Uncertainty about the soundness of the financial system and the extent of economic weakness in the US is causing a good deal of volatility on the markets. By some measures, the US stock market, as represented by the S&P 500 index, has not experienced such large daily price swings for a number of decades. Investors remain edgy and react forcefully to the latest positive or negative news.

One day there is fear that things could get a lot worse as the economy sinks into recession and the financial system stumbles in its attempts to find a footing. The next day, there is a revival of greed as optimism increases about a soft economic slowdown, along with easier credit conditions for troubled banks.

Unfortunately, there isn't a great deal of clarity about the state of the financial system to help investors form a sound judgment. Wall Street, the rating agencies and the government have been making misleading statements (well, downright lying) since the credit crunch got into full swing last year. And the fog hasn't lifted yet.

Those banks that are essentially insolvent aren't going to break the bad news to the wide world until they are about to go belly up. They pray quietly that the market revives for their illiquid assets. And for those securities that have some sort of a market, they hope that prices will rebound from deeply discounted levels.

Of course, market participants aren't stupid and readily target those banks that are deemed to be most exposed to the sub-prime debacle and the housing downturn. Such was the case with Bear Stearns, which faced a liquidity crisis as lenders stayed away. To any seasoned observer it was obvious that an injured Bear had the potential to cause a multitude of problems for other parties that dealt with it, not least leveraged hedge funds.

Given the possibility of systemic risk, rescue by the Fed was inevitable. In particular, other investment banks may have come under the gun if no action was taken. Of course, there were howls of protests from some quarters about socialism for Wall-Street speculators, and they were entirely right. Under free-market capitalist principles those who make bad decisions should fail, not just as a matter of equity but mostly to promote efficiency.

The parties that had stopped lending to Bear were acting rationally. They had re-priced risk, in dealing with an entity with a lot of problem-assets on its books. In saving Bear, in an extraordinary action only witnessed previously during the hard times of the 1930s, the Fed has committed the taxpayer to pay any costs involved.

There were no penalties imposed on the rescued bank. The shareholders took a substantial haircut but the management, responsible for the speculative excesses, got off lightly other than a hit to their stock-holdings. They had already been the beneficiaries of big bonus payments just a few months earlier.

Apart from rescuing Bear, the Fed has implemented a large number of exceptional measures to shore up the banks and pump liquidity into the system. The spectacle of so much being done to prop up errant speculators must be galling to those who have been cautious savers. They are being viciously penalised by the drastic cuts in interest rates to such low levels that savers are now earning negative inflation-adjusted returns.

And that's not the end of the story. The Fed and the government will have to do quite a bit more before the system is stabilised. Taxpayers will end up paying hugely to save troubled homeowners and financial institutions.

Currently, the main problem is that the ultimate real assets underlying the superstructure of fancy derivatives — namely, the houses — are still falling in price. And, a growing worry is that the government may not be averse to seeing a rise in inflation to help shore up house prices. But playing with inflationary fires is a risky and dangerous game in the longer run.

Fear of inflation was one of the reasons behind the rise in gold and commodity prices in recent months. There were other reasons too, of course, including greater asset allocation by institutional investors to investment in commodities, as well as the activities of a horde of speculators. Currently, commodity prices have undergone a downward correction from overbought levels.

There is the realisation that a slowing global economy will dampen demand for many categories of commodities. The exceptions are in the agricultural category, which face a different price dynamic based on cyclical and structural supply/demand imbalances.

The Fed's actions are interpreted by the markets as a deliberate debasement of the currency, which has put much downward pressure on the dollar. It appears that the policymakers are quite partial to a fall in the value of the dollar, as it helps generate higher export orders, substituting for waning domestic demand.

But playing this game too hard could have a bad ending in the form of a dollar rout. The Bush administration has put a lot of pressure on Arab governments not to unpeg their currencies from the greenback, even though their economies are suffering inflation pressures because their currencies are pegged to the US dollar.

In addition, Saudi Arabia has refused to go along with some other OPEC members who want to change the currency in which oil is priced. All these decisions have a large political element and it is not clear what the Arab sheiks got in return for their decision to stick with the dollar.

Much of the dollar depreciation has taken place against European currencies and it is hoped that as economic slowdown also takes hold in Europe there will be a degree of restoration of the dollar's value. But there is also a possibility that the desire to switch out of dollars into other currencies has not been entirely curbed. If so, another leg down in the greenback's value is likely to bring about concerted intervention by a gaggle of central banks.

Political pressure on the Fed to promote growth continues to be strong, even as questions are being raised on how far they have been bending the rules in their recent actions. Washington insiders say that the White House is not averse to picking up the phone and telling the Fed in profane language what to do. And Bernanke is not the sort of chairman who is going to refuse.

The blame game has reached new heights, as people try to identify those responsible for the credit-crunch mess. A lot of fingers are being pointed at Greenspan, the former Fed chairman who looked the other way when he saw a bubble forming. Some folks have dredged up Bernanke's voting record when he was a governor during Greenspan's reign. And, yes, he voted along with the chief as interest rates were brought down to extremely low levels, kept there for a long time and raised ever so reluctantly. So if they are going to put Greenspan in the dock, they can't avoid putting his accomplice there either.

It is obvious to everybody that we are heading into a period which is going to be dominated by an examination of the regulatory framework and the role played by regulators. Wall Street will fight to keep the imposition of new restrictions to a minimum. But their credibility is at a low level and the evidence is that they have failed in their risk-management practices.

As George Soros has commented recently, the fundamental idea that markets are self-correcting has taken a knock. Over the past two decades of deregulation, there was a premise that financial firms were able to ride out stormy seas because of increasingly sophisticated systems to manage risks. This has turned out to be somewhat illusory, partly because the methods are imperfect and partly because of human failings.