By throwing a total of $100 billion into the markets, the Fed managed to ease the credit crunch that had blocked inter-bank lending late last year. That solved the first problem but created a second, stoking fears of more inflation down the road that helped drive down the dollar against other currencies.
The Fed has not done much about that second problem, reckoning that a falling dollar would slash the monstrous U.S. trade deficit and spur an export boom as U.S. goods became cheaper on world markets.
Now in response to the mounting fears that bond insurers are looking shaky with their credit ratings being cut, and sensing a mood of panic as the world's stock markets tumbled in unison Monday in fear of a U.S. recession, the Fed has slashed interest rates by another 0.75 percent, to 3.5 percent.
Like a shot of heroin to a desperate junkie, that eased some of the short-term problems on the stock markets but made that second problem of future inflation look even worse. Interest rates at 3.5 percent are offering something close to free money, given the advance of inflation as food and energy prices go through the roof.
This risks sending the dollar even lower, if the foreigners who buy U.S. Treasury bonds reckon that the interest they receive is too low to justify the risk of a further fall in the greenback. The Fed is now gambling that with the world's share prices tumbling, its T-bonds will remain a safe haven no matter how little interest they pay, and the foreign money will continue to pour in.
Maybe. But maybe not. Some of the biggest foreign buyers of those T-bonds may have a lot less money than they used to. Start with Japan, where the government has just cut its growth forecast from 2.1 percent to 1.3 percent. Nissan's shares are down 25 percent already this month on fears of a fall in U.S. demand, where Nissan has been making almost half its earnings. And the yen is rising against the dollar, which is bad new for Japanese exporters.
Then take China, whose Shanghai index lost 17 percent in the last six days of trading, and where the markets now expect the Bank of China to write off at least $2 billion in its exposure of more than $7 billion to the American subprime market.
Analysts expect a sharp slowing in Chinese exports this year. Stephen Green of Standard Chartered Bank in Shanghai reckons that exports accounted for 2.5 percent of China's 11 percent gross domestic product growth last year, dripping to 1.3 percent this year and to zero in 2009. There are several reasons for that, but one of the main ones is that China is no longer the rock-bottom low-wage manufacturing center. Vietnam and even the Philippines are cheaper than the Guangdong-Shanghai powerhouse. New labor regulations have added an estimated 10 percent to China's overall wage bill, and with inflation officially at 6.9 percent, there are demands for pay increases.
Employers in the Pearl River Delta complain of rising costs, labor shortages, costly new environmental standards, transport bottlenecks and a government-imposed squeeze on bank lending. (Chinese banks now have to keep 15 percent of their total deposits on reserve with the central bank.) And now come energy shortages, with the Guangdong authorities warning of rotating blackouts as demand exceeds supply by 10 percent. (Because of drought, the Three Gorges dam is producing less electricity than expected.)
Nor can too much be expected from India, where the Mumbai stock market closed temporarily Tuesday because it fell so fast. And with the European markets plunging Monday, with the big banks taking a heavy hit (France's Societe Generale share price has halved from 160 euros last May to 80), it is not at all certain that foreign buyers of the Fed's T-bonds will continue to permit Americans to live above their means.
But that, of course, was what got the global economy into this mess in the first place. The fall in U.S. savings to almost zero, combined with a blithe readiness to take on new debt and carry on consuming, brought the great imbalance in the global economy that required more and more ingenious ways to lure foreign capital to the United States. The result: British, French, German and now the Chinese banks have to write down their ventures in America's ill-fated subprime market.
And yet that U.S. readiness to take on debt and suck in so much of the world's capital was also a heroic effort that helped keep the rest of the world growing during the last six years. Like an exhausted relay runner, the United States should now be handing on the baton, but the track is empty. There is no obvious new runner to take over the lead.
The way that the Baltic index of shipping prices has dropped by a third in the last six weeks suggests that world trade is slowing. Europe, Japan and China are all starting to slow, which is likely to mean that the demand for oil and thus the price of energy could start falling significantly this spring.
The good news about this is that lower energy prices will help ease the threat of inflation and put more money into consumers' pockets. The bad news is that those floods of Arab capital that were pouring into Citicorp and other troubled U.S. banks are likely to dry up. It looks like the little Dutch boy at the Fed is going to be facing a whole lot more leaks as this grim year grinds on.