NEW YORK (MarketWatch) -- The market has been dealt a historic hand and the global stakes have never been higher.

For the last eight years, the ace up the Federal Reserve's sleeve has been the U.S. dollar. They let the greenback devalue with hopes that a legitimate economic recovery would supplant the credit expansion that dominated this decade.

“ "The wishbone will never replace the backbone." ” — -- Will Henry

Since 2002, the world's reserve currency declined 35%, while everything measured in dollars reacted in kind. While that sneaked by stateside players largely unnoticed, it's been a constant source of stress for foreign holders of dollar-denominated assets.

We call this "asset class deflation vs. dollar devaluation" in Minyanville, which is to say we'll toggle between the two as policymakers pull fiscal and monetary strings. While both sides of the equation can potentially falter, the deck is stacked against the dollar and asset classes rally in synch. See link.

While near-term nuances are difficult to digest, the big picture has come down to a simple question: Will foreigners allow the dollar to devalue further, paving the way towards potential hyperinflation, or will capital drain from the system and induce a prolonged period of deflation?

Critical crossroads

What's clear is that the game itself experienced has a seismic shift. Central banks have been extremely proactive in what they do and how they do it. This has gone on for years, but the efforts increased appreciably since 2007. We opined at the time that something was afoot and the pieces have fallen into place. See link.

The credit contagion brought this conundrum to bear, and all that remains to be seen is where the bears will settle. I'm an optimist by nature, but a realist when it comes to the current financial condition. In my humble view, two potential scenarios exist as we edge down this prickly path.

The first is the continued socialization of markets, bearded nationalization of troubled institutions and the specter of hyperinflation. A significantly lower dollar is a necessary precursor to -- but no guarantor of -- this dynamic, and it could potentially "jack" anything denominated by this measuring stick. If that occurs, it would paradoxically punish savers who preserved capital.

This scenario is presumably preferred by the powers that be as an alternative to watershed deflation. The "haves" would fare better than the "have-nots" as the costs of goods and services could skyrocket and spur the velocity of money, paramount in a finance-based economy.

The other option is the orderly destruction of debt, deflationary pressures and an eventual path toward an "outside-in" recovery that paves to the way towards true globalization. The result would be a higher dollar and lower asset classes in the intermediate term, but a sustainable foundation for economic expansion thereafter.

Deflation in a fractional reserve banking system means policymakers have, for all intents and purposes, lost control of the economy. It would also impact the top tier of our societal structure tied to the marketplace, problematic for politicians and the constituencies that bankroll them.

No easy answers

The banking system, stymied with credit dependency, is not operating normally. Hidden behind bailouts, stimulus packages, super-conduits, term-auction financing, mortgage rate freezes, foreclosure freezes, working groups and Public-Private Investment Programs are politicians attempting to engineer a business cycle that long ago lost its way. See link.

The qualifier of this discussion is the elasticity of debt, stretched by historical standards. Total outstanding credit obligations are 350% of GDP and consumers, who account for 70% of GDP, are hamstrung by wealth destruction and depleted savings. As such, I would place back-of-the-envelope odds at 3-1 that deflationary forces continue to manifest.

This process will take years to unwind but ultimately will yield positive results. The destruction of debt will allow world economies to rebuild a solid foundation for future expansion that is entirely more secure than what we currently have in place.

While it would cause paper wealth to evaporate, rich nations will be forced to pour real money -- as opposed to cheap debt -- into developing economies as a redistribution mechanism. While the path might be painful, the destination will be entirely more palatable for future generations.

A marked difference exists between taking our medicine as a function of time and price, and injecting the system with drugs with hopes that the symptoms will pass. The latter continues to be the diagnosis of choice but the economic patient would be well served to understand both sides of the prognosis.