As for the mess in the middlemen who leveraged up to maximize the fees they scoop in the process, they can theoretically get out of this alive by "deleveraging", that is amortizing the debt in an orderly (synced) fashion, using whatever profit they may still be making from more "useful" (read: sustainable) business. Of course, it means all shareholder dividends are wiped out for the next 20 years (see: japanese banks). And in practice, there are a few spectacular casualties in the deleveraging.

Deleveraging will ease the stress in the financial markets in the next year or two. But the fact that american citizens will have to send everything they make to china to pay off their debt till they die in destitution will remain forever. I expect denial, printing, conflicts...

Pierre

declaring all of these exotic obligations null and void

I'd just like to point out (but haven't seen the MoA discussion), that Paulson declared yesterday that the bailout money would no longer be going to buy exotica that his team would have carefully sifted and "valued", as originally planned* , but to shoring up consumer demand. Which may not exactly mean declaring them null and void, but certainly seems to mean hanging them out to dry for a long, long time...

* this, as a number of commentators pointed out at the time the plan was mooted, was a job that would in any case take years to do seriously.

[Two brothers] owned equal shares in a pub. Whenever one wanted a pint of beer, he would pay the other a dollar, who would then pay him back for his own draw of beer. Pursued ad nauseum, this meant that the same dollar could account for unlimited quantities of beer; provided of course neither brother ever used it to buy something other than beer from his sibling. [The] game could continue until the brewery sent its chap around to collect money for all the beer that had been drunk by the brothers. As a general rule, the brewery would have wanted to get paid a little more than one solitary dollar for the whole keg of beer.

[This] story captures the idea of what happens when stated transactions do not produce incremental cash flows, or when increased liabilities are disguised as new cash. [The] dollar changing hands wasn't the payment - it was an exchange of liabilities; that is, each brother owed the pub a dollar for every pint drunk.

[In] the world before 2008, this brotherly love was best exemplified by the US-China pair, wherein the former would buy billions in consumer goods from the latter and pay with a series of IOUs. As long as China continued to accept the IOUs rather than real money as payment for the goods, the cycle continued. While this describes the supposed cash flow situation, how does the picture change if we look at the balance sheet, that is to say, the relative value of assets and liabilities?

In this case, slightly different from the brothers above, Americans were using their borrowed money only partly for consumption, with the balance for speculation on assets such as houses, stocks and so forth. For the Americans, as long as the value of their assets increased faster than their liabilities, the overall balance sheet situation remained acceptable. Effectively, the increased consumption was warranted by the increased wealth.

Eghhh... was there indeed increased wealth in reality?

He then goes on to say not nice things about Keynessian economics (aka the best thing about John Maynard Keynes is that he is dead). The second part says something reasonable again:

The key characteristic of the world imbalances of the past two decades was the lending of capital by high-growth countries to low-growth countries in the guise of currency intervention or savings protection. [Age-old] rules set by the International Monetary Fund (IMF) and other idiots were the main reason for this orthodoxy being practiced by the emerging countries. Reeling from a series of foreign investor runs on their banking systems in the 1980s and 1990s, many emerging counties adopted the IMF rules of weakening their currencies, increasing their export focus and reducing their total debt relative to the forced savings of foreign exchange reserves.

Going back to [the two brothers]..., emerging market countries became the processors (the brewer in the first example) who depended on the pub owners and beer-consuming brothers for their eventual cash flows from the sale of beer. This vendor's credit clearly created its own wave of working-capital shortages for the emerging market countries that were all too frequently borrowed over the short-term from the very people benefiting from one-dollar beer, namely the pub customers.

The second aspect of the story that is important to understand from the perspective of the brewery, that is a producer of goods such as China and South Korea in the global economy, is the distribution of profit margins. Selling goods at a fraction of their eventual sales price still generated enough profits (or marginal revenues at least) to sustain the production of Chinese and Korean factories over the '90s and later on. [The] pub owners in our starting example were not only grabbing cheap credit from the brewery, they also laid claim to the lion's share of profits generated across the entire chain of value addition. Herein lay the secret of US and European corporate profits for much of the past two decades, namely the ability to generate profits on the strength of brand names, while squeezing the margins and leverage of their suppliers in various Emerging countries.

How easy is it now to construct anecdotal models (with beer or a Ponzi scheme), and what accuracy or generality can be expected from such simple models?