The U.S. Economy Faces the Guillotine

The current troubles were years in the making, and in retrospect, easy to see coming. In the United States, the problems started with excesses and defaults in the subprime lending and housing markets. As the bubble burst, foreclosures mounted and housing activity ground to a halt. Throughout 2007, the carnage spread slowly, from subprime borrowers and home builders to middle-class homeowners and the stores they frequent, like Home Depot. As subprime debt went bad, the lenders and banks that plunged into the subprime market suffered huge losses. In recent weeks, blue-chip banks Citigroup and Merrill, Lynch took huge write-downs—more than $30 billion—on subprime mortgages and investments tied to them. What started as an effort to spread risk—securitizing mortgages, trading them and getting them off the books of banks and into the global capital markets—has in fact multiplied it. In the wake of the loss, they dispatched squadrons of corporate jets to the Persian Gulf and Asia to raise new capital from the various sovereign-wealth funds that have replaced private-equity and hedge funds as the investors of choice for ailing companies. With credit in tighter supply, consumers, who account for 70 percent of U.S. economic activity, began to scale back, leading to a blue Christmas for retailers from Dollar General to Tiffany.

Of course, at every stage, policymakers and business leaders have declared the damage contained, only to see the financial mold spread like dry rot. "It's following the well-trodden paths of past financial folly," said Ken Rogoff, professor of economics at Harvard. "Just like this one, most banking crises in the past were also driven by rising real-estate and equity prices. It takes time to sort it out."

The U.S. stock markets held up quite well for 2007 in the face of the rising distress, thanks to two strong macroeconomic trends. Economic growth was strong through the third quarter, and the Federal Reserve, under the leadership of Ben Bernanke, began cutting interest rates in September—which usually presages market gains. A continued global boom buoyed multinationals like IBM, General Electric and Coca-Cola. But one by one, the pillars supporting the stock market—housing, the consumer, financial services, luxury goods—developed cracks, and the macroeconomic news worsened through December and January. By last week, investors seemed to have retreated to their last redoubt—big technology firms like Apple with healthy margins, popular products and dramatic global growth. But Tuesday afternoon, Apple issued an earnings report that disappointed analysts; its stock has been pared 31 percent so far this year. Fast-growing Google, the darling of the late bull market, has fallen 26 percent since its November 2007 peak.

So what does all this have to do with the price of stocks in China? With the rising volume of trade, open flows of capital and tighter economic integration, the world's stock markets have become synchronous: they're far more likely to move in the same direction at the same time. That was explicitly not the case in the 1990s. Still, despite all the global growth, the United States remains the world's largest economy, and the largest single source of demand for exports from China and many other countries. "There is a very tight link now between China and the global economy," said Wang Tongjiang, a finance specialist at Shanghai's East China Normal University (ECNU). "The fall in the markets partly reflected pessimism and worries about the future for companies involved in the export industry." If the United States sneezes, economic conventional wisdom holds, the rest of the world will catch a cold. Or pneumonia.

But there's a difference between markets and the real economy. More and more business people and economists think the United States and the rest of the world may be moving in different directions. "We're seeing a general decoupling," said James Owens, chairman of U.S. machinery giant Caterpillar. While demand is weak in the U.S., he says, "South America, Asia, Russia, Eastern Europe, all have very strong commodity-based exports. The fundamental economic health in these markets is strong." In addition, companies and consumers in these countries no longer rely mostly on U.S. financing to buy tractors and construction equipment.

"Decoupling" was one of the hot buzzwords to emerge from Davos. A best-selling book is "The World Without Us," about the fate of the globe without humans. But that could well be the title for the global economy in 2008. For while the U.S. may not be contributing materially to economic growth, cocky newcomers to the global party say they can take it from here.