As I drove to work this morning, a friend I had called quipped, "it looks like another 250/50/25 day today."  His voice sounded a little edgy, a cross between a certain nihilistic abandon and something of a morose fatalism.   He was referring, I quickly surmised, to the latest drops in the Dow, NASDAQ, and S&P, each of which was now losing about 2% of their value.  The US (and indeed many world-wide) stock-markets have been taking a beating lately as (depending on who you listen to) investors worry about housing, liquidity, energy, global warming, terror, inflation, toy recalls, indigestion, acne or any of a dozen other ills plaguing our economy.

So what's really going on?  Why are the stock markets in triple digit descent one day and then in triple digit ascent the next?  Why has the Dow Jones Industrial Average lost 10% of its value from the 14,000 level just two weeks ago, and is the end in sight?  Why hasn't the Federal Reserve stepped in to calm everyone down and make sure that things continue running smoothly?  Is the end of this madness in sight and what can we expect down the road?  The answers to these questions are not necessarily obvious, but a careful analysis of what's happening today can lead us in the right direction.  This column is not usually in the habit of making predictions, but it seems clear what the next 6-12 months are likely to bring so I'll go on record and be prepared for any mea culpa’s if time bears these words foolish.

Fundamentally, the reason why so many investors are quick to panic is because we've borrowed ourselves into a fine mess.  The American savings rate is at an all time low ( some have actually measured it as negative).  The cost of money has been so low for the last few years that we have simply bought everything in sight, paying for it with remarkably cheap (and arguably subsidized) credit.  This spending binge has suited many just fine.  Consumers have enjoyed it because cheap money has (temporarily) increased their purchasing power.  Low-rate mortgages have made the dream of home buying much easier for many.  Cheap money has allowed business to spend lavishly on everything from fancy new offices to executive perks.  Politicians have been able to provide for a pork hungry constituency.

So why is this a problem?  The simple reason is that every dollar borrowed eventually needs to be paid back.  The not so simple reason is that your creditor may not be quite so obvious.  At a macro-economic level, our creditors as a nation have, as of late, been mostly from Asia.  China is now the second largest foreign holder of US Treasury bonds (behind Japan).  While this has allowed the American consumer to borrow at artificially low prices (this is due to Treasury bonds being an internationally desirable brand and thus able to sell at lower interest rates than other sovereign debt), it also makes us partially subject to the whims of foreign powers that may not coincide to our own national interest.  Witness the recent careless comments of one Chinese official who threatened that China's large holdings of treasury bonds could be used as a sort of economic weapon.  While this is true, to some extent -- China can dump US treasuries on the open market driving their price way down and forcing the US government to pay exorbitant rates to borrow the money it needs to continue operating -- in reality, China has just as much to lose as America if it pursued such a policy.  Forgetting for a moment the potential of economic battles slipping into the more traditional armed variety, China holds most of its foreign reserves in dollar denominated holdings.  If it crashed the dollar or devalued US treasuries it would simply be erasing a good portion of its own treasury.  Furthermore, such a move would almost certainly trigger a US (if not global) recession and destroy the very export market that China is thriving on.

So what does this have to do with what is going on in today's financial markets?  Globalization has very much tied the world's markets together, so how we behave affects the rest of the world and how they behave affects us.  In short, the best way to deal with a liquidity crisis -- all things being equal -- is to increase liquidity.  This might sound obvious, but the best tools we have to do just that lie (in the US at least) with the Federal Reserve who has the power to lower interest rates and thus lend banks money more cheaply so as to disperse liquidity into the economy and secondly to increase the money supply, quite literally printing more money (these are really two sides of the same coin).  The problem is this remedy has the potential, in today's economy, to do more harm than good.  This is because both actions are inflationary and the Fed would be reticent to encourage inflation at a time where high energy prices, high food prices, and increasing inflation abroad (especially in China) are causing concern.  Let's not forget that the Fed's stated priority one is to keep inflation under control.  Secondarily, given the large deficits and debt we have been accumulating, the US dollar has been under tremendous pressure, and is currently quite weak by historical standards.  If the Fed cuts interest rates it risks undermining the dollar even further.

Therefore it is this column's opinion that the Fed is faced with something of a Hobson's Choice:  They must lower interest rates a little in the short term to stave off panic and inject some immediate liquidity into a scared marketplace, but they will soon need to raise interest rates even higher than they are now to protect the dollar and stave off inflation.

In the short term this would have quite a few beneficial effects.  First and foremost it should stave off a panic and a run for the exits that could decimate financial markets and leave investors and businesses fighting off bankruptcy.  Secondly it should give the bleeding mortgage market a little bit of breathing room, allowing banks to continue lending to at least the most qualified buyers.  And potentially for others to refinance some of the disastrous loans that they had taken in the last few years that are causing the defaults fueling today's panic.  This is not to say that the Fed should act to bail out banks who made bad loan decisions, rather that decisive action should be taken quickly to stop a liquidity crisis from becoming a solvency crisis.

In the medium term we cannot sustain low interest rates for long, at least not while running record deficits, financing a foreign war, and spending without virtually any saving.  In order to return to some sort of equilibrium, interest rates will have to go quite a bit higher eventually causing less spending and increased savings which should help bring the current account deficit under control and help tame inflation and with it bring up the dollar.  All of this, however, will come at a cost as it will certainly lead to an economic slowdown and quite possibly a recession.

The Fed can carefully attempt to smooth out this rather inevitable process a little, however a loan always come due eventually.  The more we borrow, the larger the tab gets, and the longer the pain will last until we can get back on our feet.  We have delayed this process for a long time as our profligate borrowing has taken our markets further and further away from reality.  The stratospheric prices of real-estate, stocks, and other hard assets are testament to what cheap money can do if left unchecked for too long and like a house of cards, can come tumbling down when loose investors realize that their base has been shaky all along.