The Making Of America 2.0

When it comes to predicting the financial crisis, Harvard's Kenneth Rogoff, the former chief economist of the International Monetary Fund and a chess grandmaster to boot, has been right on the money. Last March, after the markets stabilized in the wake of the collapse of Bear Stearns, I asked Rogoff if he thought that would be pretty much it: were we in the clear? No way, Rogoff replied without hesitation. "This is going to end up in Congress's and the president's lap. It's not going to wait until the next administration." Rogoff forecast another big fallout from the devastation caused by failing subprime loans and mortgage-backed securities—and a giant government bailout. "Home prices are continuing to fall. The credit markets are stressed. This is a multi-trillion-dollar problem. It's beyond the Fed's balance sheet to handle it."

With a track record like that, I figured it would be worth another chat with Rogoff. How about this time? I asked him Thursday after the Senate approved a modified $700 billion rescue plan. If the House goes along, will it be enough? "It definitely will not," he replied. "This is going to be a first step. We're going to end up with far more expansive and extensive measures. What has been accomplished already is incredible, but I suspect that we're going to end up intervening much more directly in the mortgage market, propping up housing prices … I think this will cost us one to two trillion dollars by the end. That's a typical 6 to 10 percent of GDP [gross domestic product] for a crisis of this size."

Given such a grim prognosis, you might think that Rogoff has joined the growing throng of pessimists who are predicting yet again (as they did in the 1930s, '50s, '70s and '80s) the end of American financial hegemony and the eclipsing of American power. Even a gibbering lunatic like Iranian President Mahmoud Ahmadinejad sounded almost credible the other week when he declared, in his U.N. General Assembly speech, that "the American empire, in the world, is reaching the end of the road."

Instead, Rogoff sees great opportunities ahead for America, and the more I think about it, the more I tend to agree with him (I should also point out that Rogoff held these same views before he became an adviser to John McCain). Yes, the current crisis signals an end to the remarkable free ride we Americans have had for decades, when we financed our rampant, zero-savings consumerism with boatloads of borrowed investment money from abroad. "I think this is the end of that era of a 6 to 7 percent current-account deficit," says Rogoff. "The financial sector was key to that dynamic. For sure it's going to drop to half that level. [The current-account deficit] might even go back to 1 percent."

So consumption will decline. There will be an economic slowdown of unknown severity. But overall that's a healthy deflation of an economic bubble that the subprime disaster was only a symptom of: as a country, we need to stop buying things we can't afford. And Washington—the next president and Congress—will have to make some very responsible choices about how to regulate the new landscape that has emerged on Wall Street without overdoing it (the impulse will be to place a regulatory chokehold on banking since it's now clear to everyone that underregulation got us into this mess). " There's no doubt that the U.S. financial model has been undermined," says Rogoff. "The question is, are we going to come up with better regulation and produce an American finance 2.0 that's more robust and better than the first one and keeps the financial sector as the flagship of the American economy? Or we going to regulate it into a coma?"

There is ample time to get that balance right. Even amid the current worldwide crisis of confidence in America—which extends not just to the subprime fallout but to the widespread mistrust of the Bush administration over its foreign policy and fiscal irresponsibility—interest rates have remained low and the dollar strong. Those are sure signs that other countries simply have no choice but to continue to invest here and depend on the dollar. If the world really felt that America's time was pass ing, "the dollar would be tanking and our interest rates would be soaring," says Rogoff. "Whatever the newspapers are saying, foreign investors have not given up on us."