Rerun the tape!

No, we're not talking about the War in Iraq; we know how that show goes.

We're talking about the financial show. Each new twist is just a bit more absurd than the one that went before.

The plot, as we recall it, runs like this: The tech bubble blows up...the economy and the stock market tank; 9/11 comes along...the feds panic; the Bush Administration takes a modest, fraudulent surplus...and turns it into a massive budget deficit; taxes are cut...spending increases. In the span of 18 months, a total of about $1.5 trillion is added to the economy.

Desperately worried that it has a Japan-like deflationary slump coming up (a fear to which we happily contributed, albeit in a small way, in our first book, "Financial Reckoning Day") the Federal Reserve swings into action, too. It is the Ides of March every day at the Fed. Slash; cut...rates go down to a nominal 1% - or about 2% below the rate of consumer price inflation.

Then, three years later, while rates are being 'normalized', the Fed continues to worry...this time about a slump in residential housing. Even though rates are increased, the Fed boosts liquidity by allowing the money supply to expand at a 10% rate - about three times faster than GDP growth. And Adrian Van Eck estimates that another $1 trillion of new money will be added to M3 in 2007.

This tide of liquidity, by the way, doesn't stop at the U.S. border. Instead, it washes all over the world. Foreign countries need to keep their own currencies from rising against the dollar; they, too, find they have to turn on the taps just to stay even. In Europe, for example, M3 is now rising at 9.7% per year - about the same as the United States - its fastest rate in 17 years.

Where is all this new money going? Into consumer prices? Nope...not yet.

Banks, investment companies, and large speculators control the flow of this new loot. It never reaches the working man, except in the form of additional debt. So, it does not seem to lift prices of Huggies and cola. Instead, it floats up the prices of financial assets. Art...derivatives...swaps...you name it.

As things rise in price, the intermediaries are able to get even more leverage out of them. Trade 'em, refinance 'em, repackage 'em, sell 'em, restructure 'em, hedge 'em; the whole economy has become a dervish - with each whirling, swirling, twirling financial instrument throwing off fees, commissions, and spreads for the shrewd operators who manipulate 'em.

It's almost too much for us to keep up with.

The head of the European Central Bank elaborates.

"There is now such creativity of new and very sophisticated financial instruments...that we don't know fully where the risks are located," said Jean Claude Trichet. "We are trying to understand what is going on - but it is a big, big challenge."

Mr. Trichet was speaking to the illustrious group gathered in Davos, Switzerland. The Financial Times describes the debate in which he played a
role:

"Many investment bankers and some regulators and economists argued at last week's World Economic Forum in Davos that the growth of the $450,000 billion...derivatives sector had helped reduce market volatility and made the system more resilient to shocks by spreading credit risk. But other officials fear these instruments may be raising leverage and risk-taking to dangerous levels and keeping the cost of borrowing artificially low, potentially increasing the chance of financial crises."

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.