Is the U.S. economy melting down?

Whether the Federal Reserve realizes it or not, the United States economy is reeling from a one-two punch of plunging real estate values and a full-blown credit crunch that might not be alleviated with additional rate cuts.

While the Fed might have had a role in creating what has come to be known as the subprime mess, because of the way it has evolved, the Fed's ability to deal with it is rather limited. There are a number of reasons for this.

First and foremost is the fact that, on the real estate side, the damage has already been done. Because short-term interest rates today are well above the 45-year lows plumbed from the middle of 2003 through mid-2004, those mortgages with adjustable rates have or will reset to much higher rates even if the Fed decides to lower rates by a quarter of a point or even more.

As a consequence, there will likely be more delinquencies and foreclosures, which, besides causing pain for those homeowners, will result in more homes on the market, thereby depressing their prices.

In turn, this will affect other homeowners, even those with fixed rate mortgages and who and are current with their payments. They will likely be unable to use their homes as ATMs, tapping the equity to supplement their incomes.

They can't turn to savings, either, since, collectively, the nation's homeowners have been spending more than they have been earning for the past two years. The last time this happened was at the bottom of the Great Depression.

This alone is why consumers are reducing their outlays on all kinds of goods and services -- luxuries and necessities alike. Indeed, you know there's a problem out there when Starbucks reports a decline in traffic in response to, among other reasons, a 9 cent hike in the price of a cup of coffee.

Another reason why the Fed alone will not be able to ameliorate this crisis is that its main jurisdiction is over the banks, and the problem is now centered in the financial markets. This is because the banks no longer have these loans on their books, having turned them into securities and sold them to others.

In turn, these mortgage-backed securities were used as collateral for the issuance of debt, whose value, as you know, is far lower than originally thought. This has caused massive write downs by holders of these securities, cutting into their profits, but more importantly, depleting confidence in the financial system. And this reduction in confidence is spreading beyond the financial markets and residential real estate to commercial real estate as well.

To the extent the banks are involved (by holding on to some of these securities), their capital is being reduced and thus their ability to make new loans.
we need not remind you that the ability to borrow money is the lifeblood of not just business, but consumers, too.

Not surprisingly, the combination of lower real estate values and reduced availability of funding is beginning to reduce business spending on new plants and equipment. This is overwhelming the positive effect that the lower-valued dollar is having on our exports.

So while the Fed is preoccupied with communications and forecasting, the financial markets remain frozen while the economy is melting down.