The sell off has been triggered by growing fears that the US economy is heading into (or may already be in) a nasty recession. Many foreign banks hold massive amounts of American debt (bonds), some of which are probably going to be bad. There is a growing fear that the U S Government may be limited in it's ability to respond to the growing economic crisis. Heavy debt at all levels of American society from private consumer debt (credit cards & high interest mortgages etc.) to corporate and national government are weighing heavily on the economy now. Ever since George Bush took office the United States has been living on the national credit card, with deep cuts in taxes and large increases in spending to finance a shocking amount of pork and two wars. The result is that the national treasury is depleted and we have been receiving warnings that our our country's bond rating could be reduced from the AAA status it has held since 1917 to AA.
In order to finance the wars and ensure that the wealthy are not inconvenienced by higher taxes the US has been borrowing money at record rates (most of those bonds are held by foreign banks) and we have been printing more money. If you or I decided to print money to solve our financial shortfalls we would go to jail. However the Treasury Department does not operate under the rules the rest of us have to follow.
The only problem with this is that money is not immune to the basic laws of economics. The more you have of something, the less it's worth. Case in point; our money (no longer backed by gold for very good reasons) is today backed by public confidence. For decades the dollar has been the store of value in the international financial markets and the de facto currency of international finance. In short term emergency situations you can (and should ) print more money to help give a boost to the economy or keep the lights on at the government. This is perfectly OK as a temporary measure to meet an immediate and urgent need. It is not an acceptable long term answer to a knee jerk aversion to raising taxes or making politically tough decisions to cut spending. If you print more money for a long period of time you will start to loose the short term advantages and run the risk of your currency loosing its value.
Herein lies the quandary we now find ourselves in. As a general rule of thumb it's a bad idea to raise taxes or deeply cut spending during a recession. These are things you want to do during the good times so your finances are in reasonably good shape for the not so good times when you will need to use the national credit card. Also there are some things which one does not finance (at least entirely) by debt. Wars being chief among them. Since the attacks of Sept 11 2001 we have been financing two wars almost entirely through debt. At no time in the history of this country have we ever had an administration that cut taxes during war time.... until G. W. Bush. Between war spending and out of control pork barrel spending by Congress (one of the few bipartisan undertakings in Washington over the last seven years) our debt has now reached proportions that are alarming to the international financial community. Add to this the recent decline in the value of the dollar and evidence of inflation and you have the makings of a perfect storm.
Here we sit, probably in the early stages of an economic recession and the question looms large. What can the government due to help out? Yes the Fed can cut interest rates and inject currency into the markets to help stabilize things. But this runs the not inconsiderable risk of adding to inflationary pressure and further reducing the value of the dollar. Normally this would be a good time for the government to cut taxes at least short term to promote consumption and investment and increase spending in some areas in order to provide relief to people who will need some help to get through the economic tough times. But the treasury is empty. There is no rainy day fund. That was handed over lock stock and barrel to people making over a million a year in the form of tax cuts for the wealthy. We have been borrowing money hand over fist to buy bullets and body armor for troops in Iraq and Afghanistan. Where are we gong to get the money for emergency economic relief without adding to what is already an ocean of red ink?
There is a limit to how long and how much you can borrow, as any one who has ever had to live in the real world and balance their budgets can attest to, before you go over the proverbial financial cliff. So what will the government do? I am not sure. But I do feel fairly confident that they will do something. This is an election year and the appearance of being unresponsive would be political suicide. The problem is that anything that they do might be very temporary in its benefits and something we are going to pay a steep price for down the road a ways. Cut interest rates and taxes and increase spending. Those are the traditional formulas for dealing with a recession. But they are predicated on your national finances being in sound order going into the crisis. Our's are not.
The bottom line... fasten your seat belts. It's going to be a very bumpy landing.
UPDATE: The Fed authorized an emergency interest rate cut of 3/4 percent.