The financial markets gave a convulsive shiver a month ago when the Fed raised its Fed Funds rate to 5 percent and allowed as how it might well pause in its monthly quarter—point increase action.  'Oh no you don't!' came the unmistakable response, as global stocks, the dollar, US government bonds, oil, and gold all tanked.

That means that the rosy scenario, in which the Fed would tighten up to the 5 percent level and then benevolently pause while the national economy continued to grow comfortably along at 3.5 to 4.0 percent per year is probably defunct.  Interest rates are going on up, almost certainly to 6 percent or higher.  It also means that the pips are going to start squeaking as people who have borrowed on low interest ARMs have to adjust as their adjustable rate mortgages adjust upwards.

British investment banker Sir Siegmund Warburg had another term for "rosy scenario."  According to Professor Niall Ferguson, he used to talk about "wishful non—thinking."  It's a pity that Sir Siegmund's chosen successor at SG Warburg, Sir David Scholey, didn't listen to his mentor.  He overextended Warburg during Fed Chairman Greenspan's tightening in 1993 and had to sell the investment bank to Swiss Bank Corporation.

The problem is to find a balance between a healthy optimism and the "wishful non—thinking" that ignores the inevitability of a train wreck when an onrushing locomotive is already in sight thundering down the track.

Are we heading for a train wreck like 1980 when inflation, interest rates, and unemployment were all hitting 10 percent?  Or is this 1990, when the S&L meltdown was, finally, handled by liquidating the malinvestments of S&L barons like Charles Keating to the tune of $500 billion or so in government bonds?  Or will the US economy power ahead and continue to confound its critics?

The Federal Reserve Board has two jobs.  One is fighting recession.

That is the fun part of its job.  The other job is fighting inflation.

That is the unpleasant part of the job, the role of the kill—joy who snatches the punchbowl away just when the party is getting lively.

Right now, the Fed is in transition between its two jobs.  It had a grand old time in the early Noughties, spiking the punchbowl with low interest rates until it got the Fed Funds rate down to 1.0 percent.

What a party Americans had, refinancing their mortgages, buying and building mega—mansions and starter castles, boosting real—estate prices into the stratosphere on the high octane fuel of cheap credit.

Now the Fed has its hands on the punchbowl and it is impatiently looking at its watch. What will the Fed do?  Will there be a dollar crisis?  Will there be a housing crash?  Will there be a nasty recession?  Nobody knows.  Right now people are placing their bets, and hoping that they are not indulging in "wishful non—thinking."

Years ago, a wise old head wrote that the most important issue for the federal government is not fighting inflation, or growing the economy, or even saving Social Security.  For the government, job one is to float its paper: its debt and its paper money.  As long as the bond market is buying the government's bonds, notes, and bills, and people are willing to hold its paper money then everything is fine.  It is when the government loses the confidence of the bond market and cannot sell its paper or when people start pushing money around in wheel—barrows that people start to tremble.

Think Germany in 1923, Nationalist China in the late 1940s, Argentina in 2001, Zimbabwe in 2006.  These are loser governments.  In 1980, of course, at the height of the Carter inflation, there was a bobble or two of worry about the United States on the loser front.

On the other hand, the finest hour of government finance has to be the US government's financing of World War II.  The government cranked the deficit up to 40 percent of GDP; the Treasury floated an ocean of bonds; the Fed bought a lot of those bonds to keep interest rates down, and they barely broke a sweat.

Isn't it interesting that President Bush has just nominated the king of Wall Street, Goldman Sachs boss Henry M. Paulson Jr., to be Secretary of the Treasury?  Pretty soon he'll be traveling the world humming Irving Berlin's old song:

Any bonds today?

Bonds of freedom

That's what I'm selling

Any bonds today?

Scrape up the most you can

Here comes the freedom man

Asking you to buy a share of freedom today

You can see where President Bush has placed his bet.  But no "wishful non—thinking," please, Mr. President.

Christopher Chantrill  blogs here . His Road to the Middle Class is forthcoming.