As mentioned in my last post, the credit market is like any other market. True prices are given by the intersection of supply and demand; the government can manipulate the price by augmenting supply or interfering with demand; but attempting to set the price beyond its ability to manipulate freezes the market (the Soviet breadline situation).
Central banks create credit by issuing money. This money goes into the economy and creates credit and debt through fractional reserve banking. The way most central banks do this is by buying government bonds, which creates a "reserve" of those government bonds they can lend out in a crisis. In the case of the US Federal Reserve, that was about 850 billion dollars.
So the reserve is 850 bb, how much is the shortfall? Well, at US bank leverage (12:1) the 850 bb in cash would become about 10 trillion in credit. At European leverage (1:30) it would become about 25 trillion. In shadow banking, we have no idea what the leverage is but it's almost certainly higher than the European. Let's estimate with the median and say there's 25 trillion in credit.
Suppose 10% of that 25 trillion is lost to the massive housing bubbles and assorted LBO, consumer credit, and retail bubbles. Remember we have to count more than the US - Eurodollar losses will count too. The 2.5 trillion loss is far greater than 900 billion. It's too much - the Fed is not going to be able to hold down real rates. Perhaps I've been too pessimistic, but even a 4% loss in the credit markets - wildly optimistic at this point - is too much for them.
Note the losses are so large the Fed may not even be able to hyperinflate out of this. If the Fed confiscated all the real value of currency by hyperinflation and issued another 850 bb for a replacement currency, it still might not have enough - a total of 1.7 trillion is still less than 2.5 trillion. And of course, a hyperinflation will generate additional real losses that would need to be covered.
The Paulson plan technique of depositing Treasuries isn't going to help. At this point the government must borrow what it lends, so no net credit. Inflation, the only out, just isn't enough. A Paulson-style plan can reallocate credit from one market to another, and perhaps that's a good idea; but overall that just raises rates in one market to lower them in another.
Why haven't we seen this before? Well, first of all, this is the worst worldwide credit loss we've seen since the Great Depression, and perhaps ever in percentage terms. Second, leverage has generally increased over the past 20 years due to deregulation, so the central bank credit reserve is a smaller fraction than before. If, for example, we were at traditional US ratios, the central bank reserves would be 8% of credit, and with a 25% total inflation the central bank could cover a 10% shortfall. If losses were only 6% it wouldn't have to inflate at all. But when the problem gets bigger and the central bank (relatively) smaller they can't handle it.
For 75 we have stood on a solid ground of (apparently) unlimited central bank powers. If we came to a dip, we could step down. But that ground is not as indestructible as we thought and the raging torrent has swept it away and put us in the water. To step down now, to try to hold credit rates below any possible market-clearing rates, is to drown. It is time to swim.