ECONOMICS:THE FEDERAL Reserve board this week managed to prevent a further worsening in the US subprime crisis by playing virtually every card in the monetary deck.

A major bank was effectively bailed out with the aid of federal funds. Liquidity was loosened. Interest rates were cut again.

However, even with the adoption of these monetary tactics of shock and awe, a solution to the subprime crisis is still not in sight.

The Fed pre-empted mayhem when the markets opened last Monday by effectively shotgunning the acquisition of the ailing Bear Stearns investment bank by JP Morgan Chase over the weekend. The Fed provided special financing to hasten the conclusion of the deal, agreeing to fund up to $30 billion of Bear Stearns's less liquid assets.

In an effort to bolster market liquidity, the Fed announced on Sunday that it was widening access to its discount window, effectively allowing participants in securitisation markets to gain access to its funds. It also cut the discount rate from 3.5 per cent to 3.25 per cent.

On Tuesday, the Fed reduced the key Federal Funds rate by three-quarters of a percentage point to 2.25 per cent.

The Fed has now cut its central interest rate from 5.25 per cent to 2.25 per cent since the subprime crisis broke last August. Simultaneously, the discount rate was clipped again to 2.5 per cent.

On Wednesday, the Fed pumped some $200 billion into US mortgage markets through two government-sponsored mortgage lenders.

As a result of these aggressive tactics, pursued right across the financial front, the line was held, but only just.

However, despite initial euphoria on Wall Street in the aftermath of the interest rate cuts, little has changed. A catastrophe was avoided, but a crisis remains.

The chairman of the Fed, Dr Ben Bernanke, is an expert on the economics of the Depression.

As he masterminded the deployment of Fed's forces this week, he would have been conscious of Milton Friedman's famous finding that the Depression was caused, not by the stock market crash of 1929, but by the subsequent steep decline in the money supply.

In one of his last academic papers, published in 2005, Friedman restated his conclusion: "The prosperous 1920s in the United States were followed by the most severe economic contraction in its history. In our monetary history, Anna Schwartz and I attributed the severity of the contraction to a monetary policy that permitted the quantity of money to decline by one-third from 1929 to 1933."

The approach adopted by the Fed this week indicates that the mistakes of the past will not be repeated. However, this does not guarantee safe passage into clear air. The subprime lending crisis will remain unresolved until two conditions are met.

First, on the economic front, equilibrium needs to be restored to the US housing market. This remains some way off.

The former Fed chairman, Dr Alan Greenspan, writing in the Financial Times this week, estimated there are 800,000 vacant single-family houses for sale at present in the US. This excess supply of housing continues to exert steep downward pressure on house prices. The overhang on the housing market is expected to be reduced by 400,000 units this year, due principally to the rate of new household formation. However, on these figures it will be well into 2009 before US house prices begin to stabilise.

The continuing decline in US house prices is the most likely trigger for a US recession this year. The steep rise in US house prices in the years to 2006 generated significant "wealth effects" for households. Homeowners borrowed against the increased value of their homes to finance additional consumer spending. In recent years such releases of home equity, largely financed by mortgage debt, have accounted for 15 per cent of US consumer spending.

Declining house prices have thus knocked away one of the largest supports for consumer spending growth in the US.

As consumer spending falters, the economy will edge deeper into recession. In turn, the advent of recession would raise the mortgage default rate, further postponing the stabilisation of house prices.

The second condition required for a resolution of the subprime crisis is a full disclosure of the bad debts sustained by the banking system on foot of subprime lending. This is easier said than done.

Financial institutions are less than enthusiastic in recognising their bad debts or writing down failed assets. For they have seen that this route leads to Northern Rock. As a result, they will prevaricate as long as possible, seeking, within the limits of the law, to postpone the awful day of disclosure.

No one knows the full extent of subprime losses. What is certain is that they are some multiple of what has already been revealed.

All of the financial institutions know that there are large sub-prime losses still locked within the system. It is for this very reason that interbank markets are jammed.

Banks will not lend to each other where they are worried about the solvency of counterparties. They fear that their assets could disappear in a whiff of smoke. Smarter to sit on your hands and stay liquid.

The Fed is finding that it can lead the banks to liquidity but it cannot make them lend. This is negating its efforts to promote liquid, well-functioning financial markets. It is also undermining the Fed's attempts to cut the cost of credit for borrowers, thereby rebooting economic growth.

If these conditions persist the Fed may have to face up to the fact that only by financing directly the retirement of bad subprime assets itself will it be able to break the logjam in financial markets.