In February of this year, I wrote The Five Stages of Collapse, connecting each stage of collapse – financial, commercial, political, social and cultural – with a specific mental milestone, where faith in some aspect of our status quo is shattered in the face of dramatically altered circumstances. Here is what I had to say at the time about Stage 1: Financial Collapse:

Financial collapse, as we are currently observing it, consists of two parts. One is that a part of the general population is forced to move, no longer able to afford the house they bought based on inflated assessments, forged income numbers, and foolish expectations of endless asset inflation. Since, technically, they should never have been allowed to buy these houses, and were only able to do so because of financial and political malfeasance, this is actually a healthy development. The second part consists of men in expensive suits tossing bundles of suddenly worthless paper up in the air, ripping out their remaining hair, and (some of us might uncharitably hope) setting themselves on fire on the steps of the Federal Reserve. They, to express it in their own vernacular, "fucked up," and so this is also just as it should be.

The government response to this could be to offer some helpful homilies about "the wages of sin" and to open a few soup kitchens and flop houses in a variety of locations including Wall Street. The message would be: "You former debt addicts and gamblers, as you say, 'fucked up,' and so this will really hurt for a long time. We will never let you anywhere near big money again. Get yourselves over to the soup kitchen, and bring your own bowl, because we don't do dishes." This would result in a stable Stage 1 collapse - the Second Great Depression.

However, this is unlikely, because in the US the government happens to be debt addict and gambler number one. As individuals, we may have been as virtuous as we wished, but the government will have still run up exorbitant debts on our behalf. Every level of government, from local municipalities and authorities, which need the financial markets to finance their public works and public services, to the federal government, which relies on foreign investment to finance its endless wars, is addicted to public debt. They know they cannot stop borrowing, and so they will do anything they can to keep the game going for as long as possible.

About the only thing the government currently seems it fit to do is extend further credit to those in trouble, by setting interest rates at far below inflation, by accepting worthless bits of paper as collateral and by pumping money into insolvent financial institutions. This has the effect of diluting the dollar, further undermining its value, and will, in due course, lead to hyperinflation, which is bad enough in any economy, but is especially serious for one dominated by imports. As imports dry up and the associated parts of the economy shut down, we pass Stage 2: Commercial Collapse.

So far so good. In terms of mental milestones, we can tease apart financial collapse into a number of psychological levees that are being breached one by one. The first one to go was people's faith in home equity: that the value of their homes will serve as a nest egg to sustain them in retirement. What we have been witnessing for the past week or so is the demise of people's faith that their investment portfolio will sustain them. It is still easy to find investment advisers who will tell you to "go long on equities" because, you see, "eventually the economy will recover," but their reassuring words are starting to sound like a death rattle to all those whose retirement savings suddenly look laughably inadequate.

Eventually, faith in the magical, mystical properties of the US Dollar will be lost, but it seems very important to all concerned to make the process gradual. It seems safe to assume that in the limit, as time goes to infinity, the value of the US Dollar goes to zero:

It also seems safe to assume that it is negligible even for finite, foreseeable values of t. The problem is making it look like a continuous function. If the value of any given type of dollar-denominated garbage jumps to zero suddenly (because it cannot be sold at any price) then that produces a discontinuity: a rift in the fake financial space-time continuum.

This is what the current bailout plan is generally about. It is not about making anyone here happy: the fascists think that smells of socialism, the socialists think that it smells of fascism, and everyone (except for Bush, Paulson and Bernanke) agrees that it smells. Some people would like to see some heads roll, but as Robespierre discovered in the course of the French revolution, that just puts you knee-deep in headless aristocratic corpses, still with neither bread nor cake to feed to the peasants.

Speaking of peasants, everyone continues to repeat that the bailout is being financed by "the taxpayer," although it is unclear why our soon-to-be jobless and destitute taxpayer should be expected to cough up an extra trillion or more. The taxpayer may soon need a bailout too. If this mythical taxpayer actually tried to borrow her share of a trillion dollars against her future earnings, what sane person would want to give her that loan? Clearly, the gratuitous mention of the taxpayer is just a ruse designed to hide the rather obvious truth.

The bailout is actually going to be financed by foreign interests that hold US Dollar assets. Yes, the value of their holdings will go to zero, but they do not want this to happen suddenly. They wish to continue redeeming their US Dollar holdings for all manner of things of value, from capital equipment and intellectual property, which can be expatriated, to farmland and other means of production, which can be used in situ to grow food, mine ore, and so forth, which are then expatriated. There is some optimal function for this great unwinding, which will allow foreigners to expropriate the maximum amount of value in the minimum amount of time before their efforts to redeem their remaining US Dollar holdings stop paying for themselves in terms of the value of the available stuff.

As this process runs its course, the US will lose access to imports. Most significantly, it will find it more and more difficult to obtain the 2/3 of the transportation fuels that come from abroad, which are needed to keep the economy functioning. And that will bring on Phase 2: Commercial Collapse. That is probably what we are getting for Christmas this year, or shortly thereafter.

In the meantime, enjoy Stage 1. You will miss it once it's over.