(James Saft is a Reuters columnist. The opinions expressed are his own)

So it can be done after all.

Britain is poised to take tough steps to break up the large banks it rescued, setting it in stark contrast to the United States, which seems set on a policy of shoring up the unfair advantages it grants its too-big-to-fail banks while regulating around the edges.

It is quite a change for Britain, which has a sorry history of self-serving self-regulation in financial services combined with limp and outgunned official control.

Chancellor of the Exchequer Alistair Darling on Sunday told the BBC that Lloyds, RBS and Northern Rock would be partly broken up and assets sold to new entrants into the banking market. Large existing competitors such as HSBC are expected to be blocked from making bids for the assets.

Britain took over Northern Rock after a run on the bank and its rescue of Lloyds and RBS left it with stakes of 43 and 70 percent, respectively.

It is worth noting that if anything Britain is more dependent on its financial services sector than the United States.

Could it be that Britain has determined that a level playing field, strong competition and a lower risk of a crisis might actually make it more competitive internationally? I certainly think so.

It will without doubt improve the situation for the small businesses and individuals that can't access international capital markets and depend on the banks for access to credit and other financial services.

Before we get all excited and expect the United States to follow suit with Citibank and Bank of America, it is important to recall that Britain's Labour government is more or less on its death bed and faces an election in 2010 which the bookies and almost everyone else think it is highly unlikely to win.

There is also the matter of the European Union, which has a say over subsidies such as the ones Britain has showered on the banks. RBS said on Monday that it may be forced by the EU to sell more assets than it had planned. Lloyds is also seen likely to raise additional new capital to allow it to stay outside of an asset insurance scheme Britain is running for the banks and which would involve the government taking yet more equity in the participants.

OH WHAT A CONTRAST

The fact remains that Britain and the EU are saying that more competition is needed and taking steps to ensure that the banks which ended up needing state care are broken up. This must have an impact on how other big banks are ultimately treated, even if they did not receive the same level of direct state aid.

The equity buffer that is being required is also remarkable; the banks should end up with core tier one equity of about 10 percent, four times what they were expected to hold before the crisis.

Contrast all of this with the hopefully named Financial Stability Improvement Act of 2009, now wending its way through Congress. As Harvard Business School professor David Moss points out, as currently drafted this bill won't even allow the systemically important banks it is designed to control be named, a real Monty Python-esque touch.

Think about it: we won't even be allowed to know the identities of the firms we are potentially on the hook for. Moss points out that this neatly side-steps the idea of taxing too-whatever-to-fail status as a means of encouraging the behemoths to sell up and avoid the costs. The costs remain with the taxpayer, or potentially with a group of big firms after the fact.

The argument the U.S. administration is making, more or less, is that our complex global economy somehow demands that we have complex huge banks. If we don't allow huge banks to persist, we'll choke off growth. If we think we can go back to mom and pop banking, we are simply kidding ourselves. And anyway, if the U.S. doesn't allow it, foreign banks will just scoop up the cream. With Britain and the European Union taking strong steps, that argument is losing traction. And as for complexity, well I'd have to say that the record of complexity in banking is mixed, to be kind, as far as the deal it gives to taxpayers and consumers of banking services. It would be one thing to argue for huge economies of scale for plain vanilla banking processes like clearing, but it is hard to see why that needs to be combined with derivatives and trading.

It would be nice to think the winds are blowing west across the Atlantic, but this is not usually the case.

(Editing by James Dalgleish)

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(James Saft is a Reuters columnist. The opinions expressed are his own)

Don't expect the year-long rally in risky assets to be undermined any time soon by the Federal Reserve becoming concerned about inflation.

The old metaphor -- that the Fed's job is to take away the punchbowl just when the party starts getting good -- just doesn't apply in the current circumstances. That's not to say inflation isn't a threat in the medium term -- it is virtually a promise.

But punchbowl thinking dates from a time when firstly the Fed was presumed to have a degree of control over events we now know is not true and secondly to an era when asset prices were the caboose rather than the engine of the economic train.

Even with an economy that is now growing, the risk of a self-reinforcing de-leveraging spiral is enough to ensure that the Fed will not pull the trigger on tightening any time soon.

"Asset prices are embedded not only in our psyche, but the actual growth rate of our economy. If they don't go up, economies don't do well, and when they go down, the economy can be horrid," Pimco bond chief Bill Gross writes in his most recent letter to investors.

Gross argues that leverage inflated the price of assets even as investment in the U.S. real economy flagged. As this happened the U.S. economy became ever more dependent on asset prices and on the sectors, such as finance, which intermediated the borrowing. When the debt and asset bubble is pinched, the whole edifice is threatened, leading to a response like the one we've seen: massive and overwhelming aid trained on markets irrespective of the costs.

Pimco data shows that the prices of assets in the United States over the past 50 years have gone up 1.3 percent a year more than would have been expected given nominal growth in the economy, leading to a putative 100 percent overvaluation if you reason that the assets which depend on the economy for income shouldn't outgrow it.

Unsurprisingly, the real outperformance of asset prices against economic growth has come in the past 30 years, since when debt growth has accelerated.

There are other explanations for why asset prices have outpaced economic growth. For one thing, off-shoring and outsourcing have both suppressed wages in the United States, leading to higher returns on capital, and increased the income that U.S. assets receive from overseas.

It's obvious that the past 25 years have not been kind to labor, and as its share of GDP has declined the share going to asset owners has increased. In that sense increasing asset prices make economic sense, though there seems to be every chance that workers start to recapture some of what they have lost.

GROWTH, DEFAULT OR INFLATION?

Taxes on capital and profits have also fallen in the United States, and, like wages, this is a trend that could easily be reversed in coming years, especially given the huge amount of public debt that will have to be paid back.

This brings us to the other very strong reason the Fed may have for not pulling away the punchbowl -- or water bowl as perhaps we had better see it -- even when the party turns inflationary: public debt.

Since the United States have taken a decision to not allow too much of the private debt to default, it has taken on a corresponding increase in public debt which will have to be repaid ultimately. U.S. debt as a percentage of GDP will exceed 60 percent, a level not seen since World War II.

But unlike the post-war period, Europe doesn't need  rebuilding and though Asia will grow hugely those profits won't flow to U.S. coffers.

So, if growth doesn't allow the United States to repay debts, there are two options, neither pretty; default or inflation.

"No policymaker in the developed world -- and, by now, few in the developing world -- would want to countenance default as an option," writes economist Spyros Andreopoulos of Morgan Stanley in London in a note to clients.

"This leaves inflation."

To be sure, the Federal Reserve takes its mandate to control inflation and its independence seriously, but it is going to find itself in a very difficult squeeze, partly of its own making. The debt is high, growth will be poor and the time for private defaults is past. Threats to its independence will only grow.

Given that, and the dependence of the economy on asset prices, it's not hard to bet that the evil we will be left with is inflation. Whether it is engineered or just kind of happens is less interesting than the reasonably high likelihood that it will happen at all.

For a time at least, that would argue that risky assets, particularly real assets and emerging markets, do well.

Longer term, things get stickier and stickier.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(James Saft is a Reuters columnist. The opinions expressed are his own)

There are encouraging signs that shareholders are becoming more assertive in defending their interests.

The Financial Times reported on Monday that some of Britain's largest institutional shareholders - including Standard Life, Legal & General and M&G - are working on a plan to bypass investment banks by creating a club to underwrite new issues of equity by small and medium-sized British companies, a move that could save hugely on fees.

What, you may wonder, took them so long?

Second only to taxpayers, investors have been the great patsies of the financial crisis, paying massive costs to a financial services industry which has, to put it mildly, not served them well.

Activist shareholders and investors could be a key force in fixing what is wrong with the financial system. Unleashing their power to act in their own best interests should be a main thrust of new regulation.

The British investor group, reportedly being assisted by mergers and acquisition advisors Lazards, would effectively cut out the middle men by agreeing to take up any unwanted new shares in an offering. This is an idea which if successful could save companies and their owners huge amounts in fees and at the same time deal a blow to investment banking profitability.

Fees charged by banks for equity underwriting in Britain have more or less doubled in the aftermath of the crisis to 3.5-4.0 percent of the amount being raised, with the lions share going to banks rather than to the institutional investors who sub-underwrite.

While banks may argue, and in part be correct, that this is because the past two years have demonstrated the risks of capital market underwriting, it is also patently because there are now fewer banks competing for this business.

To be sure, a club approach is better suited for small and medium sized underwritings and would face huge difficulties for a major share issue involving global investors. But if a test run proves successful it would place pressure on fees for transactions of all sizes.

Even before the crisis hit, fees for investment banking services seemed not to follow with the same fidelity the laws of economics which hold such sway in microchips, steel or even tax preparation.

And it's not just investors, who consume investment banking products, who have been ill-served. Shareholders in companies, particularly in banks, have provided the capital but have not had their fair share of the fruits.

FOR WHOSE BENEFIT IS THIS ZOO BEING RUN?

That has led to bad decisions, decisions often designed to maximize the benefit to employees at the expense of the shareholders who run disproportionate risk.

Paul Myners, a British Treasury official with special responsibility for financial services, gave an absolutely scathing address last week to the Worshipful Company of International Bankers, assembled for dinner in the Mansion House in the City of London.

Myners, who is reported to be considering holding a competition inquiry into banking fees, took aim at the bonus and compensation culture in the industry.

"It could be argued that some shareholders in banks have been left holding not the ordinary shares they originally purchased, but a new form of subordinated, participating, non-cumulative equity that ranks behind rewards for the senior management, and executives of the firm in which they invested have a prior claim. This cannot be right," Myners said.

"In case anyone needs reminding, the profits of banks belong to their owners; not their managers and traders."

I imagine that the bankers were a little less worshipful on their way out then they were on the way in.

I would also argue that what Myners said about banking also holds true - to a lesser extent - in other publicly traded companies, where management is able to extract compensation out of proportion to their likely contribution.

Shareholders, and we are really talking about institutional shareholders, have allowed management to get away with it for years because they thought what they were supposed to be doing was outperforming the market by picking winners.

Much of what passed for skilled investment over the last 20 years has been little more than riding the waves of a debt-fueled economy which seemed capable of providing six to ten percent returns on an unleveraged basis.

Adding value too often meant little more than adding leverage to increase returns. When the current rally ends, as it surely will, investors should take a long look at their long term returns. What they will usually see is that they are poor.

A better strategy for the next 10 years may be to spend as much effort protecting your economic interest in what you own as you do in choosing what to own.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

--James Saft is a Reuters columnist. The opinions expressed are his own.--

When the U.S. dollar ultimately loses its status as the world's premier reserve currency it will be painful for all involved, almost certainly disorganized, and very possibly a very good thing.

World Bank President Robert Zoellick outlined the risks to the dollar's status in a speech in Washington on Monday.

"The United States would be mistaken to take for granted the dollar's place as the world's predominant reserve currency. Looking forward, there will increasingly be other options to the dollar," he said.

Zoellick went on to emphasize how choices in the United States on inflation, fiscal policy and financial system reform would help to influence the dollar's fate.

Quite true. The U.S. cannot simply devalue its way to competitiveness, nor can it appear to be inflating away its debts without risking a run on the currency. The Chinese and others would sell dollars or fail to buy up new debt if they felt the U.S. was behaving both cynically and irresponsibly.

China has good reasons not to force a crisis and devalue its holdings of dollars, but not immutable ones. The two nations are like two men trying to swim to shore while dragging a heavy box of gold, the difference being that the U.S. is tethered to the box while China is only holding on. If China decides the water is too rough it can let go, sacrifice its dollar holdings and swim for it. The United States is not so lucky.

"Exorbitant privilege" is a term coined by an understandably embittered French Finance Minister Valery Giscard d'Estaing to describe the fact that under the old Bretton Woods currency system the United States, unlike everyone else, could simply print dollars to cover current account deficits.

Bretton Woods is gone, but the arrangements which replaced it also tended to underwrite U.S. overconsumption, as purchases of U.S. dollars as reserves by other nations kept funding rates lower despite household or government profligacy.

"The United States is incredibly fortunate that the dollar enjoys this special status," Zoellick said. "When I work with countries struggling to pay for budgets or finance trade deficits, I reflect on how Americans do not spend a moment considering the unique advantages of being able to issue bonds and print money freely."

My best guess is that Americans will spend quite a few moments in coming years considering that unique advantage, and that while they will miss it, they should also be sorry they ever enjoyed the right to borrow freely and seemingly without consequence.

THERE'S NO "G20" IN "TEAM"

Of course the U.S. current account deficit has contracted massively, standing at about 3 percent of gross domestic product in the first quarter as compared to 6.5 percent of GDP in 2006. That's the result of plunging global trade and steep falls in investment in the United States. And while the personal savings rate has jumped in the United States, which after all it had to since credit was no longer easy, the government has stepped up massively as a borrower, overwhelming households' efforts to save.

Barclays Capital calculates that the United States now needs to attract 46 percent of the world's net savings, i.e. the sum of all current account surpluses, as opposed to 54 percent before the crisis broke.

That 46 percent figure is an improvement, but it too is ultimately unsustainable. It's also arguably starving lots of other places of investment that could ultimately produce higher returns.

The newly empowered G20 group of nations has meanwhile resolved to rebalance the global economy, using peer pressure to force the irresponsible to shape up and the overly tight to start spending at home.

The world's central bankers and politicians just received an object lesson in what a good idea it is to have a bunch of reserves piled up against a bad day. Even putting China aside, responsible leaders in places like India will have a very tough time trusting in an international body to protect their own best interests. And because that body doesn't have any real power to compel, it will be ignored. That means that there is a good risk, G20 or not, that everyone is trying to simultaneously keep their currencies low and exports high.

The only body seemingly exempt from market discipline, the United States, is not going to be in a position to resume eating up everybody's exports. This is a recipe for very slow growth and for rising international economic tension. That doesn't make the changes proposed at the G20 a bad idea, but they are not sufficient and threaten to be a resolve-softening time waster.

So not so much as rebalancing but a re-basing of growth expectations. Look for continuing dollar weakness alongside that, with the real drama being not the decline but the rate of decline.

--At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.--

(James Saft is a Reuters columnist. The opinions expressed are his own)

The simplest way to end the imbalances in the world's economy is also sadly perhaps the most likely: for the Chinese to stop buying U.S. debt.

This is not going to happen anytime soon, for one thing deleveraging in the U.S. will for a time make U.S. Treasuries look good value, but a buyer's strike is a heck of a lot more likely than the orchestrated rebalancing the U.S. will push at this week's G-20 meeting of leading nations.

The U.S. plans to advance a plan at the Pittsburgh summit to fundamentally change the balance of the global economy, which over the past 15 years or so has been characterized by over-borrowing and consumption in the West provided and financed by savers and workers in Asia.

That state of play kept going, as is the way of these things, until it stopped, or rather until one of its wheels fell off. It wasn't that Asians stopped saving or buying U.S. debt but that speculators, usually in Europe, stopped buying securities, often minted in London, which were being created to front run the flow of capital from Asia to the west.

That popped the asset price bubble and the flow of finance to consumers in the U.S. who, with much gnashing of teeth, began to save again and consume more guardedly.

But the debt bubble hasn't really popped, it has only shifted shape. Before we had private debts which only could be repaid if assets, mostly real estate, continued to go up in value. Now, a new wave of public borrowing is cushioning the downturn. Asians buy some of the debt and some of the money raised buys goods from Asia.

Theoretically, China and other investors in U.S.  Treasuries buy them because they believe that the U.S. will ultimately tax more, spend less and make good. In reality, it is more vendor financing and a good money after bad attempt to protect earlier investments.

The U.S. points out, in a letter to its G20 partners, that if the savings rises in the deficit countries persist and there is no rise in consumption in the savings-bloc, global economic growth will be poor. The idea, it seems, is for IMF-led international coordination to, on the one hand, jawbone the borrowers so they remain credible while at the same time somehow inducing the savers to allow their currencies to appreciate and induce their citizens to spend.

WILL SOVEREIGNS BE THE NEW SUBPRIME?

A new study of global imbalances by economists at the Bank of England points out that Asian savers will only carry on buying western debt so long as they believe it to be high quality.

"In the short run, increased supply of government bonds resulting from the expansionary fiscal policies pursued in deficit countries has provided an ongoing source of asset supply to meet the investment demand from surplus countries," according to the Bank of England.

"However, to the extent that savers in surplus countries may become more reluctant over time to invest funds in deficit-country government bonds this would tend to raise the cost of borrowing in deficit countries. This shift in the relative cost of borrowing could be an important part of the process by which a rebalancing of demand from deficit to surplus countries is achieved over the medium term."

In other words, if Asian savers lose faith in Treasuries or gilts, they will stop buying, causing interest rates to spike. This would cause demand to be rebalanced, all right, but mostly by suppressing it in the U.S. and other highly indebted countries like Britain.

This kind of loss of faith in markets can be very sudden. You could draw a parallel to the way in which investors in securitized debt lost faith in the value of a AAA rating, except this time the loss of faith will be in sovereign borrowers and we really will not be able to blame the ratings agencies as enablers.

China and other exporters of course have good reason to want to avoid this. They are stuck with trillions of dollars in Treasuries and they certainly don't want to kill the U.S. goose while it is still more profitable to sell it goose food.

There may also come a time when the world's savers calculate that they can earn more by investing at home.

Essentially much of what a controlled rebalancing would do - weaken the dollar and build opportunity for domestic-oriented investment in Asia - creates incentives for a rapid reallocation out of Treasuries.

Ultimately the rebalanceing must happen. The U.S. for very good reasons wants this to happen little by little, but it does not have to happen that way. Past attempts at a controlled rebalancing have failed and it is hard to see what will make this one different.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

--James Saft is a Reuters columnist. The opinions expressed are his own--

If and when China makes its currency convertible and opens its financial system the stage will be set for a bubble that should make the dotcom and housing booms look tame.

China has recently signaled its key aspirations: for a greater international role for the renminbi and for Shanghai to become a great financial capital. Neither is imminent, but both imply, if not require, a series of steps that, taken in combination with China's legitimately great potential for growth, could lead to a bubble of magnificent and dangerous proportions.

Magnificent in that, like the dotcom bubble or the railroad boom in the U.S. in the 19th century, a bubble in domestic China is directionally right and will build useful things which will change the world. A bubble, after all, needs a good story and China has one of the best ever.

Dangerous because, like the housing bubble, it will inevitably go too far and could take down banks and banking systems globally.

Perhaps rather than dotcom or housing, the most useful template for China is closer to home; namely the Japanese bubble which preceded its ongoing malaise, according to Dylan Grice, a strategist at Societe Generale in London.

"In the medium term we face the mother of all asset bubbles in China. The fundamental story is a good one; there are just lots and lots of people to sell to," Grice said.

"If you drop a ton of liquidity on people it is possible that they will do rational things with it, but more likely they will do something pretty stupid."

The parallels are strong. Both China and Japan successfully industrialized and opted for high-savings, low-consumption economies which concentrated on exports, exporting capital and keeping their currencies artificially weak. The result in both cases was a huge stockpile of U.S. Treasuries.

Both, too, scared their western clients and competitors witless. Remember U.S. autoworkers ritually burning Japanese cars? This of course was mingled with admiration and a sense that the global balance of power was changing, giving bubble thinking a strong push.

Japan slowly and over a long period liberalized its capital account; allowing the yen to float freely and deregulating financial markets.

Grice points out that during some of the 1980s the world fell in love with the yen, figuring that Japan's new ascendancy meant that it would rise and rise. As a result Japan Inc. could in effect borrow in dollars, swap it into yen and get paid for the privilege. Much of the money found its way into the stock market, sending stocks to stratospheric levels and reinforcing the bubble illusion.

The Nikkei index of stocks went to the moon and Tokyo residents ended up needing 100-year mortgages to afford tiny apartments.

GOOD AND BAD BUBBLES

Of course, that is not where it ended with Japan, which had its bust and which is still struggling with deflation, though that is in part a function of a shrinking workforce.

Japan liberalized its financial system and currency arrangements under strong pressure from the United States.

China almost certainly has more relative real power today and there is every sign that it will open up on its own terms and to its own schedule.

But open it probably will.

Chinese officials have expressed a desire for the renminbi to play a great role in world trade, naming 2020 as a date by which it can play the role of a reserve currency.

That is almost certainly going to require deregulation of financial markets, something also needed if Shanghai is to become a global financial capital.

China now buys Treasuries not because it thinks they are good value, but because those purchases maintain a competitive currency, not to mention protecting existing holdings. As that ends, much of the money will seek out high returns, and as the renminbi strengthens international capital will doubtless pile on and pile in.

That kind of liquidity and deregulation, in combination with strong national pride and a legitimately fantastic story, is a step-by-step recipe for a bubble. So it proved in Japan, so it likely will be in China.

A look at recent experience in China only underlines this. Speculation is rife and billions in government mandated loans have leaked into stock market bets.

China's government undoubtedly understands all of this and is surely determined to maintain control. They may not find it that easy. Getting rich, as we've seen in the United States, is a heady business and it is easy to start to believe your own press.

As the momentum builds and the money rolls in it will be easy to see it as a great country meeting its prosperous destiny.

Given the size of the opportunity and the strength of the story, China's bubble will be huge. Investors would do well to avoid being in the immediate vicinity when it bursts.

--At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.--

--James Saft is a Reuters columnist. The opinions expressed are his own--

Rest in peace, Great American Consumer. We will not see your like again.

"Cash-for-clunkers" aside, consumers seem bent on actually paying back debt rather than racking it up, a change that if sustained, as it is likely to be, will dampen economic growth not for months but for years, and not just in the U.S.

Outstanding U.S. consumer borrowing fell by a jaw-dropping $21.6 billion in July, according to data released this week by the Federal Reserve, five times more than analysts expected and the second largest monthly drop since the end of World War II.

June's borrowing was revised to negative $15.5 billion from what had been an impressive minus $10.3 billion.

Over the past year, the stock of consumer loans outstanding has dropped by 4.2 percent, or nearly $110 billion, leaving the total now lower than it was before the crisis began in 2007.

Over the long term, this is exactly what needs to happen. With household wealth badly hit by the housing and stock market crashes balance sheets are stretched. And with a huge baby boomer cohort hurtling towards retirement age also, spending and borrowing were bound to be curtailed.

The question really becomes how entrenched the trend towards the new frugality becomes.

"Memories of debt are very powerful. The generation that grew up in the 1920s and 1930s, was wary of getting into debt as it - and its parents - had experienced two periods of deflation," Lombard Street Research economist Gabriel Stein wrote in a note to clients.

"We are now in another period of debt repayment and deflation. The thought that US households will forget 2007-2009 and begin to borrow and spend as they did in the early 2000s, is fanciful at best."

For years the mantra on Wall Street was "don't bet against the American consumer," a creature so fabulously resilient as to be almost super human.

Wars and recessions did little to brook consumption and the debt that grew alongside. Even the September 11 attacks saw healthy month on month growth in borrowing in the aftermath.

Whole industries, some now vanished, were predicated on Americans continuing to borrow and spend. It's an overstatement, but only a slight one, to say that the global economy was predicated on U.S. consumption, which in turn was predicated on consumers borrowing.

THE NEW FRUGALITY

It is doubtless true that lenders of all stripes are making credit harder to get. But there is a good bit of evidence that individuals are changing their preferences. Much of the cash from stimulus handouts earlier this year was used to pay down debt rather than goosing consumption.

A Gallup poll asking Americans how much they had spent in the past day, not including major purchases or normal household bills hit $63 when most recently measured, down from above $100 a year ago.

Now on the face of it, that reduction must be overstated. If consumption had fallen by that magnitude, we'd be in a depression rather than debating the strength of a recovery.

But of course the Gallup poll is a self reported one, and I would be willing to bet that people are now exaggerating how frugal they are, where once they would have exaggerated how much they were spending. That in itself is an important marker of a social trend. Once you wanted the nice people at Gallup to think you were a big shot leaking money, now you probably want them to see you as a saver.

Gallup also looked at the data by generational group, and found that it was not just those in or approaching retirement who were cutting back on self-reported spending. So-called Generation Xers and Millennials, who followed the boomers into the workforce, are also cutting back in similar scale.

But the issue isn't the rate of savings but the stock of savings as compared to liabilities. While it is reasonably possible to cut back on spending and so increase your savings rate that is far different from suddenly becoming financially robust.

The other thing to bear in mind is that there is a huge difference between stocks and flows. A person can quite quickly raise her savings rate - as we have seen - but that does not mean that her debts are quickly paid off.

If U.S. consumers cut debt as quickly as Japanese corporations did in the 1990s, it will still take them until 2018 to get their debt down to 100 percent of GDP from recent peaks of 130 percent, according to a study from the San Francisco Federal Reserve.

If the trend in consumer borrowing continues, it will not be long before the conversation will turn back to stimulus, quantitative easing, and a relapse for the U.S. economy.

--At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.--

--James Saft is a Reuters columnist. The opinions expressed are his own.--

The effort to rein in banking bonuses, outrageous as they may be, is akin to banning glue sniffing because you are worried about the effects of intoxication.

There are, as the kids in the alley behind the high school can tell you, other ways of getting high.

Train your regulatory fire instead on requiring more and better bank capital and you will arguably do a great deal to control excessive compensation as well as doing much more to protect taxpayers and the economy.

Financial leaders from the Group of 20 rich nations agreed the skeletal outlines of a plan to reform banking last weekend in London. Included was the idea of claw backs on bonuses if earnings evaporate, forcing more pay to be deferred for longer, and more disclosure of top pay.

This may have some effect; bankers will have to wait a while for their money and some risky bets may not be made. But the out-sized rewards are the result of people within finance having an informational advantage over their shareholders and regulators and the ability to play with huge amounts of other people's capital. Combine this with an implied government guarantee for the too-big-to-fail and you end up with a crisis every ten years or so. Just making bankers wait longer for their money does nothing to affect the competition for deals and assets to leverage.

Besides the folks who brought you the CDO squared will be well able to find workarounds to ensure that money leaks out in one way or another.

More promising by far are proposals to force banks to increase the amount and type of capital they hold. Central bankers and regulators from the Basel Committee on Banking Supervision are calling for a host of measures to bolster capital, including saying that common shares and retained earnings must be the mainstay of capital, introducing a leverage ratio and minimum standards for funding liquidity. All three will make banking and the economy more stable. All three will also, in so far as they reduce the amount of borrowed money available for investment, tend to push asset prices lower.

LEVERAGE IN, LEVERAGE OUT

Kansas City Federal Reserve President Thomas Hoenig points out that the largest 20 U.S. banks have equity capital equal to only 3.5 percent of their assets, as against an average of 6 percent for their middle sized competitors.

"They have an implied guarantee, which affords them an enormous advantage in terms of their use of leverage and their ability to accumulate assets to unprecedented levels," Hoenig said in a speech to bankers made in August but released last week.

The large U.S. banks, it is worth mentioning, in turn face competition from their big trans-Atlantic peers, many of whom have leverage far in excess of theirs.

Forcing large banks around the world to raise enough capital, or dump enough assets, to put them on a level with their smaller peers would do a great deal to put an end to the rolling bubbles and bailouts.

The Basel committee also said it would consider the need for a capital surcharge to "mitigate the risk of systemic banks." If by this they mean a tax on size above a certain level, this would be a fantastic start to counterbalancing the unfair advantage enjoyed by the too-big-to-fail, not to mention the threat they pose to the public purse. It would make good sense to impose a tax on size and to phase it in over several years, so that banks would have both the time and the incentive to shed assets without resorting to a fire sale.

Control leverage and size and you will do more to control destructive risk taking than any programme can which simply makes bankers wait a few years until they can get their payouts.

If you are really worried about unfair compensation in banking you have to define who is being badly treated by it. Moderating the effect of a taxpayer subsidy by limiting size and controlling risk taking is a start, but there are still shareholders and consumers of financial services to be protected. Both of these groups suffer because they don't really understand the complex products being produced and sold by the industry. This allows consumers to be overcharged or oversold and shareholders to be chiseled out of part of their portion of the gains generated.

It is strange to say, but bank customers and owners may want to make common cause over the issue of simplicity in financial services. Simple banks with simple products might in the long run generate better outcomes for their owners and clients, just as simple index funds now do for investors. Will regulators be able to accomplish all of this? Probably not, but they would do well to concentrate their limited resources and creativity on the foundations of banking rather than the salaries on the top floor.

--At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. --

(James Saft is a Reuters columnist. The opinions expressed are his own)

Activity in the U.S. housing market has bottomed - a huge plus for the economy - but a recovery in prices will not be sustained and the threat from real estate to bank capital remains acute.

We are over the worst, but only because of massive official support, support that will soon ebb. That could lead to a relapse, especially among more expensive houses, but nothing along the lines of what we have suffered so far.

The news has been good.

Newly built homes sold in July at the fastest pace in ten months, up 9.6 percent, in U.S. Commerce Department data on Wednesday. This echoes a fairly good showing in last week's data on sales of existing homes which are selling at the fastest pace in almost two years.

Miraculous to say, prices now look to be rising, at least as recorded by the Case-Shiller home price index which rose 2.9 percent between the first and second quarters, the biggest jump in close to four years.

This all comes as a huge relief. You can construct an argument that we are now most of the way through the most painful adjustment in house values and sales activity since around the time great clouds of dust blanketed the mid-west in the 1930s.

There is no doubt that a pickup in activity, even from very low levels, will be helpful for the economy and will gently support the services and construction sectors as well as theconsumption of durable goods.

But the supply of housing, though it has dropped, remains high and is probably under-measured given a large "shadow" inventory of both repossessed houses and houses of frustrated sellers which will come back on to market to meet and probably exceed any pickup in demand.

In the more bombed out areas of the U.S. - think Las Vegas and Cleveland - it is easier to come to terms with the idea that prices will now rise.

Demand is coming not just from first time buyers but more importantly from cash investors looking, not to flip as prices rise, but to get a decent income stream from renting. These investors are a healthy part of the process of turning a marginal group of house-owners back into renters.

It is hard to look at the national data, especially at the higher end where inventory in many areas is measured in years of supply not months, and conclude that we will not see any more falls.

"Perhaps a respite is in order, but with the true underlying unsold inventory near 12 months' supply, which is double what would typify a balanced housing market, it would seem like wishful thinking that we have suddenly achieved a fundamental low in real estate values," David Rosenberg, of Gluskin, Sheff told clients.

THE GOVERNMENT GIVETH...

The recovery in housing, such as it is, has to be seen in the context of the absolutely heroic support it has received from government.

The Federal Reserve has slashed interest rates to unfathomable lows, and not content with that, also intervened directly in mortgage markets, buying something on the order of $750 billion net of mortgage securities in an attempt to drive down mortgage rates.

The Fed has a 2009 target of buying up to $1.25 trillion of agency mortgage backed securities, $300 billion of Treasuries, and $200 billion of agency debt, all of which is keeping effective borrowing rates 0.5 to 1.0 percentage points lower than they would otherwise be. That program may be extended into next year, but not in size, given a well justified fear by the Fed that such intervention invites tighter political oversight.

So, all things being equal, mortgage rates may rise relative to prevailing rates, unless of course the securitization machine rises from the dead.

An $8,000 tax fillip for first time buyers is definitely a factor behind increased turnover and improving prices, particularly at the lower end. But that program is due to expire November 30.

Like the "cash-for-clunkers" plan for cars these programs partly encourage pent up demand to get off the sidelines but also simply move some activity forward in time. Look for a bit of a slump as the effect, which is now at its height, wears off.

Late paying borrowers are proving far less likely to get back on track than they were in previous cycles, according to a recent report from ratings agency Fitch. This argues for a continuing supply of houses coming back onto the market as foreclosures, especially in light of the poor success of mortgage modification programs.

To be sure, things are better now than they have been and the very steep falls in price make housing less of a one way bet.

The real estate market is usually seasonal, with a spring spurt and a winter freeze. This year we've seen the return of the spurt, but the freeze to come may buckle some foundations.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

(James Saft is a Reuters columnist. The opinions expressed are his own)

A proposal to give banks, hedge funds and private equity firms "affordable" credit default swap-based insurance against market panics will be very effective: it will effectively encourage even more risk taking and turn the next crisis into one about government credit.

Global central bankers assembled at the Jackson Hole conference last week heard the proposal, by two Massachusetts Institute of Technology economists Ricardo Caballero and Pablo Kurlat. Their idea is that most of the damage in panics is due to a combination of investors overestimating the damage during a market seizure and policy-makers being too slow to pull the trigger on bailouts.

The solution, therefore, is to send the banks into the next panic ready armed with a Fed-backed get out of jail free card which the authorities can activate at a moment's notice.

This is akin to looking at a bunch of toddlers riding motorcycles and deciding that what will really improve the situation is putting them all in crash helmets.

The proposal emphasizes "Knightian uncertainty," which it says impairs markets during panics, as investors price in the worst about those risks which they cannot measure.  Remove this uncertainty, and hey Presto, you've cheapened the cost of the whole bubble business.

"The main antidote to fear is prime, government-backed insurance against what investors fear," according to Caballero and Kurlat.

"The silver lining of this diagnosis is that providing such insurance is inexpensive for the government, as once the panic subsides the real losses are much smaller than those initially feared by investors."

There are a few assumptions there, so let's take them one by one.

First, we don't know that markets were wrong to assume last year that bank losses would be catastrophic. Banks are performing better, but only within a context of having either an explicit or implicit government guarantee. We do not know how well their underlying assets will ultimately perform, or even if the assumptions made in the stress test will prove true. We only know that in making those assumptions and standing behind them, the government has removed risk for private investors.

Second, we do not know that the level of these losses will be affordable for governments to bear. Look at Iceland for a prime example of what can happen. The U.S. has taken on very real and very scary public liabilities in order to end the crisis. There is no guarantee that these are affordable or that U.S. creditors will keep faith.

THE FUTURE IS MORAL HAZARD

Caballero and Kurlat also say that the cause of panics is fundamentally unknowable, a surprise. While its hard to say now where the next one will come from, there are plenty of people out there who were patiently explaining where this one was going to be centered: real estate. People who ignored this advice did so for many reasons, but one thing in common many shared was that they were getting rich out of the bubble or hoped to.

This brings us to the main reason not to create these crisis swaps; they will only encourage people to take on more risk. If we effectively assume that all panics are essentially false alarms we will encourage an unwarranted confidence in risk managers and investors. Add in prospect of profits and bonuses and you have a prescription for ever expanding leverage, bubbles and crises.

The authors say that policy makers react too slowly, and compare their plan to placing defibrillators in public places to save the lives of heart attack victims. But unlike human beings, all of whom we want to save, sometimes its better if banks are allowed to die, much less hedge funds. Shareholders and bondholders, unlike life, are not sacred.

The proposal also argues that leverage in the system was not excessive, at least when compared to the last recession in 2001. But of course by 2001 the amount of leverage had already began to expand, helped along the way by deregulation. Try running the numbers compared to 1985 or 1965 and you will reach a different conclusion.

None of this is to say that financial innovation is a bad thing, or that leverage is to be altogether eliminated. But there is in markets a growing hope that we are all awakening from a bad dream. That's a delusion.

Financial panics are not nightmares to be ignored, but like chest pains, warnings to be heeded.

"In the end, the conventional common sense response to financial crisis - better regulation, rein in leverage, increase transparency, etc., is not such a bad one," Harvard economist Ken Rogoff wrote in response to the proposal.

I couldn't agree more. Let's get the kiddies off the bikes, and the sooner the better.

( At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)