...

...but the one thing it cannot do is create real money.

Every intervention costs money. And money is the one thing the feds don't have. Not real money. They only have phony money. And when investors finally realize the difference - between real money and funny money - that's when things will get very, very interesting.

So far, only one major asset class has escaped Mr. Market's correction: bonds. U.S. Treasury bonds have gone up (meaning, yields have gone down) as investors sought the safety of what used to be, and should be, the surest credit on earth. But bonds depend on not only on the ability of the issuer to repay...but also the value of the money in which they are calibrated. And if that money starts to sink in value, bonds take a hit.

U.S. Treasury bonds are unique. They depend on the value of the dollar...which the issuer itself controls. But as the war between Mr. Market and the feds continues, the U.S. Treasury will have a harder and harder time maintaining the value of the dollar. Because wars are costly.

The feds will have to stretch the dollar farther and farther in order to meet the expense. Eventually, the elastic dollar will snap...and bonds investors will have their turn. Bonds will crumple over too...

Dear Reader, this war has already caused millions of casualties...from Wall Street's masters of the universe...to the little guy with a sub- prime mortgage on his double-wide.

But when the shooting stops and the smoke clears - only one man will be left standing. That man will be gold. Make sure you are standing next to him.

*** "Is the United States no longer the global beacon of unfettered, free-market capitalism?" asks the International Herald Tribune.

"We have the irony of a free-market administration doing things that the most liberal Democratic administration would never have imagined itself doing in its wildest dreams," says Ron Chernow, a leading American financial historian.

Where has he been? Where have they all been? They might as well be a spider watching a couple make love; he sees the action but has no idea what is going on.

The Bush Administration has been the most liberal administration since Franklin Roosevelt. It has added more debt, more restrictions, more jackass programs, wars, spending, humbugs and bamboozles than any U.S. government in half a century.

The one thing it hasn't done is raise taxes to increase federal revenues; thank God. But it spent the money anyway!

Not that we're complaining. Far from it. We've enjoyed the show.

Besides, our role here at The Daily Reckoning headquarters is not to gripe and moan...but merely to try to understand.

How is it possible for a "conservative" government to nationalize the insurance business? What comes into the heads of "conservative" leaders that makes them want to spend a half trillion they don't have bailing out investors? Why would any U.S. official with his wits about him want to raise the possibility of war with Russia...over Georgia?

Maybe Atlanta would be worth defending...and even there we have our doubts. But Tbilisi?

How does it work? How do people come to think such things? We don't know, but we have a theory:

People come to think what they must think when they must think it.

In other words, history follows certain patterns. Not predictable. Not exact. But broadly reflecting the inherent blockheadedness of the race...and generally in line with historical precedents.

America is in a period of imperial decline. Its economy is slipping. It citizens are getting poorer, both absolutely...and relative to the rest of the world.

The "smart" thing to do would be to hunker down, cut costs, bring troops home, reduce Medicare and Medicaid, raise interest rates, encourage saving and give the country time to get back on its feet economically...so it could enjoy its relative decline with good grace.

But that's not the way history works. Did Alexander stop at the Hellespont? Did Napoleon stop at the Rhine? Did Hitler stop at the Oder? George Bush I stopped at the border of Iraq. But George W. Bush, under the sway of the neocons, kept going. His mission: to destroy the U.S. empire.

No, of course...he doesn't know that's his mission. He's an agent of change...a useful idiot, as Lenin would have said...a stooge...willing to do what isn't so smart, but what helps the course of history along to its end.

And now, we have a financial crisis. Does the government respond like Andrew Mellon in the '20s? "Liquidate labor...liquidate the banks...liquidate the farmer..." said Mellon, willing to let the chips fall where they may.

No. That would be smart. Get it over with. Move on. But because the U.S. economy is in a long-term decline, moving on is the last thing people want.

In the '20s, the United States could let chips fall...because it had a growing, dynamic economy. Other chips would rise up quickly. But now it must try to keep the chips from falling...because it is mature...aging...decaying. It wants to hold on...to keep things together...to avoid change.

That's why socialism is so attractive to Americans...it offers the illusion of safety and stability.

More below...

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THE DUMBEST MAN IN AMERICA
by Bill Bonner

Where did he go wrong?

John Edwards, recently claimed the title of the "dumbest man in America," when the press got wind that he was two-timing his wife and running for president at the same time.

But Edwards has more competition every day. By Monday of this week, Fuld had completely destroyed Lehman Bros.

In January of 2007, the financial industry put a value on the firm - a company it knew well - of $48 billion. This week, the bid went to zero. And then, on Wednesday, came more disquieting news: the world's largest insurance company, AIG, was failing. Martin Sullivan had run it into the ground, said the analysts. Now, it needed an $85 billion bailout.


And now the heads roll on Wall Street. James Cayne at Bear Stearns. Stanley O'Neal at Merrill Lynch. Charles Prince of Citigroup.

But who's the dumbest? Surely Dan Mudd and Dick Syron at Fannie and Freddie are still in the running. Even with the deck stacked in their favor, they couldn't stay in the game. And let's not forget the rescuers - Ben Bernanke and Hank Paulson.

They've practically nationalized not only America's mortgage industry...but, taking an 80% stake in AIG, the insurance industry too! Where does the money come from? It's borrowed too - hundreds of billions worth. Surely, there's a guillotine waiting for them somewhere.

The last 15 years have been too kind to finance. Wall Street and the City are essentially debt mongers; and in the boom, nobody didn't want to borrow. Financial profits soared.

Since 1980 the profits of the U.S. financial sector as a portion of GDP have gone up 200%. Industry owners and managers could have taken their money off the table and retired to Greenwich. But on the back of this outsize success grew a monstrous hump of self-delusion; the masters of the universe began to believe their own grotesque guff.

The financial markets were perfect, said the academics. All-knowing and all-seeing, they wouldn't make a mistake. And the chiefs at the big financial firm must have thought they supped with the gods themselves; they had the paychecks to prove it.

Of course, some Wall Street bosses were more cunning than others. In selling itself to Bank of America, for example, Merrill Lynch dodges the scaffold; but it becomes a ward of the state, almost like Fannie and Freddie before they were kidnapped outright.

Bank of America has easy access to Fed funds; Merrill figures it might need more money too.

The old regime on Wall Street was dominated by just five large investment companies. But the more they talked their own books, they more they came to think it was true - they were all too big, too smart and too rich to fail. Not only did they package and sell explosive packages of debt; they put the stuff in their own vaults too.

Now, Lehman, Bear, and Merrill have blown themselves up. Only two more to go.

Bill Bonner