The federal government is now on course to engineer the greatest expansion of credit in the history of modern financial markets. The long-term consequences will ultimately be disastrous for American financial assets, particularly the dollar and Treasury debt.

Former Fed Chairman Paul Volcker’s staunch recommendation to create RTC II or the sister version of the S&L’s Resolution Trust Corporation on Monday has landed on Treasury Secretary Paulson’s desk. Global markets are skyrocketing over the last 24 hours on news the United States will create a bail-out fund to cluster all toxic mortgage-backed paper and finally lift the dark clouds hovering over global finance since August 2007.

Markets have been crashing until Thursday’s announcement as the credit crisis reaches epic proportions -- ranked as the worst crash in inter-bank lending confidence since the Great Depression.

Thus far in September the Fed has expanded its balance-sheet by some $425 billion dollars, including extending guarantees this morning to U.S. money-market fund assets for the next 12 months. In just 19 days, the Fed has rescued Fannie and Freddie, AIG, spent tens of billions of dollars in overnight liquidity funding operations with other central banks and has extended a $75 billion dollar lifeline guarantee to money-market fund investors.

Clearly, the credit crisis requires desperate measures and only governments can help to alleviate or even quash systemic failure through the unprecedented expansion of credit and inter-bank liquidity injections. Confidence must be restored to the financial system right away. Like I’ve said all along, it’s Inflate or Die for Western capitalism.

The strains of deflation, however, will take time to extinguish. Markets are wrong to think we can all enjoy a sustained v-shaped recovery; this won’t happen. Corporate profits will decline for at least the next two quarters.

The primary trend in the markets since July has been a lightening switch from inflation to deflation as credit markets are frozen, bankruptcies accelerate and markets crash. These are all highly deflationary trends that will remain with us for the next several months until the financial system stabilizes and credit starts flowing again.

But over the next 18-36 months, inflation is going to make a formidable comeback as the chickens come home to roost in the United States and Europe.

The cost to resuscitate the financial system is primarily an American problem and will result in a massive expansion of credit; inflation is all but inevitable.

The best long-term short-sale in my book is Treasury debt. The dollar will eventually return to the basement but it has already posted huge declines until recently and might continue to rally on the premise that European rates are headed sharply lower while the U.S. is set to grow again in 2009. Though I can’t make a long-term case for the dollar, the odds are high it can continue to rally over the next several months or more, especially if RTC II is passed.

Next on the chopping block for the bears is the Treasury market. The United States will have to pay its creditors higher interest rates in the future. U.S. funding costs will eventually rise significantly unless the United States cuts its bloated spending. And the odds of that happening are nil, especially if Obama is elected.

Have a good weekend. See you on Monday.