The Federal Reserve seems poised to cut rates once again Tuesday. But the move isn't likely to dent one of the biggest challenges facing the economy right now: deleveraging.

Banks are scrambling to shrink their balance sheets. They are cutting off risky borrowers, raising margins on others and reducing their proprietary trading activities, pressuring asset prices as trading desks reduce their positions.

Banks are ostensibly acting in their own self-interest by cutting back on risk. With all of the hidden landmines out there -- Bernard Madoff's alleged megabillion fraud is the latest example -- banks are desperate to minimize their exposure to the next blowup.

But by acting in their short-term self-interest, the banks are potentially creating a long-term financial cataclysm that will haunt them. It is a conundrum in game theory known as a prisoner's dilemma. In such scenarios, individuals acting in their own self-interest create an outcome that hurts everyone involved.

'What the banks are doing on their level is rational, but when you add it up it resolves into a system that further undermines the banks,' says Mohamed El-Erian, chief executive of giant bond firm Pimco.

The expected rate cut won't break that cycle. The market won't cheer unless and until the Fed unveils a far more aggressive plan to free up bank balance sheets

Scott Patterson

美