The Fed has effectively stepped in as the lender of last resort at least to all the US financial intermediaries. I'm unsure what will happen in the case of British and European central banks, though a similar position can be expected for the financial institutions they manage. The problem is mostly in the USA one would think, but really its not because derivatives are needed by all groups. So what will be the cost? Bush has said it will be $US 1 trillion. The reality is that it could be far more.
The question is - What now? Do banks stop engage in derivatives trading? Does the Fed retain its position as the funder or insurer of last resort? Who knows? Its fair to say that the political system gains a great deal from this system, and so they are likely to fight to save it. Are we going to see a return to a gold standard? Its safe to say no politician is going to voluntarily liquidate these derivative contracts which have added so much liquidity to the market. I would suggest the only thing that would result in a gold standard would be a politician who supported it. Otherwise the issue is too technical for voters to campaign against. A soluition is unlikely to get voter support because its a 'conceptual' problem. The only thing that could change this travesty is a voter revolt. If voters take to the streets to campaign that they are not going to pay taxes to support the banking system, you can bet that would cause problems because it would result in banks again questioning the central banks ability to deliver.
Without a voter backlash, the world will continue under the current system, but it will need to live with higher inflation, higher taxation and subdued earnings. You might wonder how probable is the possibility of a taxpayer strike. I would suggest that its not probable unless there is a financial crisis which would place the burden on taxpayers. Currently there is no great burden on taxpayers. Inflation is another factor that could insight political upheaval. The threat is greatest in the USA because US citizens are actually not obliged to file income tax returns in the USA, but they do. In fact the US courts have occasionally recognised this illegality in the law, but on occasion they have chosen to breach the U.S. Constitution. Breaching the Constitution is considered good sport these days by politicians wanting to retain power. President Roosevelt was the first evil monger in the 1910s. But all politicians to my knowledge seem to celebrate the existence of the welfare state, and thus the system of government that finances it. Ron Paul is the only (Republican) presidential candidate who rejects the current paper money standard.
Andrew Sheldon www.sheldonthinks.com