The tough stance of the Fed to banks that have made foolish loans was altered somewhat yesterday when like the European central Bank they supplied cash to the market to allow banks and others to settle their debts.

??This was an important development. Prior to this week the Fed’s stance was that the economy was??growing well with a danger of more price rises??and it was no concern of the Fed if some banks and funds had lent foolishly or borrowed too much. They would have to sort it out, and the Fed would leave interest rates where they are to ensure inflation was controlled.??Commentators suggested that in some miraculous way the banks and funds that had made a mistake would be able to reduce their risks and sort out their bad loans whilst everything else went on as normal. Investment professionals were telling people shares were still "good value" or even "cheap".

During the course of this year many commentators held this view, with the growing exception that they admitted the bad lending on mortgages was having an impact on US house prices and house building. This they thought would remain isolated whilst the rest of economic life carried on strongly. Followers of the European economies saw it all as a problem over there that need not change views in Europe towards the state of the European economies.

This week has seen some growing understanding by commentators of three things.

1. The problem of US mortgages is not just over there. We live in such a global market. The bad loans have been bought and sold around the system, and do affect European banks as well as US ones.

2. The real impact on the US housing market will have knock on effects to other parts of the US market. If people are struggling to find the money for the mortgage they do not have so??much to spend on other goods and services. Builders are losing their jobs, so they have less money to spend.

3. The so called financial economy generally is an integrated part of the whole global economy. A credit squeeze means just that - it means more and more people and businesses will no longer be able to borrow money easily - or at all- to buy or invest in what they want. It is designed to lead to a slow down or even a fall in activity and a fall in the value of investments. That’s how higher interest rates stop inflation. When they have succeeded in cutting the goods and services people can afford to buy sufficiently, those still left in business offering the goods and services are no longer able to put their prices up. A credit squeeze means bankruptcies and lost jobs.??It’s that crude and that simple.

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So what happens next?

There are the three scenarios I have talked about before:

??1. The Central Banks decide they have done enough damage to the banking system and to people’s investments, and?? relax the credit squeeze. Instead of supplying more money to damaged markets on a panic basis like this week, they cut interest rates sufficiently so enough people can??afford the interest on their debts. The global economy moves forward again on credit, and the Banks say they have now killed enough of the excess credit and excess demand to bring inflation under control anyway.

2. The Central Banks still believe inflation is not under sufficient control despite the obvious distress in credit markets, and decide to run current interest rates for longer to make sure inflation is under control before cutting rates. This probably means more turbulence and further falls in the value of dodgy debt and shares.

3. The Central Banks continue to increase interest rates, as both the Bank of England and the European Central bank have implied in their recent statements. That is even more likely to lead to further falls in debt and shares, and could produce some substantial casualties amongst investment funds, banks and other financial institutions. If it were continued for any length of time it would bring on declines in jobs and activity in far more sectors than just US housing and would lead to recession.

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This week??seems to have??changed the balance of probabilities around these three. More commentators in the US now believe that the Fed will cut interest rates soon. That would be largely good news for the stock and bond markets. If the US does it but not the other main central Banks, however, it makes owning dollars less attractive as returns on dollar cash are reduced. There would be more reasons for overseas investors not to hold dollars. Further falls in the dollar would provide another boost to US exporters to narrow the gap on the US trade accounts.

It would be odd for the European central Bank to hold firm to its course of interest rate increases now that it has seen the real damage to European banks from the US crash, and now there are figures showing a weakening not just of the Italian and French but also the German economies. However, the ECB would need to find a way of changing its public position that was not seen as being too weak on inflation.

There remain?? potential causes of more turbulence.

The first is the large so-called yen carry trade. Large numbers of investors borrowed yen at tiny interest rates to buy dollar assets at much better interest rates. This gave them a good profit all the time the dollar did not fall against the yen. If lower US interest rates leads to a fall of the dollar against the yen many of these people will need to sell their dollar assets and repay their loans quickly.

The second is the attitude of China to US dollar assets. China has huge foreign exchange reserves from her turbo charged success as an exporter.??China has been investing these in dollar bonds. Recently??the??Chinese authorities??have announced that they want to diversify beyond buying US government bonds. China is in a very strong position vis a vis the US. Chinese decisions on whether to carry on propping up the US markets with her money or not will be important in settling future price trends and stability.

The Central Banks?? just supplying money to markets in distress on really bad days does not end the credit squeeze. We will have to watch intently over the next few weeks to see if the Central banks are going to move their position from inflation fighting to recession preventing. They must by now have achieved one of their objectives, to burst the borrowing bubble and to make people think twice before offering or accepting a loan.

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