This week has been filled with surprises. It began with bad news for international stock markets. It got rolling with unprecedented news from the Federal Reserve System. It got wild with nutty news from a bureaucrat in New York. Then it settled down to wild swings on the American stock market.

All in all, this week was a sign that the economy is headed toward the falls. Keep close watch on the canoe 100 yards ahead of you. If, without warning, it disappears, start paddling for the shore. Either shore. Fast.

On Monday, Americans were home, celebrating the birth of Martin Luther King. Well, maybe not celebrating. But home.

The American stock markets were closed. That left foreign markets to set the pace. They fell. They looked like they were in free-fall. Then, the next day — day two for them — they fell again, only worse.

Fifteen minutes before the New York Stock Exchange opened, there was an announcement from the Federal Reserve System. The Federal Open Market Committee had met in secret the night before and had voted, 8 to 1, to lower the target rate for the Federal Funds rate by three quarters of a point: 75 basis points, as they call it in the trade.

First, this announcement came a week before the scheduled meeting of the FOMC. This was unprecedented. Second, the FOMC met secretly overnight. Third, the rate cut was the largest single cut in over two decades. Fourth, the announcement came 15 minutes before the market opened.

What does this tell us? This: eight of the nine members of the FOMC thought the stock market was about to collapse. This was a panic move by eight frightened men in the face of a potential panic sell-off by frightened mutual fund managers, on behalf of frightened investors who would start selling as soon as the market opened.

This is exactly what happened. Sell orders from the day before were executed. The Dow Jones Industrial Average fell like a stone by 450 points. This carried the Dow below its high in March, 2000, officially wiping out all profits for eight years, not counting the 21% loss due to price inflation, i.e., lower purchasing power.

Then the market turned. Oh, joy: the FOMC had intervened to save the stock market! Up, up, up it went, almost to the opening price. Then it fell 170 points. Then it rebounded almost to break-even. Then it fell. Then it rebounded. Then it fell. It wound up down by 128. Whew! Saved by the FED!

Overnight (for us), stocks rebounded in Asia (day three). There was one cause: confidence that the FOMC’s action would save America from a recession. Asia’s markets recovered most of what they had lost for two days.

This recovery was extremely important, but not for reasons offered. It revealed that Asian stock markets are completely dependent on the Asian investors’ perception of America’s economy. This means that if the U.S. stock market falls, Asia’s stock markets will fall. The economies are interlinked. But America’s economy is the tail that wags the dog.

SOROS’ WARNING

George Soros doesn’t think so. I hate to argue with the multi-billionaire currency futures guru, but what happened this week says he’s wrong.

On Tuesday, he gave a speech in Davos, Switzerland at the annual Davos summit. He said that America is clearly headed for a recession. He also said that Asia isn’t.

He added this: the U.S. dollar is now being abandoned by central banks. It will no longer be the world’s exclusive reserve currency. Bloomberg reported:

“The current crisis is not only the bust that follows the housing boom, it’s basically the end of a 60-year period of continuing credit expansion based on the dollar as the reserve currency,” Soros said in a debate today at the World Economic Forum in Davos, Switzerland. “Now the rest of the world is increasingly unwilling to accumulate dollars.”

This is true, but this has been going on for several years, as I have noted before. This quiet abandonment of the dollar, not America’s price inflation (low) or monetary inflation (zero in recent years — M-1), is why the dollar has been falling and gold has been rising.

A recession is almost certain in the United States, he said. But he is optimistic about the world’s economy.

“I think it is almost inevitable that the turmoil in the financial markets will affect the real economy,” said the founder of New York-based hedge-fund firm Soros Fund Management LLC, which has $17 billion in assets. China and India are benefiting from globalization to a degree that “I don’t expect a global recession,” he added.

While I don’t control $17 billion in assets — why, not even 10% of this — I think he is wrong. I think what happened early this week indicated how wrong he is. The world’s stock markets went into a tailspin on the threat of a U.S. recession. Then most of them recovered because of the supposed ability of the FED to avoid a recession here.

Why would the stock markets move in lock step if the underlying economies were not so tightly intertwined that a fall in demand from the United States will not spread?

Here is one possible response: “If China’s economy is growing at 10%, why should a 1% or even 2% decline in the U.S. economy pull down China?” Here is my answer.

CHINA’S BOOM

China’s central bank has already announced that it will take steps to control price inflation. A Reuters story on December 30 announced:

China’s central bank will implement a tight monetary policy in 2008, using a range of tools to keep a check on liquidity, the central bank governor, Zhou Xiaochuan, reaffirmed.

The People’s Bank of China has waged a war on excess liquidity and inflation in 2007, raising interest rates six times and increasing the proportion of deposits that banks must hold in reserve 10 times, to a record level. Still, annual consumer inflation is running at the quickest pace in over a decade, and many economists are concerned that it could spill over from food into the broader economy.

The imagery of faithful central bankers waging war on inflation is as inspiring as the image of Alan Greenspan waging war on investment bubbles. The economic boom in China has been created in large part by the central bank, which has inflated M-1 at rates in the range of 17% to 19% for years.

For China’s central bankers to warn about price inflation is comparable to the warnings from the Federal Reserve’s spokesmen regarding price inflation. In both cases, the central banks are the exclusive cause of the price inflation. From 1938 until now, there has been only one year — 1955 — where America’s prices fell, and then by only 1%. That is because the FED has increased the money supply every year since 1933.

At some point, China’s central bank will be successful in slowing price inflation. The economic boom requires ever-larger percentage increases of the money supply. By merely following the policies of the previous year, the central bank will produce a recession. If the central bank is serious about slowing inflation through interest rate increases, it will see its goal achieved. Price inflation will in fact slow. The cause of the slowdown will be a recession in China.

What could trigger this? A recession in the United States could. Falling demand for the goods produced by China’s export sector will produce bankruptcies in China. They will order no more goods and services. These effects will ripple through the Chinese economy. In the absence of the recessionary efforts of central bank policy, these ripples could be contained by growth in the other sectors. But a reduction of Chinese economic growth is already in the pipeline. The central bank’s policy of letting interest rates rise is sufficient to create a domestic recession.

When China goes into recession, assuming the U.S. is also in recession, the whole world will go into recession. This is why I think Soros is wrong. The crisis in the subprime market is spreading to the corporate bond market. The bond insurers are facing bankruptcy. This will lower the ratings of the bonds held by banks all over the world.

This leads me to Wednesday’s stock market reversal.

THE 600-POINT RUMOR

The Dow opened Wednesday in panic sell-off mode. It opened at 11,950. It gapped down in one shot to 11,750. Then it fell to 11,700. Then it went back up almost to 11,850. Then it steadily retreated to 11,650. That was just before 1 p.m. Then it reversed. Up, up, up it went. It closed at 12,200. The move was in the range of 600 points, and was reported as such by the press.

What could cause such a reversal? Only after the market closed did the general public find out.

At about 1 p.m., there was a report issued by the office of the New York State Insurance Department. The head of the Department had called a meeting of New York bankers, which was beginning. London’s Financial Times described what happened next.

Leading US banks are under pressure from New York state’s insurance regulator to provide as much as $15bn to support struggling bond insurers, people familiar with the matter said on Wednesday night.

Eric Dinallo, New York insurance superintendent, held a two-hour meeting with bank executives on Wednesday and urged them to provide as much as $5bn in initial capital to support the insurers — the largest of which are MBIA and Ambac — and ultimately to commit up to $15bn.

Consider what this meeting was about. Companies that have issued insurance contracts to cover for losses in bond holdings are now threatened with bankruptcy because of the turmoil in the subprime credit markets and also the huge market called credit default swaps. These companies may not have enough money in reserve to cover the losses. Their stock market value had tumbled. They were facing bankruptcy. (In my view, they still are.)

Who are the parties who have paid premiums for this insurance? Banks, mainly. Hedge funds are also on the other side of the contracts. If these insurers go belly-up, the market value of the formerly insured bonds will fall. This will create losses for the banks and hedge funds — potentially gigantic losses.

So, the head of the state insurance department called in bankers — whose portfolios are at risk by the bankruptcy of the insurers — and suggested that the pony up as much as $15 billion to cover the losses of the insurers.

Got that? The insured are supposed to insure the insurers against loss. Why? Because if the insurers go belly-up, the banks will experience a loss.

This sounds crazy. But it makes sense under this scenario: the collapse of the bond market threatens the banks by a lot more than $15 billion. If the banks called in are facing losses so huge that $15 billion looks like a bargain, can you visualize what the threat is internationally? After all, the commissioner did not call in banks from outside New York.

The International Herald Tribune, owned by the New York Times, reported on January 24 that the threat of default is creating widespread concern.

Regulators fear a possible chain of events in which the troubled bond insurers, MBIA and Ambac, might be unable to keep their promise to pay investors if borrowers default on their debt.

That could leave the buyers of the bonds — including many banks and pension funds — on the hook for untold billions of dollars in losses, shaking confidence in the financial system.

It was in this context that the discussion of a $15b bail-out took place.

The notion that the failure of even one big bond insurer might touch off a chain reaction of losses across the financial world has unnerved Wall Street and Washington. It was a factor in the Federal Reserve’s decision on Tuesday to calm investors by reducing interest rates by three-quarters of a point, to 3.5 percent.

The bond-insurance industry has never before been threatened by a failure of major bond insurers. It has been a low-risk industry, the article reports. Not any more.

“Regulators are furiously trying to come up with a plan,” said Rob Haines, an analyst at CreditSights, a research firm, who was not at the meeting. . . .

While $15 billion might seem like a large amount of money for banks to commit to bond guarantors at a time when many investors have lost faith in them, Haines said it would be smaller than the billions the banks might have to write down if the companies lost their top ratings or incurred major losses.

“It’s a calculated kind of risk,” he said.

A spokesman for Ambac did not return calls seeking comment. A spokeswoman for MBIA declined to comment.

What are we talking about in terms of potential losses?

MBIA has estimated that in the worst case, which it described as a one in 10,000 event, it expects to incur losses of $10 billion, a fraction of the $673 billion it has insured.

I don’t know about you, but when I read “$673 billion,” insured by a single company in the industry, I grow nervous. Sorry, but I do.

I also think: “What kind of people paid premiums to a company to insure $673 billion worth of bonds?”

Answer: the best and the brightest, the people whose decisions have laid the foundations of the present crisis, which, if it occurs, will re-shape the world’s economic system. You know: people like Charles Prince, the former CEO of America’s second largest bank, under whose administration, Citigroup has lost (so far) an admitted $18 billion.

My conclusion: The international capital markets are at the edge of the abyss.

The article in the Financial Times added this information.

People familiar with the matter said the specifics of a possible capital infusion had yet to be decided, but contributions would not necessarily be based on how much exposure each bank has to bond insurers.

Some participants in the meeting described the discussions as at an early stage.

Let me summarize. A bureaucrat in charge of regulating MBIA calls in New York bankers to discuss a bail-out totalling (initially) $15 billion. There are no specifics announced. This is only a preliminary discussion. Result: the Dow rises almost 600 points in the afternoon.

If you think stock mutual fund managers were ready to grasp at straws, you have the picture.

CONCLUSION

We appear to be in the early phase of a financial earthquake that will get into the history textbooks. The volatility of the American stock market indicates something severe, yet at present is being contained. Contained by what? By rumors and hope.

I do not suggest that you entrust your financial future to people who invest in terms of rumors and hope. These are the same people who advised clients that they should hold a balanced portfolio of American stocks back in early March of 2000. That portfolio is lower today by 21% due to price inflation, and if the portfolio was the S&P 500, lower by an additional 15% because of recent market declines.

The bad news is just getting rolling.

Stay tuned.

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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