The US economy continues to show sign of weakness and this has prompted policymakers to move aggressively on both the monetary and fiscal fronts. Not too many months ago, the chairman of the Federal Reserve was fairly optimistic about prospects for the economy, enunciating quite inane phrases about getting the balance right between growth and inflation.

But those who had looked more closely at the recent history of Fed policy-making decisions expected that there would be a bias towards promoting growth at the expense of the need to fight inflationary pressures. The political pressure is unrelenting and FOMC members are going to bend according to which way the wind is blowing. Realists have always known that the theoretical independence of the Federal Reserve does not always meet practical tests.

Paul Volcker was one of the few Fed chairmen who was willing to take effective but unpopular action. Recently, he wondered aloud who was in charge of the central bank. In times of trouble people look for leadership. And these are troubling times indeed. But Bernanke, the head of the Fed, appears to be hiding behind, rather than leading his officers.

In the past two weeks, the Fed has cut interest rates more rapidly and aggressively that at any time during the past several decades. This sort of precipitate action is tinged with a degree of panic. What we are witnessing is not a fine-tuning exercise but a sledgehammer approach. It gives the appearance that policymakers are not in control and do not fully grasp what is happening in the environment. They are doing their best to counter any lurking danger. It is like a scared soldier who sprays everything with his machinegun and throws a few grenades as well, for good measure.

What does it do for their credibility? Only last year, before the credit crisis exploded all the complacent assumptions, markets had become comfortable with the view that central bankers had the magical touch of fine-tuning all trouble away. The problem is that the fools at the central banks also believed it themselves. But the reality was that years of reckless monetary ease and credit expansion had created a rickety house of cards. Policymakers promoted maximum economic growth and ended up with a slew of problems.

There is belated criticism of Alan Greenspan for having fed the housing bubble and promoted risk appetite with too much easy money for too long. But, at the time, most people were praising him and cheering him along. There was hardly a word of disapproval on Wall Street, Main Street, or in Washington. Speculators, big and small, were making money hand over fist and were very happy.

Ever since the sub-prime debacle and resulting credit-market wobbles last year, central banks have been intervening massively to shore up the financial system. Of course, these policymakers had a big part in creating the mess in the first place. They provided very easy monetary conditions that fed the global economic boom and created unsustainable conditions in the United States. The worst offenders were the Fed, along with the authorities in China and Japan.

In a globalised financial system, liquidity flows easily around the world. Japan's perennially low interest rates have been a source of liquidity to the global economy for many years. And, the Chinese authorities' refusal to allow a substantial revaluation of the renminbi is also helping to maintain easy global credit conditions.

As we mentioned above, over the past few years the belief grew that central bankers had perfected the art of fine-tuning their policies to manage the economy. It was thought that they could achieve maximum growth without stoking up inflation, a little bit of pressure on the accelerator and a touch on the brake. Along with this view, the belief grew that the market was now largely capable of managing risk adequately.

The quants guys on Wall Street and elsewhere went to work on fancy models to manage risk. Big and small firms told us that they had whole systems set up to quantify their risk exposure. The value-at-risk approach was supposed to tell them, with a large measure of confidence, what was the most they could lose on any given day. However, when the storms occurred, many of these models failed to provide even a reasonably accurate prediction. The losses suffered by firms such as Merrill were much larger than what was expected.

The problem is that many of these models are incapable of taking into account sudden changes in the environment or the confluence of several untoward events. We have seen this occur previously in the late nineties and we will undoubtedly see it recur in the future. It has partly to do with the difficulties of modelling, and partly its inherent limits. There are qualitative factors that can't be modelled adequately.

Some modellers are aware of these issues and don't claim more than they can deliver. But several years of experiencing calm seas can build up complacency. And when the storm arrives suddenly, without much forewarning, you may be unprepared.

There was another factor involved in the general belief that the market was now more adept at handling risk. Investment banks had been busy creating a multitude of fancy derivative products that were supposed to allow superior hedging and risk spreading. Of course, the creators of these products were keenly interested in making money for the investment banks, which they did very successfully.

As for the users of these products, some were not fully aware of their complex nature. Others did not investigate how well these instruments would work under difficult circumstances. And for a certain class of products, institutional investors relied on the published opinion of rating agencies. Unfortunately, the latter had neither the skills nor the motivation to issue a reasonably accurate rating.

It is no secret that when credit conditions are easy and borrowing is cheap, risk appetite increases substantially. Even normally illiquid assets take on the aura of liquidity. Greed is a well-known factor in financial markets and people respond when monetary authorities create the right conditions.

Now that fear has also made an appearance, the same people on Wall Street, and elsewhere, who only yesterday were extolling market solutions are calling for massive government intervention to prevent a market slump, and to boost economic growth. What? You never heard of hypocrisy on Wall Street? Ignorance, deception and fraud are perennial factors in the financial markets. Normally, market participants are partly responsible for sorting out these issues by themselves. But, obviously, regulators also have a role in protecting investors. The difficulty is getting the balance right between providing adequate protection and avoiding the sort of over-regulation that squelches innovation and discourages proper risk-taking behaviour. Investors don't need to be mothered constantly. Given sufficient information, they can sort out risk versus return trade-offs and take optimal decisions.

Regulators and monetary authorities aren't there to save them from making wrong decisions and the facing the consequences of excessive risk-taking. The market does that by dishing out reward for good and punishment for bad decisions. Unfortunately, the Fed has distorted the market mechanism by supporting speculative bubbles and coming to the rescue when there is an impending crash that is about to correct the excesses of the past.

As we have said in previous articles, the issue is not so much one of fairness as of market efficiency. If investors, big and small, think that there is always a rescue package waiting if they get into trouble, they will take on excessive risk. It's a case of heads I win, tails I am bailed out. This is not the way to run an advanced economic and financial system.

Policymaking in the United States has become almost entirely short term, with little regard for long-term consequences. The current aggressive fiscal and monetary packages are aimed at preventing a recession. But, in fact, a recession, while painful in the short term, would benefit the longer-term health of the US economy.

The savings rate in the United States needs to rise in tune with slower productivity growth. This would also help to narrow the external deficit. An additional benefit would be a restoration of discipline, so that people would have second thoughts about engaging in speculation.

The policy measures implemented in the US and backed by a number of economists have little basis in a sound theoretical framework. They smack of impromptu recommendations and actions. A market-oriented theoretical framework would entail the pursuit of growth and employment objectives via microeconomic policies, not macro ones such as fiscal policy. Even is a Keynesian system of aggregate demand management, fiscal policy should be balanced over the business cycle, such that the government would run a deficit in slump years and a surplus in boom years. Patently, that is not what is happening in America.

As for monetary policy, its prime role should be the management of inflation, not trying to fine tune growth and employment. There is a role for the central bank to protect the financial system and manage crises. But they shouldn't be in the business of helping to create speculative bubbles in the first place and trying to clean up the mess later.Conditions are certainly more challenging for the Fed this time around than they were when it cut interest rates aggressively in 2000. At that time, the US was still benefitting from the tail end of the productivity-growth boom of the late nineties. Inflation was muted and interest rates were expected to stay low. The consumer was better placed to increase spending, and house prices were still relatively low by historical standards. In addition, the benefits of globalisation were feeding through rapidly - in particular, the deflationary effect of China's manufacturing exports.The situation is different today. US productivity growth is lower than before. Inflation is problematic and bond investors are willing to extract an inflation premium. House prices are still historically high and may need to undergo further correction. The American consumer is not in a position to increase spending as in the previous period. Also, China and Asia are not playing the same deflationary role that they did before.The policies implemented in the US may possibly avoid a recession, but at the cost of a protracted period of sub-par growth. And, we should note that the trend rate of non-inflationary growth is lower, now, than it was in the years of high productivity growth. So it is likely that averting inflationary pressures may prove to be a challenge.The large interest-rate cuts by the Fed will have their main impact, not on the consumer and business sectors, but on the banks. A steeper yield curve will certainly have an effect in filling up bank coffers. The banking sector, which generally borrows short-term and lends long will benefit from a wide interest-rate spread. Banks have diversified their business models considerably. But intermediation activity between original lenders and final borrowers is still a large part of their business. And the Fed has come to the rescue.Apart from the banks, there is a lot of repair that needs to take place in the financial sector to put it on a relatively sound footing. But, this is not something that can occur over just a few months.We heard a lot about the decoupling of the global economy, last year, and many of us were skeptical. Well, guess what? Goldman Sachs, the chief proponent of the decoupling thesis switched over to the re-coupling view earlier this year - - easier than you can flip a coin. Now, instead of guessing, let's try to shed some light on this coupling issue.The US economy is a major component of the global economy and a recession in America will have an impact on all regions. This includes Asia, which exports a substantial amount to the United States. But there are also important changes taking place that will change the balance of forces in the world economy in the years to come. These changes are gradual but important, and they also have political consequences.Intra-Asian trade is growing in importance. Sure, some of it is composed of intermediate goods transacted between various plants of foreign multinational companies. But trade in the final goods component is also rising. In addition, trade between Europe and Asia is also trending higher, reducing the importance of the US export market as a destination. As these trends continue, the global economy will become more balanced, characterised by a diminution of US economic presence.Here's the blurb.Iraj Pouyandeh is a Strategist and Senior Portfolio Manager at LOM Asset Management. He manages the LOM Global Equity Fund. For more information on LOM Asset Management please visit www.lomam.com