91Èȱ¬

Please forgive me for not having published a column for a bit. I've been pre-occupied sorting out family stuff.

That stuff isn't quite ticketyboo yet. So the blog will go into hibernation for some weeks (please don't look so pleased).

There will be plenty to talk about when I return - so I hope fervently you will still want to have a conversation with me.

In the meantime, it seems appropriate to discuss what a radical reform of the financial system would actually look like.

I say the "financial system" rather than the "banking system" because arguably the debate has been too fixated on institutional reform of banks rather than the size and scope of the financial system as a whole.

The governor of the Bank of England is widely seen as having joined the radicals' camp - in that, overnight himself the friend of those who wish for sprawling banking conglomerates to be broken up, such that banks' more speculative activities would be separated from those functions vital to the functioning of the economy (see Stephanie Flanders' note on this).

As usual for the governor, it's an exquisitely timed intervention in the debate - in that the Financial Services Authority will be publishing its latest reforming thoughts later this week.

So the poor old FSA is bound to be characterised as sleepy and unimaginative compared with the bold and courageous Bank of England.

And, do you know, I almost feel sorry for the FSA. Because the remedies proposed by Adair Turner, the FSA's chairman, are arguably a greater challenge to the status quo than King's.

In some ways, King's position has not shifted a jot since the crisis began in the summer of 2007.

He has always been fixated on moral hazard, on the idea that it's lethal for the efficient functioning of markets that institutions should be protected from the consequence of their mistakes.

And, as a matter of social justice, very few would fail to share his frustration that taxpayers have bailed out British banks to the tune of a short trillion pounds only to see the bankers making plans to pay themselves fabulous bonuses once again.

His characterisation has been incendiary: "never in the field of financial endeavour has so much money been owed by so few to so many - and, one might add, so far with little real reform".

For him, it is a matter of overwhelming importance that when banks and bankers gamble and lose, they pay the price - that the casino isn't rigged such that the winnings always go to them, while losses are forced on the state, on us.

That said, there is probably no way to avoid the provision by taxpayers to banks of financial protection for those functions that protect our savings, that provide vital credit to businesses and that move money around the economy.

What should be avoided (King would say, and most would agree) is what happened last autumn - which is that we rescued the speculative or casino operations of banks, the parts that generate the spectacular gains and losses, along with the supposed utility parts.

Which is why hiving off the banks' trading activities may well be a sensible way of limiting taxpayers' liability in the long term.

And it is perhaps testament to the lobbying clout of the big banks that the proposal from Paul Volcker, the distinguished former chairman of the Federal Reserve, for the separation of banks' investing and trading functions has not been embraced by Barack Obama or Gordon Brown.

But although breaking up the banks may be a sensible and necessary reform, it's by no means clear that it would be sufficient to correct the flaws that got us into this mess - even when combined with the recent international agreements to strengthen banks by obliging them to hold more capital and liquid assets.

Which brings us to Adair Turner and the FSA.

He would part company with King on an issue of fundamental principle.

The point - and most in the City will find this impossible to believe - is that King is much more the bankers' ally than Turner.

Because King, and others who argue for breaking up the banks, want onerous regulation and heavy supervision to be concentrated on a relatively narrow area of what banks do - those utility activities I've described as being the infrastructure of a healthy economy.

For King, there could be a relatively free, unfettered market for trading and investment banks, so long as the incentives for bankers can be corrected, such that the risks they take are genuinely risks for them, the proprietors of their institutions and professional creditors.

Turner would not agree.

He believes there is no serious alternative to much more intensive interference in all credit markets by the authorities. And he also believes - which is arguably more radical than breaking up banks - that credit markets have become far too big and opaque and that governments should take active steps to shrink and simplify them.

Perhaps his main point of dispute with King would be whether the guarantee against losses provided by taxpayers is really the main contributor to boom-and-bust cycles in credit.

With Keynes and Hyman Minsky, Turner would argue that the heart of the problem is simply that there is always a subjective element in valuing the future stream of earnings from any loan or investment, and that therefore the pricing of financial assets is always prone to overshoots and undershoots, depending on whether there is a prevailing climate of euphoria or despair.

No-one would argue - surely - that the insane dotcom bubble in shares prices of 1997 to 2000 was in any sense a moral hazard phenomenon. There was no taxpayer protection for over-enthusiastic investors who bought shares in "we_saw_you_coming.com" at multiples of 1,000 times notional prospective profits.

Investors paid far too much for "new economy" shares for the same reason investors traded their life savings for a single tulip bulb in the 1630's - hysteria and greed persuaded herds of investors that they were going up forever.

Precisely the same mania afflicted bankers and professional investors who lent colossal sums to over-indebted companies from 2005-7 with few strings attached and bought bonds made out of poor-quality subprime loans that were priced only a bit more cheaply than high-quality sovereign debt.

In the recent credit bubble, the equivalent of the insane heights touched by shares in 1999 and 2000 was the ludicrously low cost - in July 2007, just weeks before wholesale financial markets froze and the credit crunch began - of insuring against possible losses on loans to banks through the use of credit default swaps (CDS's).

The CDS premium for bank debt at the time was as low as it had ever been: it implied there was almost no risk of lending to a bank, when in reality there had never since 1929 been a riskier time to lend to a bank.

This was as much a bubble as had been the dotcom one.

But there is a really important difference between the two bubbles.

The retail and commercial banks on which we all depend are more-or-less prohibited from investing depositors' money in shares, so when share prices collapse there's little impact on their viability or solvency.

But when a credit bubble goes from boom to bust, there is a hideous feedback loop which damages the banks, then the economy, then the banks again: banks suffer losses on their investments and loans; their ability to lend becomes constrained which leads to a slowdown in the economy; which in turn generates greater losses on loans and investments for banks; and so on, till we're all paupers.

It would of course be theoretically possible to stipulate that retail banks benefiting from a taxpayer guarantee should be prohibited from any lending or investing at all, that they should only be allowed to hold high-quality government bonds or cash (which is similar to what the economist John Kay has recently argued).

But that would only protect depositors' money. It would not flatten the credit cycle.

The important point is that it is not just the more obviously tradeable forms of credit, the bonds made out of loans, that are prone to being overpriced and underpriced; banking history is an epic of periodic manias in all kinds of loans.

For Turner, therefore, if it's acknowledged that the big risk that has to be reduced is the susceptibility of the economy to boom-and-bust cycles caused by boom-and-bust cycles in credit, there is at best only a partial cure to be found in breaking up the banks.

The economy would still be inextricably dependent on credit provided by banks and other financial institutions, whether those banks are narrow insured retail banks and uninsured trading and investment banks, on the one hand, or today's conglomerates, such as Royal Bank of Scotland and Barclays.

So, for him, a better prophylactic against the boom-and-bust cycle is to curb what he calls the more socially useless and frothy trading by all and any banks, whether they are pure investment banks like Goldman Sachs or conglomerates like Barclays.

He has, for example, already said that he sees a powerful case for introducing a tax on much of the trading in wholesale financial products.

And, as I understand it, he would also be highly sympathetic to the suggestion of George Soros, the hedge fund billionaire, that there should be a prohibition on so-called "naked" trading in credit default swaps - or that only those holding the debt of a company or institution should be able to take out insurance against that debt.

Which may sound technical and dull. But it would shrink the CDS market by many trillions of dollars, since something like 90% of the market in recent years has taken the form of pure speculation, according to industry statistics.

By the way, if you are one of those who want to see a substantial and permanent reduction in bankers' bonuses, Turner may be your man - because he wishes to see a substantial diminution in banks' revenues, so the bonus pot would inevitably become much smaller.

What is clear to me is that the British financial services industry should be feeling quite uncomfortable.

The City of London is sandwiched between Mervyn King at the Bank of England, who wants to break up the likes of Barclays and Royal Bank, and Adair Turner, who believes its activities should be fettered and constrained to an extent it hasn't experienced for almost 30 years.

Perhaps the bankers are hoping for a Tory government and assuming that George Osborne as chancellor would see off the irksome King and Turner.

If so, that's as likely to pay out as the massive bets many of them took two and half years ago that the banking system had never been sounder.

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The Chancellor isn't going to let Lloyds out of the Government Asset Protection Scheme (GAPS) without extracting a price.

The Treasury saved Lloyds earlier this year by promising to provide it with the protection of GAPS - which was a statement that taxpayers would absorb 90% of future losses on £260bn of poor quality loans and investments.

In that sense, taxpayers were giving a valuable pledge that losses Lloyds may incur on reckless loans would not kill the bank (to be fair to Lloyds, most of those reckless loans were made by HBOS, the bank it bought in such controversial circumstances).

So even if GAPS has not yet been created in a formal sense, Lloyds has been benefitting from the offer of GAPS for months: taxpayers have been keeping the bank's head above water.

How much should Lloyds now pay for being kept out of Davy Jones's locker by Alistair Darling?

Well a 1-1.5% fee on the implicit increment to Lloyds' capital generated by the APS would seem a reasonable starting point for negotiations.

That de facto capital increment was just under £16bn. So a 1% fee would see Lloyds paying just over £150m to the Exchequer.

Lloyds' board may haggle about the size of the break fee - but I am told its directors are reconciled to paying something.

And they also know that the Chancellor will force the bank to honour one very important commitment it gave when initially agreeing to the APS - and that was to increase by £14bn the volume of credit it makes available to businesses and households.

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I'm not quite sure why there has been another great flurry of speculation overnight about how Lloyds intends to raise additional capital.

Nothing very significant has changed since the last couple of times I wrote about this (in my notes Lloyds: Mind the GAPS and Lloyds to cut use of taxpayer insurance).

As I said back then, Lloyds is desperate to make zero use of the Governments' Asset Protection Scheme (or GAPS).

But its ability to steer clear of GAPS depends on whether it can raise sufficient capital from commercial sources to satisfy the regulator, the Financial Services Authority, that it doesn't need new insurance from taxpayers against potential losses on loans (under GAPS, taxpayers would insure £260bn of Lloyds' poorer quality loans and investments in return for a fee in so-called 'B' shares of £15.6bn).

The amount of new capital it would need is between £24bn and £25bn - or so the FSA ordained last month.

To put this into context, Lloyds' total market value is only £26bn.

So it would need to raise capital equivalent to its own current size, which is not the easiest thing to pull off.

However, it believes that's do-able (as I've said before).

Its plan would be to raise a record-breaking £15bn or so in an issue of new shares and finance the rest through disposals of businesses such as the life insurer and investor, Scottish Widows.

We'll know in a fortnight or so whether this will happen.

There are a number of outstanding imponderables.

One of those is Neelie Kroes - or rather what agreement will eventually be reached by Lloyds with the EU competition commissioner on branches and assets it must sell such that, in Neelie Kroes' view, it doesn't reap unfair competitive advantage from all the state support it has received.

I am told a deal with Kroes may be announced simultaneous with the announcement of how Lloyds intends to raise capital (which makes sense, since there are implications for Lloyds' future cash flow from the forced disposals).

Then there are the other obvious questions.

Will private-sector investors wish to provide the additional capital? Probably, would be my judgement (which in itself tells you something about how the confidence of investors has improved).

Will the scheme satisfy the regulator? Again, probably.

And what will be the attitude of the largest shareholder, the government - as represented by UK Financial Investments - which has a power of veto, as owner of 43% of Lloyds.

The buck will, in the end, stop with the chancellor.

It won't be an easy decision for Alistair Darling to take. Because it is by no means clear that what the board of Lloyds perceives to be in the bank's interest is actually in the interest of taxpayers and the economy.

Now Lloyds motivation for trying to raise capital and avoid the GAPS is straightforward: it doesn't want to increase its financial dependence on the state or defer the day when it can claim to be a freestanding commercial organisation.

But there are other considerations for Alistair Darling.

One is whether Lloyds will be less likely to provide the vital credit needed by businesses and householders if it opts to raise capital from commercial sources rather than the GAPS.

Well, as I understand it, Lloyds projections for growth in what are known as risk-weighted assets (loans and investments adjusted for their riskiness) would be broadly similar were it to go down either route.

Which implies that Lloyds won't lend less to vital parts of the economy if it's a little less tied to the state.

Of course, the chancellor has to decide whether he's comfortable diluting his leverage over Lloyds, just in case the economy recovers less strongly than he would hope and it would be useful to boss Lloyds around to force it to lend more.

But probably the most important judgement for him is about what will provide the greatest certainty for taxpayers of the greatest return for them on their existing investment in Lloyds over the shortest timescale.

Arguably it will be easier and quicker for the government to flog its 43% stake over the coming years if Lloyds remains an ostensibly "clean" bank, viz a bank that doesn't contain a "bad" part insured by GAPS.

All that said, there is one final and difficult judgement for Darling.

The great problem for him of Lloyds going for an issue of new shares is that the Treasury would have to invest up to £6.5bn of additional and precious cash, to prevent dilution of taxpayers' stake.

From an investment point of view, it would be insane for the Treasury not to put the money up. That will be the advice the chancellor will be given by UK Financial Investments.

But - as I think we all know now - Darling doesn't have £6.5bn (or even six shillings) simply lying around at the Treasury, available for any emergency.

If he wants to invest the £6.5bn, he'll have to borrow it.

It will add to the government's already ballooning public-sector deficit.

And even in the context of the £203bn net of gilt-edged government debt being sold this year, £6.5bn is not a rounding error.

By contrast, the great advantage of going for GAPS is that there are no upfront costs for taxpayers. All the cash costs would come later, as and when the insured assets would deteriorate in value.

Finally, there would be a very tricky task of managing public expectations if he puts an additional £6.5bn into Lloyds.

Which is that most taxpayers would assume that if he puts in all that extra money it would give him the right - and indeed the obligation - to boss Lloyds around even more than he has been doing. Which, of course, is precisely the opposite of what Lloyds board both wants and assumes.

There is a painful paradox here for Lloyds' directors, which I am not sure they have grasped.

A so-called private sector solution to its capital shortage would involve a huge additional injection of taxpayers' money. And as far as taxpayers are concerned that should oblige the bank to become more of a servant to their needs and interests, not less.

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contained a striking number of eye-catching proposals.

What he appeared in the round to be proposing was a programme of national sacrifice to reduce debt and create a culture of saving.

I will leave to Stephanie Flanders and Nick Robinson the analysis of his policies to reduce public sector borrowing and cut government expenditure.

But Osborne's remarks will reverberate through the public sector and the private sector.

In particular, he's made it difficult for anyone at the top of the income ladder in any part of the economy to be awarded a big pay rise in the next year or two.

A Tory government would cut the pay of ministers by 5% next year and then freeze it for the rest of the Parliament.

And anyone "who wishes to pay a public servant more than the prime minister will have to put it before the chancellor".

In theory that implies there'll be big pay cuts for senior directors of the Bank of England (including the governor), the chief executive and others at Royal Mail, the head of Network Rail and a fair number of 91Èȱ¬ executives, among others (unless the salaries of the incumbents are grandfathered*).

As for the banks, the shadow chancellor gave them an unambiguous warning that unless they voluntarily reduce bonus payments, he would take steps to curb their take-home pay, including "through the tax system".

In other words, they must either resist the temptation to use any of the state support they've received to enrich their staff or he'll introduce a special, punitive tax on bonuses.

Then there was big stuff on pensions.

He announced a longer-term aim - which won't be implemented in the next Parliament - to restore the ability of pension funds to claim back the tax deducted on dividends (the famous dividend tax credits for pension funds that were abolished by Gordon Brown in 1997).

And he said that no public servant would henceforth be able to draw a pension in retirement of more than £50,000 a year (although existing pension entitlements would be protected).

Finally, he said that because he would force a pay freeze on all public servants earning over £18,000 a year, he could not "even think of abolishing" the new 50p top rate of tax being introduced by the government - though he did not want it to be a "permanent feature" of the tax system.

For the better off Osborne was saying no jam today and maybe - just maybe - there'll be a bit of marmalade for breakfast in a few years.

Update 1336: I've now checked the fine print of Mr Osborne's speech, so here's a bit more detail.

The current governor of the Bank of England and today's chief executive of Royal Mail can breathe easy. George Osborne, if he becomes chancellor, won't be cutting their pay.

Those in public sector jobs already being paid more than the prime minister will have their remuneration grandfathered; they won't be forced to take a pay cut.

But if the Tories are elected, no new appointee to a public sector job would be paid more than the prime minister without the explicit approval of the chancellor - which Osborne implied he would withhold.

Two other things.

The £50,000 ceiling on public sector pensions would apply to all existing members of public sector schemes, not just to future entrants (although those lucky enough to have already earned an entitlement greater than £50,000 will keep what they've accrued).

And Osborne doesn't yet know how or when he'll give pension funds back the cash flow they lost when the dividend tax credit was abolished - but he's signalling that he'll find a way.

Update 15:15: Two further points.

First, it is significant that the most draconian of Mr Osborne's plutocrat-bashing ideas - viz a possible tax on bonuses and a slash-and-burn approach to top public servants' pay - are not firm pledges.

Both, really, are threats to banks and public-sector organisations to show some sensitivity to the public mood on pay, or face a potentially savage lop from Mr Osborne when he's at No 11.

And who can be sure whether he would really be in scything mood, if he became chancellor.

That said, he certainly seems keener to scythe than members of the current government.

Second, he has created something of a recruitment nightmare for local authorities, the 91Èȱ¬, the Royal Mail, the Bank of England, UKFI, the Financial Services Authority, assorted competition authorities and utility regulators, Channel 4, Network Rail, and so on.

They all pay their top people more than the prime minister earns.

So what do they do if they want to recruit someone at a senior level in the coming few months, before the general election?

Do they ignore the revealed wishes of the party that polls suggest will form the next government and pay the successful candidate more than the PM's earnings - and risk alienating future ministers?

Or do they pay what George Osborne has signalled as the new maximum - viz £197,689 (actually presumably it's a bit less than that, since the Tories would impose a pay cut on all ministers)?

But if a newly recruited boss of Royal Mail, or the 91Èȱ¬ or the Bank of England were paid less than £200,000 a year, surely all his or her more junior colleagues would also have to see their pay slashed?

It has the potential to create something of a farce - which will be hilariously funny for millions of citizens and very painful for the relevant institutions.

PS. And what about Lord Turner of the Financial Services Authority, who is expected to move to the Bank of England to become a deputy governor as and when the Tories break up the FSA and move the banking supervision bit to the Bank of England?

Would he be expected to take a pay cut of more than 50 %?

* Some people have been in touch to ask what "grandfathered" means. In the words of the OED it is "To exempt from new legislation or regulations, usually because of some prior condition of previously existing privilege." I am using it to mean that individuals currently in post will have their salaries protected, though their successors wouldn't have that protection.

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I've talked before about the fallacy of composition arising from all banks discovering virtue and prudence at the same time.

If all banks increase their holdings of liquid assets, shrink their reliance on wholesale finance and lend less relative to their capital resources in one fell swoop, well there would be a collapse in lending to the real economy and we'd be in a fair old depression in no time at all - and the banks themselves would soon find themselves bust.

Even so it's to the benefit of the economy over the longer term and in the interest of the banks individually for the banks collectively to strengthen their finances in just that way (though we should be under no illusion that in the first phase of the credit crunch, in the year before the collapse of Lehman, the knee-jerk evasive action taken by banks to shrink their balance sheets relative to their capital and liquidity - which was encouraged by regulators - did tremendous damage to the economy, in curtailing the supply of credit).

But even if the banks are given long enough to reinvent themselves as more cautious, well capitalised, better balanced institutions, it would be very foolish to believe there won't be costs - and most of those costs will probably fall on us, their customers, rather than on the banks themselves and their shareholders.

The point is that safe liquid assets, such as high quality government bonds, have a lower yield - they pay out less income - than other kinds of riskier loans. So when banks have to hold more cash and government bonds, their revenues fall.

Also, capital - which is vital for banks as insulation against potential losses - is expensive. Banks have to reward the providers of capital with fat dividends.

So safe, sturdy banks are intrinsically less profitable banks. And safe, sturdy banks have a huge incentive to endeavour to recoup their lost profit by pushing up what they charge households and businesses for loans and also by reducing what they pay for deposits (although that is harder, when deposits are in short supply).

How big a price will we have to pay for a fit banking system?

Well, in spelling out yesterday, the City watchdog, the Financial Services Authority, gave some estimates of the profits that banks will forego.

It is impossible to be precise at this stage, because the FSA has yet to determine quite how much stress it wants banks to be able to withstand.

But on the basis that banks are also forced to reduce their dependence on unreliable short-term wholesale funding by up to 40%, well they would be forced to hold between £310bn and £450bn of additional top quality liquid assets.

And, according to the FSA, that would lead to a reduction in their profits of between £5.7bn and £7.8bn.

Which is not trivial. Especially since the FSA says that "we expect these costs to be absorbed by the wider economy [rather] than by the banks themselves."

In other words, merely making sure that banks have enough cash to meet demand from creditors in a panic would take up to £7.8bn every year from households and businesses in the form of higher interest charges or lower deposit rates.

If you translated that into an equivalent tax rise, there would be uproar.

But, funnily enough, there hasn't been any debate about how much we are prepared to pay to make our banks safe.

Some would say the FSA - and other regulators around the world - are imposing taxation without any kind of representation.

What's more, the cost to us of forcing the banks to hold more capital could be just as high, if not higher.

In the case of capital, banks were previously obliged to hold 2% of their assets in the form of what's called core tier one capital (or more-or-less pure equity, genuine risk capital). Right now - at the urging of regulators - that's risen to between 6.5% and 9%. And the FSA has signalled that it wants banks to hold even more, probably 10%.

So the amount of core tier one capital that'll be held by banks will have quintupled.

Which will increase the banks' costs of doing business very significantly.

So they'll levy another de facto tax on all of us running to many billions of pounds in the form of higher interest charges and lower deposit rates.

To be fair to the FSA, it seems to recognise that in imposing these costs on banks and us without actually asking us, there is something of a democratic deficit (to put it mildly).

It is therefore working on an assessment of the impact of the economy of these separate measures to strengthen banks.

Which - let's hope - should spark a debate.

Because it's all very well to say that we want a safe banking system, one that isn't vulnerable to the kind of meltdown we experienced last autumn.

But if we wanted to eliminate all risk from the banking system, that would be very expensive indeed: a zero-risk banking system would be one which supplied very little and very expensive credit; and it would probably be associated with a sclerotic, stagnating economy.

It's very much like safety on the railways.

We need to decide the maximum price we're prepared to pay to avoid crashes. And we should recognise that the cost of eliminating all risk of crashes is prohibitive.

PS. In a world where capital requirements have gone through the roof, shouldn't we all just club together to form mutuals - so that the price of servicing all that additional capital is distributed between lenders and borrowers, rather than transferred to outside shareholders? Just a thought.

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There's a broad consensus that economic recovery is under way more-or-less everywhere.

Where there is considerably less agreement is whether that recovery will be strong and sustained, feeble and fragile or just the brief prelude to another contraction.

The message of stock markets - which have bounced between 40 and 50% in most countries from their lows of the spring - is that good times for business are just around the corner.

This is the biggest share-price boing since the 1930s - and is rational if company profits and dividends are set to surge very strongly in the coming two years, having fallen in the previous two.

Certainly many analysts and investors expect just such a rehabilitation. According to Bloomberg, they are anticipating a rise in corporate profits from 2010 to 2012 of more than 50% in aggregate.

Which would wipe out most of the recession losses.

But what about the business leaders who actually run the world's biggest companies?

Well, the ones I encounter are bemused by the optimism implied by the performance of share prices.

Take Steve Ballmer, the chief executive of Microsoft whom I interviewed this morning.

Microsoft ought to be more sensitive than most companies to economic conditions almost everywhere. And Ballmer does not believe boom times are near at hand.

Yes, we're over the worst, he says.

But he finds it difficult even to use the world "recovery" about where we are.

He says we're bumping along the bottom and will do so for a considerable time - which is presumably measured in years, because for him insipid growth is the new economic reality.

And then there's Michael Geoghegan, chief executive of HSBC, who - - says he is anticipating the economy to shrink again.

So who's right - the investor bulls or the management bears?

Well neither have 20:20 crystal balls. And both have vested interests.

Any investor long of equities is hardly going to call the turn unless and until he or she has gone short.

And as for the Ballmers and Geoghagan, it's rational for them to dampen expectations of profits growth and then deliver more than promised.

Also in Ballmer's case, he has a double motive for being gloomy - since his sales pitch du jour, as per a lecture he gave this morning for the CBI, is that hard-pressed companies could do worse in their straitened circumstances than to improve productivity by upgrading (you guessed) their IT.

I suppose I could turn for adjudication to professional economists. But their forecasting record in the past few years on the stuff that matters has been so poor as to make weather forecasters seem imbued with godlike gifts of foresight.

So we're just going to have to accept that our vision is obscured by fog - although many, I'm sure, will have mentally said a big "yes" at , that there is a bubble element to the bounces in share prices, bond prices and commodity prices.

Or to put it another way, the massive exceptional monetary stimulus of central banks has lifted up financial markets rather faster than it has buoyed the real economy.

And the big unanswered question is whether economic reality will catch up with financial-market hopefulness, which would be the benign outcome, or whether the rising prices of bonds, commodities and shares contain an element of unattainable fantasy.

Update, 15:45: Here's why the stock market may be more rational about the prospects for big companies than Ballmer, as per a successful investor in global blue chips with whom I've been chatting.

First, the productivity of US companies has held up in spite of the sharp fall in economic activity - which implies that big companies are typically more efficient than they've ever been and will generate stupendous growth in profits on even modest growth in turnover.

Second, if China is true to its word and "rebalances" to stimulate domestic demand (albeit slowly and steadily), there'll be huge long-term opportunities for businesses with big brands such as Nike, Coke, pharma businesses and so on.

Third, the income-return on equities is so much higher than on deposits, lending to the government or property that the risks are priced in.

Which is all fine and dandy unless you think that there simply won't be any sustained economic growth and/or oil prices will rise so much as to persuade central banks that there's a risk of generalised inflation - which would lead to a rise in interest rates.

A rise in interest, if it came so soon, would be an agonizing blow to the bulls' vulnerable parts.

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If, as expected, the Serious Fraud Office announces today that it intends to request permission from the attorney general to prosecute BAE, that will be an important milestone in perhaps the most sensational criminal case ever against a big British company.

It comes after years of investigations into allegations that BAE paid hundreds of millions of pounds in bribes to secure contracts from Africa, to the Middle East to Eastern Europe. It also follows BAE's admission last year that it hadn't in the past employed the highest ethical standards in the way it won business and promised to clean up its act.

But here's what may surprise many.

BAE, Britain's biggest manufacturer, would dearly like to make a limited admission of guilt, pay a fine and move on.

It would love to settle the case by plea bargain and turn over a new leaf, to use the cliché.

That's wholly rational, in that most of the senior executives of the company weren't with the business in the period when, by its own admission, it wasn't as scrupulous in its business practices as it would now like to be.

But its directors have a legal duty not to hand over cash or damage the reputation of the company - through what would be seen as a confession of wrongdoing - unless they are advised by their own lawyers that the SFO has an overwhelming case.

And they feel that the sum of money being demanded by the SFO for a settlement - between £1/2bn and £1bn () - is not warranted by the strength of the case.

It will continue to negotiate with the SFO to reach an agreement to cease hostilities.

The balance it has to strike is between the attractions of removing the heavy millstone of the case from around its neck, and the potential damage to its ability to win business in the future from sensitive international customers (typically governments) if it were to make a frank admission of guilt.

The stakes are high, not only for the company and its shareholders. Whether you love or hate that BAE is a world leader in defence, it is the biggest manufacturer in the UK and is a significant part of the British economy.

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