US Treasury Secretary, Henry M. Paulson, did his best this week to ensure the further demise of his country’s global competitiveness: he proposed more regulation, more legislation, more bureaucracy and more oversight. The US financial sector is already one of the most regulated and bureaucratic in the world, an honor that didn’t help prevent the current credit crisis.

There is a perception that the current credit crisis is a failure of free markets and capitalism. Quite the contrary: it is entirely the result of government actions and intervention in the process of free markets. The government attempts to eliminate business cycles by manipulating money supply and interest rates. The result is not the elimination of business cycles, but their distortion. Every time the government cuts interest rates and stimulates the creation of more money, it postpones the down cycle further into the future. The business cycle gets stretched over a longer period of time and its peaks and troughs become amplified.

In a free market without intervention there will be ups and downs: the down cycles correct the mistakes made during the up cycles. Because these occur naturally with regular monotony they seldom become grossly distorted either during the up cycle (bull market) or the down cycle (bear market). Exceptions obviously occur, but they, too, self-correct. When governments intervene to prevent a down cycle from correcting corporate excesses and capital allocation mistakes, those mistakes get compounded because risk becomes mispriced. The current credit crisis is precisely such a mispricing of risk that occurred as a result of the belief that the Fed will always intervene and prevent the market and asset prices from correcting.

Inflation of the money supply also played a major role in the current crisis. Fiat inflation devalues the currency and while most people don’t pay close attention to monetary aggregates and other statistics, they absolutely get a sense that their money, and hence their savings, are losing value.

Paulson’s proposed regulations and rules will not solve the problem. The only sure outcomes of his proposals are increased financial costs and a decline in global competitiveness for US financial institutions. The bubble was caused by the US Federal Reserve, the Treasury and the government, who, together, are responsible for the devaluation of the US dollar through fiat inflation, for deficit spending, and for creating a false sense of security among businessmen, bankers, investors and consumers. This false sense of security promoted excessive use of financial leverage.

If the Fed and the government would just leave the markets alone now, many banks will go bankrupt and many hedge funds will evaporate. Hundreds of billions, if not trillions, of dollars will be lost by investors, and businesses would be sold to more prudent investors who are flush with cash. They, in turn, will insist on more conservative and prudent management and the world will function normally again.

But that won’t happen. Instead we will get more of Paulson’s rules, regulations and legislation, and more of Bernanke’s (soon to be) worthless paper dollars.

The further devaluation of the US dollar exchange rate and the deterioration of the dollar’s buying power will decimate the American middle class beyond what they deserve for living far beyond their means through debt. The painful adjustment of reduced living standards is inevitable: they will eventually have to pay those debts. But the further erosion of their living standards due to fiat inflation that will destroy the value of their remaining capital can be prevented, except it won’t -- it is the certain outcome of government intervention in free markets.

The Federal Reserve announced a $200 billion plan this week that will allow bond dealers to borrow liquid US Treasuries by pledging illiquid mortgage backed securities. This allows bond dealers to shore up their balance sheets by giving the mortgage backed securities (which are in free fall) to the Fed and getting US Treasuries in return. The Fed also announced an increase in its swap arrangements with four other central banks that will make more US dollars available to those banks to lend out to financial institutions under duress in their jurisdictions.

These actions attempt to increase liquidity but they don’t address the underlying problem which is not a liquidity problem, but a credit and pricing problem. Mortgage bonds, corporate bonds, consumer credit, and a whole host of other debt obligations were packaged and sold at unrealistic prices. The risks were underestimated and the prices paid were much, much too high, meaning that the interest rates offered to borrowers were much, much too low. Underestimation of risk is now haunting the lenders; higher interest rates still need to filter through to borrowers although they are already in the pipeline.

Spreads between mortgage backed securities and US Treasuries have risen to 3.5%, the widest range since 1986. Yet the mispricing is not in the mortgage assets, but in the Treasuries. The yield on a 30-year US Treasury is 4.4%; if we add 3.5%, which is the reported spread, we get a yield of 7.9% on mortgage backed securities. M3 for February increased by 16.8% year-over-year, and in an environment where money supply (inflation) is running at almost 17% year-over-year, even a 7.9% yield on a thirty year mortgage bond is ridiculously low. Interest rates must rise substantially on all forms of debt. The increase in the spread between mortgage backed assets and Treasuries shows that the process of re-pricing has begun, at least for consumer and corporate debt.

The pressure is mounting on Treasuries too. An auction of $10 billion 10-year Treasury notes this week drew the lowest demand in four years, causing yields to rise 10 basis points (0.1%). While not a large increase in yield, it is but one small step in the direction Treasuries will trade going forward.

Today’s CPI figures will fuel support for another interest rate cut by the Fed. Don’t let that fool you. These are overnight interest rates; medium to long term interest rates are going to soar. A betting man might want to short 30-year government bonds.

The IMF has thrown balancing budgets out the window and is now calling on its members to do all they can to stimulate spending -- that is econo-speak for “print money”.

The US dollar fell hard again on foreign exchange markets, dropping to below 100 yen for the first time in 12 years. Soon it might reach parity with the yen -- don’t laugh -- call Ben Bernanke and congratulate him.

The falling dollar, of course, meant that oil, gold, and commodity prices rose in dollar-terms. Gold briefly breached $1,000 an ounce yesterday and traded decisively above $1,000 today. At the current rate of monetary inflation it will take less than five years for gold to double again and reach $2,000 an ounce, but let us not forget that gold is up 50% in six months, and nothing goes straight up.

The short-term risk, which will be no more than volatility, is a rally in the US dollar. The dollar doesn’t deserve to rally but that’s beside the point. According to Morgan Stanley and Goldman Sachs the dollar’s record-breaking slide may trigger the first coordinated intervention in 13 years. Europe is whining about the falling dollar, so is Canada, and a host of other nations. Therefore it should be easy for the Fed to orchestrate a coordinated effort to temporarily halt the decline of the dollar. If they manage to engineer a rally it could bring gold and oil prices down sharply for a while, and that would certainly look good during an election year. So while I think gold is going to $2,000 and oil to $200 I would not at all be surprised to see them both fall 10% to 15% in the near term.