The origins of the current credit crisis lie in a loose monetary policy and excessive capital flows that were turbo-charged by "financial engineering" techniques used by banks.

Borrowing bought more borrowing, fuelling price increases in financial assets -- debt, equity, property, infrastructure.

In recent months, major banks have reported losses of around $45 billion on their investments. Up to $1 trillion of assets are also on their way back onto bank balance sheets as complex off-balance sheet structures (collateralised debt obligations, conduits issuing asset-backed commercial paper and structured investment vehicles) are unwound.

The major regulatory response has been cuts in the US Fed funds rate (0.75 per cent per annum) and the discount rate. In recent weeks, the differential between inter-bank rates and the central bank targeted rates has widened to levels not seen since August.

This points to further potential cuts in both rates by the end of the year. Lower cuts are inconsistent with above-target inflation levels resulting from high oil prices, higher food prices, increasing cost pressures in emerging economies such as China and the potential inflationary effect of a weaker dollar.

The US central bank's strategy is clear. The current credit problems require a substantial reduction in the level of borrowings and leverage in the global financial system. Asset prices ramped up by excessive debt need to adjust. The adjustment can take place via a "crash". This would be de-stabilising and would wreak further havoc on already weakened banks.

Alternatively, the de-leveraging and price adjustment can be achieved by creating inflation through a loose monetary policy. If asset prices remain at current levels, higher inflation allows values to fall in real terms. Higher inflation also reduces the value of borrowings that must be paid back allowing the required reduction in leverage.

Between January 1960 and December 1974, the Dow Jones Industrial Average was substantially unchanged. This is despite significant periodic rallies during the "go-go years". If inflation averaged 5 per cent per annum, then the value of the market (ignoring dividends) lost around half (50 per cent) of its value in real (inflation-adjusted) terms.

The Fed strategy also assists affected banks. The large writedowns in risky assets and the expected re-intermediation of assets mean that some banks need large infusions of capital. Given recent performance and subdued profit outlook, it would be difficult for them to raise this capital at acceptable prices.

Lower short-term interest rates allow banks to borrow cheaply. The money can be used to purchase government bonds that provide higher returns than the cost of borrowing. This generates profits for the bank without the banks having to hold capital against their assets (banks generally are not required to hold capital against government securities). The profits help re-capitalise the bank.

An added benefit is that the US government can fund its deficit by selling its debt to the banks. This would be handy if foreign demand for US Treasuries decreases in response to the weaker dollar. The Bank of Japan used the same strategy to re-capitalise the loss-making Japanese banks after the collapse of the "bubble economy" in 1989.

Higher inflation expectations are already evident in higher gold prices, the steeper US yield curve (long-term rates are higher than short-term rates) and the weaker dollar.

Foreign investors, especially large sovereign investment funds, are switching from financial assets (bonds) to "real" assets (companies with real businesses) reflecting higher inflationary expectations.

The strategy is dangerous. Inflation can lead to a significant transfer of wealth from investors to borrowers. Inflation once embedded in the economy distorts economic activity such as investment and savings. The experience of the late 1970s and early 1980s highlights the difficulties in recapturing the inflation beast once uncaged.

Paul Volcker, then Chairman of the Federal Reserve, bravely increased interest rates to stratospheric levels to squeeze inflation out of the financial system.

The strategy may also not work. The cuts in rate do not appear to have had the desired effect in improving market liquidity conditions. Default risk concerns continue to inhibit lending and other routine financial transactions. Lower rates may set off further bubbles, for example, in equities and emerging markets. Asset prices may fall sharply anyway. In fairness to Ben Bernanke, he has limited policy alternatives available.

Central bankers have stated that "errant" banks and investors will not be "bailed out". Actual actions suggest otherwise. Banks have played their "nuclear" option well. The spectre of "systemic risk", whether real or not, is one a central banker cannot ignore. The strategy has attracted little scrutiny or comment despite being implemented by unelected officials with public money and without any transparent political debate.

In a 1998 speech during the Asian financial crisis, Lawrence Summers, then Deputy Secretary of the US Treasury, preached the merits of American-style "transparency and disclosure". A new term, "crony capitalism", was coined to describe the cozy relationship between Asian governments' regulators and the private sector. It seems that crony capitalism is not exclusive to emerging markets.

Banks continue to privatise gains and socialise losses. Socialism on Wall Street will prevail, once again.

The author is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.