Inflate or die. That’s the Federal Reserve’s mantra since last August when the subprime credit crisis first emerged on its destructive path pummeling global equity and bond markets. Since August 2007, global banks have lost a combined $1.6 trillion dollars’ worth of stock market capitalization – the worst year-over-year loss in history.

Before it’s over, Americans, Sovereign Wealth Funds (SWFs) and other investors will pay an astronomical price to rescue the battered U.S. financial system. The bull market for financial services stocks that began in 1982 hit a crushing dead-end in August 2007; it will be years before this sector fully recovers.

Banks, in a desperate effort to recapitalize smashed-out balance sheets continue to dilute shareholder equity through massive rights offerings and new issues. Dividends have been sliced and diced. Since last August, a cumulative $476 billion dollars has been written off or lost amid the worst credit crisis in a generation.

Postponing, not Avoiding Systemic Risk

Over the last 12 months, the Federal Reserve and the U.S. Treasury have orchestrated spectacular bail-outs to preserve the financial system and avoid systemic risk. But the long-term consequences of these actions will be enormous as existing and future generations of Americans pay dearly for rescuing one financial institution after another.

There is no “avoiding” systemic risk. The final consequence of Morale Hazard is a larger, more threatening financial panic down the road that ultimately will be too big to contain.
Bail-outs and government nationalization of failed enterprises only increases long-term inflation. To pay for bail-outs, the government ultimately turns to taxpayers to fund the expansion of credit. By interfering with capitalism’s natural progression, the government delays its own financial reckoning; an insolvent institution must be allowed to fail.

Morale hazard has played a major role on Wall Street and at the Bernanke Fed since March. Investors and analysts have seriously questioned the Fed’s unorthodox role as lender of last resort. What business does the central bank have to collateralize a failed institution’s almost worthless debt with Treasury securities? That’s what the Fed did with Bear Stearns Cos. in March and other troubled but unnamed investment banks and banks over the same period.

Is Morale Hazard Justified?

Is a bail-out justified if that institution mismanaged its business model? More importantly, should the government rescue a financial firm in the interest of deterring systemic risk?

The Bear Stearns’ bail-out deflected a major financial panic. Contrary to most financial news reports in March, several large hedge funds were in the process of liquidating their accounts at Bear Stearns, a leading prime broker for hedge funds; one hedge fund, among the largest in the world, sparked a run by other hedge funds as the entire gamut of players scrambled to get assets out of Bear. There’s no doubt a major global financial panic would have ensued on March 17 without some sort of rescue.

In July, the government officially assured investors that GSEs or Government Sponsored Enterprises, Fannie Mae and Freddie Mac, would be guaranteed by Uncle Sam. Prior to Secretary Treasury Paulson’s assurances in mid-July, markets were reeling at the prospects of a Fannie and Freddie collapse. Again, a failure of both mortgage giants would have caused sheer panic in global markets because of the significant role they play in mortgage financing, debt issuance and liquidity to banks.

The Piper will Come Calling – Eventually

Bail-outs and Morale Hazard are highly subjective topics among investors and policy-makers since March. In the end, the United States will have to finance these and future financial bail-outs with enormous amounts of credit, mostly from taxpayers. The drain on the economy, American capital markets and ultimately the dollar are inevitable.

The United States is already losing its financial pre-eminence to London, Frankfurt, Hong Kong, Singapore and Dubai this decade. Capital flows to safe, tax-efficient shores. With regulations likely to surface as a consequence of the sub-prime mortgage debacle and other banking oversights, the United States will increasingly lose more market share to other international financial capitals.

Eventually, other financial systems will also feel strained by America’s slow but progressive financial dilution.
The United States still plays a vital role in global finance and it would be naïve to think Dubai or Singapore would not be adversely affected by another major U.S. financial crisis in the future. That’s why I continue to buy gold. All governments are tied in one form or another to each other as global trade and capital flows have grown increasingly inter-connected. There’s no safe-haven overseas ahead of the next major crisis.

The dollar, the euro and other currencies are a bunch of drunks created by a warped bartender. Fiat paper is a poor store of absolute value compared to gold and other tangible assets like oil and gas.

Hedge your future with gold and other hard assets – paper money won’t protect your purchasing power from the upcoming inflationary storm in the United States and eventually, everywhere else.