Since August we have been overwhelmed with nothing but bad news from the sub-prime mortgage front and from the global liquidity arena. The news and events since August have been almost enough to make people admit defeat. And that is precisely the discussion I had with a gentleman from Wachovia Securities whilst in Cancun recently at the FAMMS Conference.

The terminology we bantered about was the phrase “liquidity trap”. A liquidity trap tends to occur in an economy when financial intermediaries are not willing to lend to each other. Consumers scale back their spending even though interest rates remain favorable. Financial markets tend to then suffer (just ask the Japanese who endured a decade long liquidity trap). And a liquidity trap is precisley what we may be facing now.

Banks are sitting with off-balance sheet assets (the true extent of the SIV's still is unclear) and the economy is waiting for the “other shoe to drop” as it were. Consumers are starting to scale back in the face of a weakening housing market and the financial markets are up one day and down the next as uncertainty prevails. A recent report on BBC even suggested that 34% of sub-prime mortgages are going into default in the USA.

Noted US economist Milton Friedman (1912-2006) once suggested that a monetary authority can escape a “liquidity trap” in the economy by by-passing financial intermediaries to give money directly to consumers or businesses. This is referred to as a money gift or as helicopter money (this latter phrase is meant to call forth the image of a central banker hovering in a helicopter, dropping suitcases full of money to individuals).

Rightly or wrongly, Fed Chairman Ben Bernanke has been labeled with the moniker Helicopter Ben as he is from the Friedman school of economic thought. This week we may well have seen his first efforts to live up to that moniker. In a deal brokered by the Fed, a consortium of global Central Banks will be trying to increase global liquidity by allowing the US Fed to use an alternative to the two more traditional models of inter-bank lending and the Fed discount window.

In the realm of fractional reserve banking, banks in the US are required to have a certain amount of cash on hand in "reserve". If this reserve figure dips below the minimum required at a certain bank, that bank can borrow from another bank that has a surplus reserve. The rate of interest for this borrowing activity is dictated by the Federal Reserve.

Problem is right now, banks are not playing with each other. After all, would you lend money to your friend or neighbor if the collateral he posted possibly contained sub-prime mortgages? No you would not. That being said, the other liquidity avenue that exists is for a bank needing short term funding to approach the Federal Reserve directly and borrow from the so called discount window. Problem is, once a bank does this, it becomes public knowledge.

With the world fixated on sub-prime debts, no bank wants to admit it had to approach the Fed for money. The stigma would potentially cause severe gyrations in the equity shares of said bank. What the Fed is now going to do in the alternative model offered up this week is to make available up to $40 billion in new money to be auctioned off directly to banks. And the type of collateral accepted against this borrowing will be “expanded” somewhat.

As I noted above, this is what Friedman called Helicopter Money. Now, what we as market players have to hope for is that this approach works. Friedman’s theory may be relatively untested. If it works, he will be remembered posthumously as a genius and Ben Bernanke will bask in the glory of knowing he had the guts to put Friedman’s theory to the test.

But…if it all fails, then the stuff I have talked about over the past weeks with regard to a new 4 year equity market cycle getting underway, and a robust Commodity SuperCycle that will last for years yet...will all severely be put to the test. I liken this situation to a car coming down a winding mountain road. Unfortunately, the car has now lost control and is now careening wildly.

Let us all keep our fingers tightly crossed that the Central Bankers behind the wheel of the car can get it under control. Let us also hope that Alan Greenspan was also correct about Milton Friedman when he said "There are very few people over the generations who have ideas that are sufficiently original to materially alter the direction of civilization".