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I tend to view gross distortions emanating from (now out of control) global systemic liquidity excess as today’s critical issue. From this perspective, the unparalleled $500bn (or so) y-t-d increase in foreign central bank reserves is indicative of the inverse of 1998’s liquidity-constricting biases and dis-inflationary forces. Today, powerful expansionary biases foment only greater financial excess and historic asset and commodities inflation. At this point, the risk of irreparable system damage comes not from an unwind of leveraged speculations, but rather an all-encompassing frenzied expansion of global finance. About the only "de-leveraging" likely in this environment is buying associated with the covering of bearish hedges and speculations. One can think liquidity excess-induced marketplace dislocation or, perhaps, Mises’ "crackup boom" on a synchronized international scale.

Undoubtedly, such incredible excess sets the stage for an eventual devastating reversal of financial flows. While the inflated "Periphery" is no doubt vulnerable, the wildly distorted "Core" is at great and escalating danger. Here, also, it is helpful to compare and contrast the late-nineties to today. Back then, chairman Greenspan and his "committee to save the world" had some distinct advantages that Mr. Bernanke will not enjoy. First, maturing "King dollar" gave the Fed great leeway to "reliquefy" and reflate. Second, the global disinflationary backdrop allowed global central bankers to loosen policies in an unprecedented fashion without worry of negative inflationary consequences. Third, as the world’s sole financial and economic "locomotive" at the time, U.S. monetary policy had significant sway over global energy, commodities and goods prices. Fourth, Asian, Russian, and "developing" economy central banks were desperate to build dollar reserves to protect against future currency runs. Fifth, the ("unaccountable") GSEs were in aggressive balance sheet expansion mode. Six, the U.S. Mortgage Finance Bubble had not yet financed an historic housing inflation, encouraged U.S. households to take on incredible amounts of debt, and thoroughly distorted risk markets. And, seven, derivative markets were not approaching $400 TN, with incomprehensible risks and ramifications.

In short, the Fed (overseer of the world’s reserve currency) has lost both its control over the inflationary process and its consequences, as well as its flexibility to respond to events. Admittedly, these extremely important developments are lost in today’s liquidity onslaught. When the eventual reversal of flows and dislocation arrives, it should be expected to have profound effects on the maladjusted U.S. economy and fragile U.S. and global Credit systems. I’ll venture a prediction that hedge fund de-leveraging will pale in comparison to the widespread tumult that will likely engulf currency, securitization, and derivatives markets – in risk intermediation generally. The derivatives markets are poised to falter into absolute liquidity nightmares, and this will not be a hedge fund-like de-leveraging issue easily resolved with aggressive rate cuts. And the longer current destabilizing flows are allowed to run roughshod – distorting prices, risk perceptions, and economic structures in the process - the more arduous the unavoidable adjustment period. That’s just the way it works.

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