The Fed has finally flexed its “lender of last resort” muscles. The question, though, is what comes next. There’s a good chance that the liquidity squeeze in the U.S. is effectively over, especially since the Fed stressed that it “will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. “ Yes, a lot of mortgage companies will still go under, a lot of financial firms will absorb big losses, and a lot of homeowners, unfortunately, will lose their houses. But the Fed has clearly put a cushion under the U.S. markets.

But the discount rate cut doesn’t mean the global financial crisis is over. Nor does it mean that the U.S. economy (as distinct from the financial markets) is out of the woods. In particular, I’m worried about two things—the fragility of the Chinese financial system, and the slowdown in U.S. productivity growth.

Let me take U.S. productivity growth first. The recent revisions in the economic statistics suggested that productivity growth in recent years has been significantly slower than thought (for example, only 1% in 2006, via 1.6% as previously thought). What’s more, the analysis in my offshoring cover suggests that even these figures may be significantly overstated.

If productivity growth is slower, that means the present value of the economy’s future output is lower. As a result, the economy can comfortably support less borrowing than previously expected. That may be one reason why the financial markets suddenly seized up. If so, then we are likely to go through a considerable work-out period in the U.S., to get debt in line with the new expectations for growth.

My second worry is the Chinese financial markets. During the Asian financial crisis of the 1990s, the Fed was strong enough to protect the global economy with its rate cuts. That’s not true any more. The Fed is capable of cushioning the U.S. financial markets, and working in concert with the ECB, the broader markets in the developed countries.

But the conditions are in place for a big financial crisis in China. Markets are overheated, investment is happening at a breakneck pace, and the financial system is weak and nontransparent. If the slowdown in the U.S. leads to a slowdown in Chinese exports and the broader economy, we may be looking at an emerging market bust that makes the recent turmoil in the U.S. look like a picnic.

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