The Federal Reserve System may have run out of room to maneuver. Facing a looming recession, it resolutely lowered its discount rate and frantically expanded its credits. Eager to stimulate the sagging economy, it enabled and encouraged businessmen to invest more and consumers to go ever deeper into debt. Yet the specter of recession refuses to fade away.

What is the Fed, the appointed "guardian of prosperity," to do? If it persists in expanding its credits, it may weaken the dollar and ultimately frighten foreign creditors around the globe. The dollar may fall versus the euro and other currencies, which may persuade foreign lenders to reduce or even liquidate their dollar holdings. But the Fed may also discover that all its expansionist efforts may be in vain as economic activity contracts and goods prices stagnate or even decline. In uncertainty and fear, the people tend to cling to their cash holdings, which may render all Fed efforts to "reinflate" rather ineffective. Further discount rate reductions may fail to spur economic activity.

The Fed's dilemma springs from an abused and maladjusted credit market which, after many years of Fed intervention and manipulation, is turning unmanageable. The laws of the market, in particular the law of supply and demand, are inexorably working their ways and prevailing over Fed hopes and aspirations. In 2001, the Fed lowered its discount rate eleven times in order to invigorate the economy. In 2002, with the discount rate at 1¼ percent and the Federal Funds rate not much higher, total Federal Reserve credit has been expanding at rapid rates. On September 2, 2002, it stood at $665 billion, up from $609 billion a year ago. Relying and building on this credit basis, commercial banks and other financial institutions expanded the stock of money (M3) from $7.6 trillion to $8.2 trillion, engaging in "loan securization," that is, the conversion of loans into marketable securities for sale to investors. They lend, securitize, sell, and lend again, in a continuing process of credit expansion. Offshore banks in the Cayman Islands, in Hong Kong, Panama, and Singapore add unknown volumes of their dollar credits, keeping the world money markets awash in U.S. dollars.

Should any other of the 174 central banks imitate the Fed and expand credit at such rates, its currency would depreciate immediately and goods prices would soar. It soon would face double-digit inflation and, should the expansion not cease promptly, run-away inflation. In the end, it would experience a universal flight from the currency and complete loss of its purchasing power. The Federal Reserve System is subject to the same inexorable principles of economics but, in contrast to all other central banks, the demand for its currency is world-wide. It is the world central bank managing the world dollar standard. It attained this prominent position for reasons of the eminent position of the United States in world trade and finance. Although several other currencies are demonstrably more stable than the U.S. dollar, their small volumes render them unsuitable for assuming the universal position and function. The euro which, since 1999, has been the currency of several European countries, may turn into a potential competitor to the U.S. dollar.

The dollar's eminent position in the world bestows extraordinary powers on the Fed. It grants the Fed a leeway of expansion much wider than that of any other bank. The world-wide demand for U.S. dollars supports their exchange value and offers the Fed a wide margin of credit expansion without visibly weakening the dollar. In its economic transactions with the rest of the world it enables the United States to suffer annual deficits of more than $400 billion in its "current accounts," that is, it allows the American people to import more goods and services than they export, which obviously benefits them greatly.

Many economists view the deficits as clear evidence that Americans are living beyond their means which cannot continue indefinitely, and may even invite envy and enmity. Secretary of the U.S. Treasury Paul O'Neill and his economists, on the other hand, seek to reassure their followers that a current-account deficit is always offset by a surplus in the capital account, that is, a net influx of capital. The deficit, in his belief, is cogent proof of the desirability of the United States as a haven for foreign capital. As long as the United States offers ample opportunities for profitable foreign investments, there is no reason for concern. The trade deficits are mere symptoms of the attractiveness of American capital markets.

The O'Neill argument unfortunately ignores several recent developments that cast doubt on some aspects of this attraction. Much foreign capital that is seeking profitable employment in the United States does not find its way into economic production but rather finances private and public consumption. While the current-account deficits have risen in recent years, foreign enterprise investments have dwindled. Nearly all the deficits now are financed by debt instruments which must be served out of current income. The foreign purchase of U.S. Treasury bills, notes, and bonds facilitates government spending; foreigners now hold more than $800 billion of U.S. government debt which is serviced by tax funds. If foreign investors should ever tire of financing the deficits, the U.S. dollar would come under pressure. In fact, it would fall, if foreign holders should lose confidence in the dollar and begin to liquidate their dollar investments. The flood of imports would subside, American exports would increase, and goods prices would soar.

In recent months the U.S. dollar has fallen substantially versus the euro, the Japanese yen, and the British pound. While further interest rate reductions by the Fed may accelerate this fall, they may not cause many goods prices to rise. On the contrary, a recession may initially overwhelm the forces of inflation and develop symptoms of contraction. Distress and liquidation sales tend to depress goods prices as do producers and consumers clinging to their cash holdings. A growing demand for money obviously increases the value of money and depresses goods prices. In popular jargon, a recession may usher in "deflation," no matter how frantically the Fed may inflate its stock of money.

The Japanese recession, which has held the country in its grip ever since 1991, may serve as a warning example of the unintended consequences of interest rate cuts and massive deficit spending. The Japanese economy is sinking ever deeper into a depression with unemployment rising and stock prices falling although the Bank of Japan's discount rate hovers near zero and the prime rate is quoted at 1.375 percent, which compares with 1¼ percent and 4¾ percent respectively in the United States. The Japanese government indebtedness exceeds 150 percent of GDP, which compares with the U.S. government debt of just 50 percent of GDP. The government obviously is trying to spend its way out of recession by consuming the people's savings, but instead merely is aggravating the decline. Indeed, the world is wondering how the Japanese people will ever be able to emerge from the deep hole dug by their government and its central bank.

In a recession the quality of many credit transactions is called into question. With total indebtedness in the United States more than double the annual GDP, higher than ever before, a recession would jar and unsettle the whole credit structure, which would render any further Fed interest-rate reduction rather ineffective. When numerous companies suffer staggering losses and finally are unable to discharge their liabilities, they cannot be saved by another cut in interest rates. If, in desperation, the Fed should drive its rate even to zero, it could not thereby help an enterprise whose notes and bonds are marketed at double-digit rates. In short, the Fed may become rather impotent when the economy sinks into recession. Nevertheless, it can be expected to continue its policy of ease in the hope of rekindling the boom and thereby justify its existence.

The current Middle East crisis could leave its mark on the American economy. If, in the coming months, the United States should strike at Iraq in order to remove a persistent source of terrorism, the price of oil undoubtedly would soar, which, together with the weakened dollar, would soon lift many goods prices. In previous international crises the U.S. dollar actually strengthened because foreign capital sought refuge in the safe capital harbors of the United States. In a new Iraqian crisis the United States may lack the support of its traditional allies in Europe, which may actually lead to a withdrawal of some European funds and a decline of the dollar in world money markets. Moreover, American financial markets surely would lose some deposits and investments of the oil sheiks of Saudi Arabia and other Islamic countries, which would aggravate the pressure on the dollar. If the Fed should substitute its own funds for the foreign funds withdrawn it would weaken the dollar even further.

No one can foresee the scope and duration of such a conflict and its economic consequences. Yet we do presume that the symptoms of recession would soon give way to the well-known characteristics of inflation as federal spending accelerates and the Fed accommodates the spending. As the dollar weakens and, in turn, reduces the stream of imports, goods prices are likely to rise again. They would improve the profitability of many industries, which would encourage new investments and more consumer spending. Economic activity would soon accelerate and the present correction and readjustment process draw to an end. New distortions and maladjustments would be heaped on the old. In short, the needed correction would be postponed until, a few years from now, it would begin anew with a shrunken dollar. In the meantime, the excitements of war would make us forget our economic troubles.