The U.S. Economy Faces the Guillotine

"There are no silver bullets here, but it will be very helpful," said Rep. Barney Frank, chairman of the House Financial Services Committee, who played a key role in negotiating some measures in the stimulus package. But the impact—and the ultimate passage—of the package remain in doubt. The Senate must still weigh in. Some Democrats are disappointed that it doesn't extend unemployment benefits and increase food stamps, which tend to get spent quickly. Sen. Kent Conrad of North Dakota, chairman of the budget committee, frets that checks likely wouldn't arrive in consumers' mailboxes until June. "The 2001 results show that it took one to two quarters for people to actually spend the money," he said. That could be too late to help retailers that are closing stores by the dozen. While the mortgage measures can't hurt, much of the damage has been done. Existing home sales fell again in December by 2.2 percent, with prices slipping further. Last Thursday, Lennar, the giant home builder, reported that home sales fell 50 percent in the fourth quarter from 2006. Lennar CEO Stuart Miller's glum prognosis for 2008: "We are not expecting market conditions to improve."

It's not all doom and gloom, however. Even as politicians congratulated themselves for taking the courageous step of voting to send cash to voters in an election year, investors were looking to the Federal Reserve to cut interest rates further at its regularly scheduled meeting this week. Unemployment claims have hovered at a low 300,000 in recent weeks, suggesting the economy may have added a decent number of jobs in January, notes Ian Morris, an economist at HSBC. "This is the reason why we have so far been reluctant to call for a recession." If the economy responds as it traditionally has to such dramatic measures, it's possible any recession will be mild and relatively short.

But politicians are more optimistic than most analysts and economists at the moment, in part because of a widespread fear of further problems with credit—beyond consumers, businesses and homeowners. The U.S. financial system is like the game Jenga, where participants remove supporting beams from the structure until it topples. The stimulus package won't do much to shore up the current weak links in the tottering edifice. Over lunch in Davos, hedge-fund manager George Soros spun a tale of credit sufficiently dire to make several journalists choke on the veal steak with shallots. "The ability of the Fed to come to the rescue is constrained to an extent it wasn't before," he said. It's not simply a matter of cutting rates to enable banks and companies to get more money. His concern, and that of many others, is the value of bond insurers, credit-default swaps and other derivatives—obscure, largely unregulated corners of the market.

Starting in the 1990s, investment banks developed a sort of parallel credit system. It includes credit-default swaps, a form of insurance that pays off if a bond goes bad. The global value of such contracts in 2007, according to the International Swaps and Derivatives Association: $45 trillion. Companies that used to be in the boring business of insuring municipal bonds branched out aggressively into this system, insuring bonds based on subprime debt. The declining value of subprime debt has brought into question these companies' own stability and the validity and value of the insurance they sold, and it could lead to a downward cycle of write-downs. Defaults on these could trigger up to $250 billion in losses, according to Bill Gross, founder of the bond mutual-fund giant PIMCO—about the amount that investors will lose on subprime mortgages. Concern over the plummeting share prices of bond insurers like MBIA and Ambac has risen to such a level that New York State Insurance superintendent Eric Dinallo has been meeting with financial-services-industry executives to organize a potential bailout. "We have dealt with liquidity, now we must deal with solvency," Soros said.

Economists aren't generally an ironic lot. But there's a great deal of irony in the global economy today—especially when insurers need insurance. Subprime mortgages, and the bonds based on them, are the U.S. equivalent of lead-laced toys and chemical-spiked toothpaste from China—exports presumed to be safe that can prove toxic.

Last year's bears and scolds at Davos have become this year's sages. In 2007, U.S. private-equity and banking executives were the rock stars on the Swiss slopes. This year, the managers of sovereign-wealth funds from the Persian Gulf and Asia were the main attraction. What was generally regarded to be the world's strongest financial system now seems one of its weakest, while emerging economies are practically paragons of fiscal and monetary health. In the 1990s, crises in the developing world—Latin America, Russia and the Far East—roiled the global markets. Today problems in the most-developed countries—subprime in the United States; the failure of mortgage lender Northern Rock in the U.K.; the rogue-trading scandal at France's Société Générale. A new financial order is clearly dawning.