The dollar has fallen dramatically for more than a year and a half, eroding the nation’s wealth more than 16 percent. Sixteen percent gone in less than two years! Vanished.

In the past seven years, the dollar has fallen by 40 percent. Yet the Federal Reserve just cut interest rates again, even though it thoroughly understands this move will only damage the dollar’s value further. Why?

The Fed is scared silly by the alternative.

Since the dot-com bubble exploded in 2000, one big thing has kept the U.S. economy going. It certainly hasn’t been manufacturing, exports, or any other form of productive wealth creation. It has been consumer spending. But now Joe Consumer’s atm card may be close to empty.

When the 2000 stock market bubble burst, central bankers threw caution to the wind, injecting enormous amounts of money into world financial markets to try and prevent a looming recession and perceived threats of deflation. Eventually, much of the money bankers had unleashed on the world ended up, literally, in Joe Consumer’s backyard, as the liquidity ended up fueling the real-estate market.

As a result of all the newly created central bank money, interest rates fell, banks competed to originate mortgages, more people could afford homes, and consequently, home prices appreciated at double-digit rates in many areas. Further, millions of construction, renovation, home-supply and mortgage-financing jobs were created, and the economy was saved—for the time being.

As home prices soared, Joe Consumer embarked on probably the greatest spending spree of all time. Homeowners across the nation spent money like kings. Credit was readily available, skyrocketing home prices made people feel rich, and many even began thinking of their homes as a checking account, withdrawing home equity just like using an atm card at a bank machine.

But even though the increased spending made the economy look better on the outside, the Fed’s firing up the digital printing presses and throwing money at the problem didn’t actually fix anything. In fact, it just ended up creating multiple bubbles, two of which were in the real-estate and lending markets. And these two bubbles fueled a third bubble: unsustainable consumer spending.

“Sadly, the endgame [for these bubbles] could be considerably more treacherous for the United States than it was seven years ago,” says Stephen Roach, former chief economist at investment bank Morgan Stanley. Bubbles eventually burst, and what happened with the dot-com boom in 2000 is happening today in the housing and finance sectors. Only this time it’s worse, Roach says, because the consumer will be much more dramatically impacted.

The first two bubbles have already popped and are in the process of deflating. If consumer spending follows, and it almost assuredly will, the economy will be in serious trouble.

As most people realize, home prices across the nation have stopped appreciating and are now even falling. Mortgage delinquency rates and foreclosures are also skyrocketing. Just look at the numbers. Foreclosures are endemic, well beyond the former irrationally exuberant property markets in California and Florida. Foreclosure rates are up over 50 percent in many states. In Florida, Iowa, Minnesota, Ohio and Wisconsin, foreclosures are up more than 130 percent. In Arizona, Arkansas and Nevada, they are up by more than 200 percent. Vermont and Virginia have seen foreclosures rise 400 and 516 percent respectively; in Connecticut and Massachusetts they are up between 920 to 1,000 percent or more.

A Congressional report suggests that over 2,000,000 homes financed by subprime loans will go into foreclosure in the next 18 months. That’s just the subprime loans; there is evidence that Alt-A mortgage holders are also starting to have trouble.

Some analysts have argued that because the soaring number of foreclosures were limited primarily to the subprime market (approximately 20 percent of total mortgages), the rest of the economy would not be seriously threatened. But this thinking is hugely simplistic.

Subprime loans may only be a limited proportion of all mortgages outstanding, but they are a huge proportion of the loans that drove real-estate prices to the record levels they are at today. Now that banks have virtually stopped issuing these loans, the whole housing market will come under pressure. A huge chunk of potential home buyers are gone.

The ramifications for the economy are potentially huge and go far beyond just falling home prices and slower home sales. The real-estate and associated housing industries were responsible, directly or indirectly, for 40 percent of all jobs created from 2001 through partway last year. But now, those industries are not only not creating jobs, they are shedding them.

Falling home prices, coupled with job losses, are sure to hit the consumer. After all, Joe Consumer can no longer extract home equity, or flip houses for profit.

Once Joe realizes that tougher times are around the corner and that he should stop spending and actually start saving, the odds the economy will avoid a recession are practically nil. Consumer spending currently accounts for a record 72 percent of America’s gross domestic product. According to Roach, that’s “a number unmatched in the annals of modern history for any nation.”

In August, the subprime mortgage meltdown also spread to Wall Street, as many banks, lenders and investment funds began reporting massive losses related to the mortgage market. The central banks around the world, including the Fed, responded by dumping billions into the financial system to keep it from seizing up (read “The Con That Turned the World Against America”). But the problems clearly aren’t over.

Last Wednesday, the Federal Reserve rolled over $41 billion in temporary reserves into the banking system, making it the largest one-day cash infusion since the September 11 terrorist attacks. The fed also lowered its inter-bank lending rate for a third straight time in an effort to get money flowing between banks.

“Just as dot-com was the canary in the coal mine seven years ago, subprime was the warning shot this time,” notes Roach. “[B]oth cases [have] eerie similarities—as do the spillovers that inevitably occur when major asset bubbles pop.”

America is faced with a deflating real-estate bubble and the associated Wall Street subprime lending bubble. In August, when Wall Street started seizing up due to all the bad subprime loans, the Fed knew that if it didn’t do something, banks scrambling for cash to cover their losses would tighten lending, and the real-estate market and associated industries would get hit even harder, also impacting consumer spending.

Consumer spending is the last bubble. If that goes, the whole economy goes.

Previously, the highly indebted, happy-go-lucky consumer spent money because he thought that his house was his bank account. Last year, his house appreciated by 10 percent. It was making him rich—so why bother saving? Those days are over. Home prices are falling. Now many homes are worth less than their mortgages. Joe Consumer is about to receive a wake-up call.

So the Fed must inflate or die. That is why it is abandoning the dollar. It can’t re-inflate the economy and protect the dollar’s value at the same time. It is one or the other. The U.S. administration can pretend that it wants a strong dollar, and officials can even preach a “strong dollar” mantra, but their actions indicate otherwise.

Last Tuesday, U.S. Treasury Secretary Henry Paulson, on a trip to India, said, “I’m strongly committed to a strong dollar.” On Wednesday, the Federal Reserve cut interest rates by a quarter point, knocking the legs out from underneath the dollar again.

“In words, we have a strong-dollar policy,” said Michael Woolfolk, senior currency analyst at Bank of New York Mellon. “In action, we have a policy that favors a stable dollar in the form of a slow, steady decline.” It would be almost laughable if it wasn’t so serious—if people’s life savings weren’t being eroded away in the process.

How can a government policy favor a “stable” dollar but also a “declining” one at the same time? Which is it?

As in all ruses, people, investors, America’s trade partners and foreign creditors may be deceived for a while, but eventually actions reveal the truth.

Why would the Federal Reserve be easing interest rates when the dollar is falling to new all-time lows? Oil is approaching $100 per barrel, gold is at $800 (a level not seen since the last dollar crisis in the 1980s), virtually every commodity on the planet is skyrocketing, and inflation in everyday items like milk, eggs and bread is raging! Why now?

It’s because the Fed knows the economy is so precarious that even a mild recession could easily spiral out of control.

A few years ago, Mr. Roach—then the head economist for Morgan Stanley—said America had less than a 10 percent chance of escaping “economic Armageddon.” Since then, the housing, lending, and consumer spending bubbles have only grown bigger, and Morgan Stanley has shipped Roach off to Asia. Apparently, sometimes reality is hard to hear.

Will the Fed be successful in fending off an economic collapse? It might be for a while; the economy may muddle along for a couple of years; the dollar still has some value left. But history is clear: No nation has ever devalued its way to prosperity. In fact, the contrary is true: Currency devaluations and banking crises go hand in hand—along with economic crisis.