The Short View: Doubts over Paulson plan

By the close on Monday, US stocks had sold back down to their levels of last Thursday, erasing most of their gains since news leaked that Hank Paulson, US Treasury secretary, was floating a plan to bail out the "toxic" securities held by US financial services companies.

This was more than cancelling out one day's worth of gains in the stock market. Traders' fears have moved emphatically from the 1930s back to the 1970s.

Pre-Paulson plan, the fear was of multiple banking collapses. This is what happened in the wake of the 1929 Great Crash. That fear has abated.

But attention has now turned to the cost of the Paulson plan. It entails a big increase in the US government deficit. The extra borrowing could crowd out the private sector. Or the US could raise taxes and cut spending - a combination that will depress economic activity.

Printing money plus depressed economic activity sounds like stagflation, as suffered in the 1970s. And so, sure enough, on Monday there was a record oil rise.

Last Tuesday, benchmark oil futures traded at $90.51. At one point on Monday, they hit $130, a swing of 44 per cent. For context, in the five days after the 1990 invasion of Kuwait, oil gained only 40 per cent.

Monday's move had nothing to do with supply and demand in the oil market, much to do with a squeeze of short positions ahead of futures contracts expiring, and a lot to do with Paulson. Fearing inflation's corrosive effect on financial assets, traders bid up all real assets, including silver and gold.

We have been here before. Until July, markets were betting on the "stagflation trade" by buying oil and selling short financials. But that was based on easy monetary policy, or cheaper money from the Federal Reserve. Fed Funds futures barely moved on Monday.

This time, the market is banking on cheap money from the Treasury, not the Fed.

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