Right now in the financial sector the Collateralized Debt Obligation, CDO for short, is considered the great villian. Nouriel Roubini took after them the other day.

The reality of the financial system is that it wasn't lenders paying fees to people to assure that the loans being made were good, it was lenders paying access to the land of cheap money. You borrow at between 15% to 25%, the carry trade made it so that Japan was virtually paying people to borrow huge sums of money. The entire financial chain was about giving you access to 6% money that cost, basically, 1%. That 5% arbitrage was what mortgages were made of, and then giving access to home equity loans which cut down on credit card, and then getting tax deductions.

The hard neo-classical reality here is that the mortgage interest deduction is one of the large distorters of the economy, it is also going to be the untouchable sacred cow, along with selling homes tax free. And yet these, as larger distorters of the economy in favor of consumption over exports are what any absolutely honest neo-classical solution would rest on: remove the mortgage interest deduction and the deductions for home sales.

Ain't gonna happen of course.

Keynes quipped that politics is often the choice between the unpalatable and the disastrous, but more usually politics is a way of imposing the disastrous on others to avoid the unpalatable. It is not that it is necessary to remove the mortgage interest deduction, but, if we are to pursue a neo-classical economic scheme where scarcity is imposed on consumers through price signals, then clearly the current scarcity of oil must be effected by removing government subsidies for activities that consume oil. This means allowing communities to drop off the air grid, this means removing the mortgage interest deduction, and indeed almost all forms of subsidies for home ownership.

Since these things are less than merely unlikely to happen, I give social security privatization better odds than removing the mortgage interest deduction, we cannot pursue a neo-classical strategy any longer with any real effect.

This puts us back in the realm of liberal and Keynesian solutions, and brings us back to what Congress does, for example in the Agribusiness bill, which is redistribution.

The logic of redistribution is rather important, and often overlooked. It goes back to one of the oldest of human problems, the "city problem".

The city problem works like this. Cities, because they concentrate capital, communication, demand, and liquidity, are engines of value creation. They can create a great deal more value from inputs, precisely because people can specialize. However, this creates a problem: namely inflationary pressures rise, and labor commands a greater price. It also leads to pressures of concentration itself: disease, overcrowding, crime, political instability, social turbulence.

But fatally, it lead to the problem that it would act as an engine of credit, and the high inflation of the city environment would eventually leech the money out of the agrarian hinterlands. These hinterlands would collapse into debt to the cities, their workers would pour into the cities looking for work, setting off a spiral of food inflation and deprivation that would eventually consume the surplus that the city could generate as an economy. The backbone of the military class, the agrarian class, would collapse.

The problem of harnessing a city's power of value creation, while maintaining the balance of the city itself is the subject of Plato's Laws and Constitution. The feverish city of creation collapses into the cold city of dictatorship or war. Athens, Rome, Nanjing, Baghdad, Constantinople/Istanbul, Paris, London, New York City - and many others - all faced the city problem.

Many pieces of the solution were proposed, but it was Adam Smith and Hume who realized that it was the concentration of money in the city itself which was a core part of the problem, and taxing that concentration - as a concentration - would only reduce inflationary pressure. This insight, however, was not heeded, in no small part because monarchial political coalitions sooner or later come to be rooted in the financial power of the central city, and side with the banks, which take advantage of the concentrating factor.

Industrialization merely increased this disparity, and imperialism was one solution: that is, have agricultural hinterlands under some form of occuapation, or face constant agrarian turbulence. It was only with the collapse of Tsarist Russia, and then the Great Depression, that the ultimate end points of the twin imbalances, that of an urban underclass, and an exurban outerclass, became untenable.

The Liberal solution to this problem was two kinds of redistribution: vertical and horizontal. Both are taxing of inflation from rents and concentration of money, and redistribution of the buying power. This leads to spreading of demand, and the consequent reward for economies of scale.

In otherwords, if more people can buy cars, there is every incentive to make more cars more cheaply. Economies of scale help the national economy, both in exports and in military equilibrium, and provide greater well being.

The liberal coalition then distributed money downwards in building infrastructure, outwards in price supports and subsidies, and both downwards and outwards in the form of Social Security and Welfare.

Then we reach the neo-conservative era. The neo-conservative era did not dismantle this process, though they pretended to want to, instead, by attaching a Byzantine set of notions of moral deserts to the receiving of redistribution, one designed to allow nearly unlimited redistribution to members of the inner political coalition, while not allowing much redistribution to others. This has lead to a series of progressively increasing financial crisis points, as the maldistribution of buying power led to distortions in buying decisions. Because this was key about the old liberal consensus, with broad redistribution, it was possible to cancel out distortions to a great extent.

In the present this pattern continues: the defense budget, prison budgets, home ownership subsidies, transportation bills, among others, are all designed to subsidize the buying power of narrower ranges of interest who "deserve", and not on other interests who "do not deserve". Thus "taxpayers" "deserve" to get "their" money back, or to not "pay" in the first place. This inverts the question, the question wasn't a refund on overpaying taxes, but the ability to use taxes to transfer wealth accumulation from inflation and rent and to capital. The more people want to get rich from inflation and rent, and not capital, the more the process accelerates.

This lead to the rebifuraction of money. This was an inevitable effect once rent, inflation, and arbitrage, were the primary ways of making money. The reason free marketeers want the government out of controlling rent, arbitrage, and money is that they can perform the same services, at a much higher mark up. Even centrist economists like Roubini realize this. Even market leaning economists realize this.

This bifurcation of money comes from this, in an pure scarcity environment of money, how does one price the possibility of abundance? If there is one money, then there is a present future value of that abundance, and so, the ability to spend that right now. However, this conflicts with scarcity, and indeed the value of that future abundance is that it breaks present rents and scarcities. Conflict: society can't give people the unlimited ability to spend future abundance to claim present scarcity for consumption, when that same present scarcity is needed to create the future abundance as investment.

Which is why, in the split money universe, there is a need to price control separate from consumption. Of course those who have control will consume lavishly compared to others, but more importantly they will control the flow of investment. They can then arbitrage by offering selective access to speculative money, which must be at very low rates of interest because it theoretically will pay back over a long period of time past present scarcity, and consumption interest, which must, in real terms, be quite high to force the pricing of current scarcity.

Historically speaking, this game lasts for perhaps 30 years or so before it collapses under twin pressures. The first is the obvious pressure that this division is absolutely corrupting in two directions. Those inside the speculative money system, however tangentially, are paid 100, 1000, 10000, 100000 times as much as those outside of it, and this creates envy from below, and the temptation from within to treat this as a sinecure. The second is what happens when the day that abundance arrives, and it is already spent on projects to collect the rents charges for buying it in the first place?

A good example is the battleship arms race at the beginning of the 20th century: greater prosperity from the advance steam/electrical economy arrived... and was spent on an imperial arms race and the most expensive war in history to that time.

We are reaching that point now. Much of the money in the investment system is supposed to, in essence, price not needing old sources of oil. However, instead of investing the money in development of these substitutions for existing energy supplies, they were spent collecting rent on the access to the speculative money system itself. This lead to misallocation of investment in US housing stock, because that was the thing easiest to collect rent on, and not on finding ways of increasing the number of people who could live the affluent life style, which was what was supposed to be happening.

Globalization was used to mask this, by dumping people out of affluence inside the developed world, and elevating people in the developed world who were happy on less, however, that cross over point is being reached. In PPP terms, the upper middle class of Beijing is now making about what people in the middle class of the United States are making at similar levels of career and education. They have problems in consuming, but they also have much higher savings opportunities in a currency that is bound to appreciate. They also have more access to personal service and a number of other things. They just have an acute air shortage right now.

Labor arbitrage, while political poison to more and more of the developed world working class was also a prisoner's dilemma, as long as most people in the working class were willing to save a bit on scarcity to buy foreign made goods, the process would drive itself. That and a political agreement to use things like H1-Bs to carve down parts of the middle class that were making too much, in the view of those above them. This choked off the engine of growth: more and more people could not earn enough, and had to borrow, to stay in the life style that was needed to produce economies of scale on things like wireless devices and HDTV, both of which are lagging in their introduction well behind the development curve.

Notice I have not said anything about derivs, CDOs and other financial vehicles used to rationalize this irrational split level money system. This is because the packaging of risk, qua packaging of risk, is neutral. CDOs and the rest could easily have been financial innovation which allows the spreading of capital costs and hedging of bets for large pools of investment. Or they could have been used as shells to hide the lack of investment supply. The sign that they were used to do the latter rather than the former is pretty clear - oil is smashing every record for cost, as those of us paying attention repeatedly predicted it would at some point. Since oil was one of the scarcities that future capital abundance was supposed to solve, the answer is that all of the investment schemes of the last 30 years have failed to do what they claimed they would do, that is, that unfrettered, unregulated, unexamined, unquestioned, unlimited, untaxed capital markets would create supply. That is what they claimed with "supply side" economics, that the rich people supply the good in the world, and that poor people should get out of the way while they supplied it.

In reality liberalism is the real supply side theory of economics, in that it argued that the distribution of buying power, not the concentration of rent, was the real engine of creation of new supply. Make more people who can buy things, and that would pressure those that made things to make them at a price that more people could afford. Capital concentration could be handled by well regulated investment, driven by a demand for future returns in retirement and national investment. Basically, people today would forgo some consumption to get a retirement, and that consumption would create the capital concentration needed to bring to market innovations created, to no small extent, by government demand. People could live will, be rich, but there was no rental access to this realm of money per se. On the contrary, the rich paid rent to the government to remain rich.

So where do we go from here? Well the are really two choices. While there is a broad consensus to "bail out and regulate" there is not so much a consensus to make a clear decision about the future of money. This is a failure which assures that there will be another, larger and more brutal, financial crisis later. The root cause is that either there is one unitary supply of money, and the social choice of government forces investment to produce expected abudance, or there are two kinds of money and rent on the access to speculative money is ruthlessly controlled. Since the latter has never been accomplished the former is correct until someone comes up with a better theory on how to prevent people who can buy the free market and governments from doing just that and then ignoring the rules, regardless of outcomes, and passing the ruin on to others.

The reunification to the point where "money does not matter" is based on the realization that there are disequilibria in the financial and economic universe. People who don't get enough to eat, starve. There are often swings of financial equilibrium based on information assymetries which are greater inefficiencies than a market system can handle. Wars happen. Things like this.

The government then taxes enough present control in order to deal with these results. The mythical market system, where governments just let financial institutions go belly up misses this point - if ordinary people have to take the risks of the profits of bankers, they won't bank, but will hoard, they won't invest, but will instead press outwards, conquering or subjugating others as they go, because in that case they have control over the risks and are not presented with information assymetries about say, whether a bank is going to go belly up. You can survey an area and see that it is free of natives, you can't take a gun into a bank and demand to see the books in person. When faced with risks, people choose those, even if worse, which they can see for themselves. The mythical financial market people know that the rapid leaving of participation from intransparent banking systems leads to a lower equilibrium of production. Much lower as it turns out.

To reunify money means to both price present scarcity, often by direct government intervention in markets and prices, and force investment in future abundance, often by direct government choices. The longer we let this go, the more governments will have to intervene. That is what a war is, the government directly intervene a whole lot in production, consumption, prices, investment and activity. The bigger the war, the more distortion.

At the present significant intervention will be reqired. The global opportunity cost of the Iraq War certainly tops 5 trillion dollars, so please, no whinging about the size of interventions, when we have just seen one that is much larger than any that have been openly proposed by any party on the left. But it will take an intervention that is larger than that to set things on the right course. This won't happen yet, hence there will be another worse financial crisis after this, and a worse one after that, until war drives people mad and allows a political consensus for even more massive intervention and rebuilding.

The only way, in otherwords, we are going to convince people to give up on a great deal of the petroleum driven capital out there, is to bomb much of it into the ground, and to make the rest of it useless by sapping the amount of oil. Could we do otherwise? Oh, why yes, certainly. But no one is ready to vote for it yet, and not a single political leader has come out and said that this is what must happen.

So, we continue on cruise control for long term global war, somewhere around the time that China can produce sedans in quantity and can thus dump dollars and buy oil directly. This is about 15 years off, though it could be closer. Americans who are paying 8 dollars a gallon for gasoline will find a way, trust me, to convince themselves that some vital interest is threatened, and war is required.

The political class chooses not to see this outcome, and instead believes that if we simply slow down consumption somewhat that we can replay the neo-conservative era one more time. We can't, because in 1992, there was no one else to buy the oil. Russia was entering depression, Europe and Japan were topped out on sprawl and were integrating, in Europe's case, Eastern Europe, China was not ready, South America was in financial crisis. In short, if the US chose not to buy, then it would force oil prices down. Now, every barrel the US does not buy, someone else will. Bank on it. Any austerity here, will simply mean more prosperity for someone else. Bank on it.

Hence, the US has two choices, drag farther down the spiral, or change the game. We still have the ability to change the game, but addicts for the land casino that we are, we are not yet able to stop playing the game we are losing day by day.