The risks inherent in rescuing a Struggling Economy

Almost frantically at times, federal officials are attempting to bolster the crumbling U.S. economy and prevent a global collapse.

The Federal Reserve and the Treasury Department have made unprecedented forays into the private sector in an effort to repair a financial system run amok.

Economists say such actions are needed.

"I think there's no choice but to come to the rescue of the U.S. and global economies with concerted effort because the alternative is horrific," said Nariman Behravesh, chief economist at IHS Global Insight.

However, Behravesh and other experts said, taking some of the sting out of the incipient global slump carries grave risks:

Dangerously low interest rates and floods of government money could seed the next asset bubble.

The government's involvement in private credit markets has become so deep there is no clear exit.

By pushing banks to lend more than they feel comfortable doing, federal officials are delaying the debt reduction by families, businesses and goverments needed to restore the economy's health.

Recessions, like the one now gripping the U.S. economy, are miserable, but they are the economy's way of clearing out weaknesses, like dead branches, so healthy growth can occur.

In the most recent expansion, the unsustainable growth was concentrated in the housing sector, where untested financial instruments - including exotic mortgages and complicated debt securities - brought a flood of money into the mortgage market. Such easy credit made it possible for homeowners to borrow more than ever before. That propelled house prices to levels far above historical norms.

Now those instruments have failed, leaving millions of homeowners owing more on their houses than they can sell them for. As dreadful as that sounds, such homeowners are in the same position as the person who bought Yahoo shares, now worth $13, for more than $100 in 1999.

This downturn - which many economists predict will last at least through next spring - has regulators in a tough spot because the continuing shock in the banking system is the most dangerous to mature markets since the 1930s, the International Monetary Fund said.

Moreover, the IMF said, recessions preceded by distress in the banking system are more likely to be severe and protracted than those preceded by distress in other areas of finance or those that happen with no accompanying shock to the financial system.

The Fed's weapons for combating the downturn include interest rates and the supply of money available to the economy. Those monetary moves are famously imprecise because it takes nine to 18 months for the changes to work their way into the economy.

Last week, the Fed reduced its key interest rate to 1 percent, despite the widely held opinion by economists that the cut would not make any difference to the economy because rates were already so low.

Remember, 1 percent is where the target rate for overnight bank loans stayed for too long in 2003 and 2004, becoming a key factor in the artificially high housing prices that are a core reason for the economy collapsing and a reality that assures recovery will be slow.

Politically, monetary policy is asymmetric because it is easier to cut rates on the downside of the economic cycle than it is to raise them on the upside, said Richard J. Herring, a professor of international banking and finance at the University of Pennsylvania's Wharton School. "I hope they have the courage to do that," he said.

Danger lurks in more than just interest rates. Goverment bailouts globally total more than $2 trillion, according to Grail Research L.L.C.

"All this liquidity that is being pumped into the global economy could leak out and result in another asset bubble," though there is no threat of that until the end of 2009, Behravesh said.

Economists worry about long-term consequences of federal officials providing stopgap measures such as loan guarantees.

"My concern is that they are so engaged in firefighting that they are doing exactly what we've criticized all over the world in emerging markets, giving us a system that it will be very difficult to exit from," said Herring.

When governments guarantee loans, they "always say it's temporary, but there is never a good time to lift them," he said.

Such measures also increase the financial strain on the U.S., whose debt has climbed $1 trillion in the 12 months ended Sept. 30. Some of that went to absorb private-sector losses and some of it to boost the economy.

Meanwhile, households are strapped, with more and more of income dedicated to paying debt. Debt levels must come down, economists said.

"This is almost looking like a permanent-type belt tightening that we need to go through," said Robert Dye, senior economist at PNC Financial Services Group Inc. in Pittsburgh.

Ironically, the fact that the market values of so many houses are less than their mortgages will help reduce the country's leverage - the amount of debt relative to income or assets - because it puts significant downward pressure on house prices.

"The deleveraging that's taking place is a natural market process," said Martin D. Weiss, president of Weiss Research Inc. The government is trying to get in the way of that when the White House or Rep. Barney Frank (D., Mass.) exhort banks to boost lending.

For the financial world to get back in balance, house prices may lag inflation for a few years. The early 1990s, for example, saw a far milder housing downturn, but for much of 1992 and 1993, gains in home prices lagged increases in the consumer price index.

Households, businesses, and governments must clean out their mistakes and start over, said Olivier Garret, chief executive of Casey Research Inc., a publish of investor newsletters.

"There has to be pain at this point. The government, the electorate expect some magical solution," he said.