By Aaron Krowne, Implode-Explode Heavy Industries, Inc.

After the financial melee of the past few weeks and the extended distress of the past year, many vocal people who should know better are now quite sure that hedge funds are responsible for the worst of our problems. With the collapse of the lending bank HBOS in the UK -- blamed on short sellers -- that country banned short selling entirely. The US quickly followed, no doubt moving with special urgency after Goldman Sachs complained shrilly that short sellers were savaging its own stock.

Nevermind that less than 3% of HBOS's float was sold short (most selling of that stock came from long-side holders of the stock, not short sellers). Nevermind that Goldman Sachs has long been one of the "ring leaders" of short selling -- with its own proprietary trading arm and prime brokering operation for hedge funds -- and further, has been fingered by some in the savaging of Bear Stearn's stock. Nevermind that small investors betting that banks have been grossly over-valued (including myself) have now been thrown under the bus -- punished for getting the story right. Apparently, we need a "demon," and those short-selling hedge funds look guilty. Plus, they don't have the kind of lobbyists the banks and GSEs have.

Amidst all this chaos, few have stopped to question how we got here -- and I mean going beyond the superficial diagnosis of "rampant speculation" and "not enough regulation". I am disappointed to see that this is about as far as even a handful of Nobel laureates have penetrated with their dime store editorials. Yes, of course, speculation was a coincedent problem. Yes, of course, it was permitted to do its damage by negligent (and perhaps intentionally ineffective) regulation.

But even accepting all that as proximate cause of the collapse, how did this situation develop? Few have asked. We (should) have free markets in this country, so speculation per se is not the problem. Taking a calculated financial risk is in fact a core American value. And regulatory structures (some would say they are Byzantine) have been present the whole time -- yet somehow they came to be "defanged." These two aspects are related: with a "fake" regulatory superstructure, speculation ran rampant beyond natural bounds. Speculators were emboldened by the belief (now, sadly, being validated) that government would protect them from their losses, providing a "PUT" under the market. As a result, unsound speculative activity became more extreme and widespread -- essentially becoming the core of the financial economy. Now, that financial economy has collapsed -- and it is being replaced by nationalization, at the public's expense.

Acknowledging all of this still does not reveal the root cause. To understand it, we must look back to 1971. That is the year that, under the strain of trade and fiscal deficits much like we are experiencing today, Richard Nixon severed the dollar from the last vestige of the gold standard. Before this point, for most of recorded history, money had been backed by some combination of gold and silver. More recently, this took the form of the British pound sterling and/or the US gold and silver bimetallic standard. Whatever nation served as the financial hegemon, a concrete tie to real value was always available, as an intrinsic property of money itself.

After 1971, no more. Virtually any long-run chart of financial markets, inflation, and commodity prices after this point shows an obvious explosion in volatility. The meaning of this "phase shift" has been generally underappreciated. Unmoored from the foundations of real value, the financial markets became veritable minefields. After 1971, virtually everyone was forced to walk these minefields, in a desperate attempt to preserve their own wealth. Instead of stabilizing markets, this has made things worse.

Like typical middle class citizens, instititions and the wealthy -- (those controlling large pools of capital) also wanted to preserve the value of that capital. Naturally. But they too were subject to inflation and volatility. They were also less able to give their money over to mutual fund types to manage it, as mutual funds would not (and could not) promise short-term capital preservation and growth. Thus, Hedge funds began to appear in the mid-70s, to cater to this market.

There then followed a phase from the early 90s till recently where inflation seemed to be tamed, risk premiums fell, and yields fell, causing the bond market to rally. While the reasons for this are outside of the scope of this article,1 the thing to remember is that the authorities recognized a breakdown in our money and banking system, so they began to patch it up by aggressively increasing the leverage permitted.

This steady but dramatic increase in leverage from the early 90s was essentially the source of all the apparently market "stability" since then. It helped aggressively "financialize" our economy, at the continued expense of real manufacturing. Just when this seemed to be coming to an end in 2000, Greenspan and the rest of the financial regulatory complex pulled one final hail-mary, and tipped off the growth of the housing and mortgage securitization bubble. Greenspan's final "PUT" of 1% interest rates along with encouraging ARMs and turning a blind eye to fraud and unsound loans put the leverage train back on track, and emboldened the financial "speculators". Until August 2007, that is.

Since that is now all over, we find ourselves back to where we were in the early 90s: dealing with a fundamentally volatile, unsound, and ailing economy, because of a fundamentally unsound banking and monetary system. It turns out that all of the sophisticated vehicles invented to tame risk and volatility did little more than postpone the pain and increase its severity when it finally arrived. Likely extensive official lies about inflation and other important econometrics did not help either, sending the wrong signals about inflation and the health of the economy to the market.

This all adds up to extensive rot in the banking and monetary system. Hedge funds and "short sellers" are simply not the problem. They exist as a natural reaction to an economy without sound money. Hedge funds and long-short strategies (which of course involve a shorting component) really turn out to be nothing more than a failed attempt at mimicing the capital preservation function of sound money. There is no capital preservation in fiat money, therefore it technically fails to be money. It is at best currency. Hedge funds are just one of the many vehicles created to emulate investment money, and shorting is a necessary strategy in a hedge.

So the government created the problem by eliminating sound money, and now hedge funds and other investors using shorting are being crucified for reacting in essentially reasonable ways to fight for their own survival and the preservation of their capital.

Meanwhile, the real heavy artillery is now coming into service to protect the bankers and others who bought into the fictitious fixed income market bubble. Government intervention, as always, is arbitrarily selecting the winners and losers -- and in this case the ones most responsible for the dysfunctional system are to be protected and rewarded.

As some are now finally beginning to mention (after Paulson's truly scary $700B bail-out proposal), it is not necessary at all to directly prop up the Wall Street firms now spiralling into collapse; they can (and should) go bankrupt, like all other busted businesses based on failed and wrong-minded models. But we must remember that bankruptcy is not the equivalent of a nuclear detonation; it is only a bookkeeping operation through which ownership is changed. After bankruptcy, worthwhile assets can recovered by private (or public) parties, should they have any value. If the government needs to step in, it would make much more sense to do so in the fashion of the original RTC (which required the "saved" banks to be bankrupt or go into conservatorship), or the Depression-era HLC, which supported individual home loans, not opaque bank securitizations.

I am not saying this wouldn't be painful, but the pain would be more localized to the financial economy, where it belongs. The real economy can always be kept going with government support of consumer loans directly, or god forbid, letting interest rates rise to market-clearing levels to bring back private participation.

Long term, increased government involvement in the financial economy beyond the basic regulation we should have had amidst the mania would be a fatal mistake for the US. The genesis of these problems was the elimination of sound money; nationalization of finance will not resolve or reverse that problem. It can only spread the pain around, and drag down the overall economy. Even direct government support of consumer loans should be done sparingly, to wean us off our general addiction to debt.

Only the re-institution of sound money can actually cure the deep-seated disease, and allow the United States to return to prosperity, individual freedom, and a well-earned role as a world leader. While most do not recognize it (and those who should know better deny it), we do in fact have a centralized economic system in the United States. Only, that system does not consist of soviet bureaus and five-year-plans, rather it consists of a fiat money monopoly, a central banking system (which actually is governed by a soviet-like bureau), and an informal partnership with Wall Street constituting a finance-based "FIRE" economy. This is the antithesis of a decentralized, free market system.

Until sound money is re-legalized, we cannot have true free markets, and the United States will remain a place of unsound speculation, financial rogues du jour (the worst of which actually having ties to the government, as Paulson is to Goldman Sachs), extreme volatility, a declining middle class, worsening extremes of wealth, and heavy-handed regulation in critical areas. We can avoid a continued descent into this morass by owning up to one key, universal fact (neglected for the last 35 years): if money itself has no ultimate value, then it is only a matter of time until the economy as a whole becomes unable to recognize value -- and then begins to destroy instead of create it.

[1] The causes of this period of fixed-income-market tranquility (from the mid-90s till the end of the housing bubble) weren't singular, but the main thrust was that leverage was allowed to increase throughout the financial system.

First, Greenspan's Fed lowered reserve requirements and began to allow banks to circumvent them with "sweeps" manuvers in the early 90s. This loosening was intended to get us out of the 90/91 recession. It worked. But these changes were never reversed. In 2004 the banking system had fewer Federeal Reserve System reserves than it had in 1992, despite more than a decade of economic "growth".

Then, in 1995, we appeared to be headed back into recession. Right around then the government came out with a "strong dollar policy". There were no public actionables of this policy, but right around then, Japan was encouraged to lower interest rates to almost zero in response to their persistent economic stagnation. This indeed sent a flood of capital into the United States, bolstering the dollar and inflating our capital markets. This was the birth of the "Yen Carry Trade". The government also likely began to "lease" the public gold reserves at this point, which had the effect of increasing the apparent gold supply, and hence lowering the price of gold, making the dollar look even better. The strong dollar policy in fact worked beautifully.

Finally, in the early 2000s, the Western regulators moved from a "fractional reserve" framework to a "capital adequacy" framework for the banking sector. This meant that high-level notions of capital reserves and liabilities were abandoned, and bank reserves requirements were determined by adding up capital withholding percentages for each particular position the bank held. Ratings in this framework played a key role of "objective" determination of risk (as if such a thing were possible). But it was easy to achieve the desired rating by shopping around, and soon none of the "big three" ratings agencies would put up much of a fight. Further, off-balance-sheet vehicles essentially of the sort Enron used to hide its liabilities became standard banking fare. These were also used to lower reserve requirements, and hence increase overall leverage. The same went for derivatives, essentially insurance obligations the banks sold to each other, but which were entirely out of regulatory scope (except inasmuch as they effected ratings on loan pools).

With the banking system gutted of capital and almost entirely credit-based, the stage was set for the panic of 2008.

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