It is a primary theme of current Credit Bubble analysis that the unfolding Government Finance Bubble-driven global reflation will be of an altogether different nature than previous Fed/Wall Street-induced reflations. For one, the major reflationary monetary mechanism has shifted from Wall Street finance (securities firms’ balance sheets and securitizations, “repo” finance, hedge funds, etc. - to various avenues of government finance. As such, we are expecting a lasting shift in the flow of finance away from the asset markets, with important ramifications for household wealth and spending. The Flow of Funds provides confirmation of this analysis.

Household Balance Sheet data make for dreadful analysis. Despite incredible government stimulus, Household sector Assets declined a further $1.444 Trillion during the quarter. This brought the one-year drop to an unrivaled $10.075 Trillion (13.5%). At $64.517 TN, Household Assets have returned to year-end 2005 levels. Over the past year, Financial Assets declined $7.869 TN (16.3%) to $40.296 TN and Real Estate dropped $2.279 TN (10.3%) to $19.819 TN. Household Liabilities contracted at a 3.2% rate during the quarter to $14.141 TN, with a one-year drop of 2.1% ($301bn). As such, Household Net Worth contracted $1.330 TN, or at a 10.3% rate, during Q1 to $50.376 TN. Household Net Worth dropped $9.774 TN over the past four quarters, or 16.2%, deflating back to about the Q3 2005 level.

There are also indications of potential trouble from Rest of World (ROW) flow analysis. ROW holdings declined for Agency/GSE-backed securities, Open Market Paper, U.S. Time Deposits, Inter-bank Assets, Corporate Bonds, and Loans to Corporate Business. Meanwhile, Treasury holdings expanded SAAR $636bn during the quarter to $3.341 TN. Our foreign Creditors may be content to recycle dollar flows back into Treasuries, but they are thus far in no mood to return to financing our business or household sectors. This may prove a major factor contributing to an altered flow of finance throughout the U.S. economy. It can also be read as a warning that the crucial process of dollar recycling rests increasingly on market perceptions of the soundness of one single market – U.S. Treasuries.

Financial reform received keen focus this week. Everyone agrees the previous regulatory framework failed profoundly in restraining excesses throughout mortgage and Wall Street finance. So I would like to know which regulator in the new regime is going to protect the system from similar excesses throughout government finance. Same problem as before: No one will step up and reign in a Bubble. There’s always an excuse – masterful justifications and rationalizations. And, of course, the intellectual frameworks operating in Washington and elsewhere would adamantly insist that now is the absolute worst time to reign in government borrowing.

So disciplining Washington will be left to the marketplace. On the one hand, the markets were content to accommodate Wall Street’s self-destruction for far too long. On the other, the markets were burned and would seemly now be heedful of “Ponzi Finance” dynamics.

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.