Can the U.S. financial crisis be contained within America's borders?

For months, economists have debated whether the United States is headed toward a recession. Today, there is no doubt. The severe liquidity and credit crunch from the subprime mortgage bust is now spreading to broader credit markets, $100 barrels of oil are squeezing consumers and unemployment continues to climb. And with the housing market melting down, empty-pocketed Americans can no longer use their homes as ATMs to fund their shopping sprees. It's time to face the truth: The U.S. economy is no longer merely battling a touch of the flu; it's now in the early stages of a painful and persistent bout of pneumonia.

Canada and other countries are watching anxiously, hoping they don't get sick, too. In recent years, the global economy has been unbalanced, with Americans spending more than they earn and the country running massive external deficits. When the subprime mortgage crisis first hit headlines last year, observers hoped that the rest of the world had enough growth momentum and domestic demand to gird itself from the U.S. slowdown. But making up for slowing U.S. demand will be difficult, if not impossible. American consumers spend about $9-trillion a year. Compare that to Chinese consumers, who spend roughly $1-trillion a year, or Indian consumers, who spend only about $600-billion. Even in wealthy European and Japanese households, low income growth and insecurities about the global economy have caused consumers to save rather than spend. Meanwhile, countries such as China rely on exports to sustain their high economic growth. So there's little reason to believe that global buyers will pick up the slack of today's faltering American consumer, whose spending has already begun to drop.

Because the United States is such a huge part of the global economy -- it accounts for about 25% of the world's GDP, and an even larger percentage of international financial transactions -- there's real reason to worry that an American financial virus could mark the beginning of a global economic contagion. It may not devolve into a worldwide recession, but at the very least, other nations should expect sharp economic downturns, too. Here's how it will happen:

TRADE WILL DROP

If output and demand in the United States fall -- something that by definition would happen in a recession -- the resulting decline in private consumption, capital spending by companies and production would lead to a drop in imports of consumer goods, capital goods, commodities and other raw materials from abroad. U.S. imports are other countries' exports, as well as an important part of their overall demand. So such a scenario would spell a drop in their economic growth rates, too. Several significant economies -- including Canada, China, Japan, Mexico, South Korea and much of Southeast Asia -- are heavily dependent on exports to the United States. China, in particular, is at risk because so much of its double-digit annual growth has relied on the uptick of exports to the United States. Americans are the world's biggest consumers, and China is one of the world's largest exporters. But with Americans reluctant to buy, where would Chinese goods go?

China is also a good example of how indirect trade links would suffer in an American recession. It once was the case that Asian manufacturing hubs such as South Korea and Taiwan produced finished goods, like consumer electronics, that were exported directly to American retailers. But with the rise of Chinese competitiveness in manufacturing, the pattern of trade in Asia has changed: Asian countries increasingly produce components, such as computer chips, for export to China. China then takes these component parts and assembles them into finished goods -- say, a personal computer -- and exports them to American consumers. Therefore, if U.S. imports fall, then Chinese exports to the United States would fall. If Chinese exports fall, then Chinese demand for component parts from the rest of Asia would fall, spreading the economic headache further.

HOUSING BUBBLES WILL BURST WORLDWIDE

The United States also isn't the only country that has experienced a housing bust: Britain, Ireland and Spain lag only slightly behind the United States as the value of their flats and villas trends downward. Countries with smaller but still substantial real estate bubbles include France, Greece, Hungary, Italy, Portugal, Turkey and the Baltic nations. Countries including Australia, China, New Zealand and Singapore have also experienced modest housing bubbles. There's even been a housing boom in parts of India. Inevitably, such bubbles will burst, as a credit crunch and higher interest rates poke holes in them, leading to a domestic economic slowdown for some and outright recession for others.

COMMODITY PRICES WILL FALL

One need only look at the skyrocketing price of oil to see that worldwide demand for commodities has surged in recent years. But those high prices won't last for long. That's because a slowdown of the U.S. and Chinese economies -- the two locomotives of global growth -- will cause a sharp drop in the demand for commodities such as oil, energy, food and minerals. The ensuing fall in the prices of those commodities will hurt the exports and growth rate of commodity exporters in Asia, Latin America and Africa. Take Chile, for example, the world's biggest producer of copper, which is widely used for computer chips and electrical wiring. As demand from the United States and China falls, the price of copper, and therefore Chile's exports of it, will also start to slide.

FINANCIAL CONFIDENCE WILL FALTER

The fallout from the U.S. subprime meltdown has already festered into a broader and more severe liquidity and credit crunch on Wall Street. That, in turn, has spilled over to financial markets in other parts of the world. This financial contagion is impossible to contain. A huge portion of the risky, radioactive U.S. securities that have now collapsed -- such as the now disgraced residential mortgage-backed securities and collateralized debt obligations -- were sold to foreign investors. That's why financial losses from defaulting mortgages in American cities such as Cleveland, Las Vegas and Phoenix are now showing up in Australia and Europe, even in small villages in Norway.

Consumer confidence outside the United States -- especially in Europe and Japan -- was never strong; it can only become weaker as an onslaught of lousy economic news in the United States dampens the spirits of consumers worldwide. And as losses on their U.S. operations hit their books, large multinational firms may decide to cut back new spending on factories and machines, not just in the United States but everywhere. European corporations will be hit especially hard, as they depend on bank lending more than American firms do. The emerging global credit crunch will limit their ability to produce, hire and invest.

MONEY FOR NOTHING

Optimists may believe that central banks can save the world from the painful side effects of an American recession. They may point to the world's recovery from the 2001 recession as a reason for hope. Back then, the U.S. Federal Reserve slashed interest rates from 6.5% to 1%, the European Central Bank dropped its rate from 4% to 2% and the Bank of Japan cut its rate down to zero. But today, the ability of central banks to use monetary tools to stimulate their economies and dampen the effect of a global slowdown is far more limited than in the past. Central banks don't have as free a hand; they are constrained by higher levels of inflation. The Fed is cutting interest rates once again, but it must worry how the disorderly fall of the dollar could cause foreign investors to pull back on their financing of massive U.S. debts. A weaker dollar is a zero-sum game in the global economy; it may benefit the United States, but it hurts the competitiveness and growth of America's trading partners.

Monetary policy will also be less effective this time around because there is an oversupply of housing, automobiles and other consumer goods. Demand for these goods is less sensitive to changes in interest rates, because it takes years to work out such gluts. A simple tax rebate can hardly be expected to change this fact, especially when credit card debt is mounting and mortgages and auto loans are coming due.

The United States is facing a financial crisis that goes far beyond the subprime problem into areas of economic life that the Fed simply can't reach. The problems the U.S. economy faces are no longer just about not having enough cash on hand; they're about insolvency, and monetary policy is ill equipped to deal with such problems. Millions of households are on the verge of defaulting on their mortgages. Not only have more than 100 subprime lenders gone bankrupt, there are riding delinquencies on more run-of-the-mill mortgages, too. Financial distress has even spread to the kinds of loans that finance excessively risky leveraged buyouts and commercial real estate.

There is also much less room today for fiscal policy stimulus, because the United States, Europe and Japan all have structural deficits. During the last recession, the United States underwent a nearly 6% change in fiscal policy, from a very large surplus of about 2.5% of GDP in 2000 to a large deficit of about 3.2% of GDP in 2004. But this time, the United States is already running a large structural deficit, and the room for fiscal stimulus is only 1% of GDP, as recently agreed upon in George W. Bush's stimulus package. The situation is similar for Europe and Japan.

President Bush's fiscal stimulus package is too small to make a major difference today, and what the Fed is doing now is too little too late. It will take years to resolve the problems that led to this crisis. Poor regulation of mortgages, a lack of transparency about complex financial products, misguided incentive schemes in the compensation of bankers, wrongheaded credit ratings, poor risk management by financial institutions -- the list goes on and on.

Ultimately, in today's flat world, interdependence boosts growth across countries in good times. Unfortunately, these trade and financial links also mean that an economic slowdown in one place can drag down everyone else. Not every country will follow the United States into an outright recession, but no one can claim to be immune. - Nouriel Roubini is chairman of RGE Monitor and professor of economics at New York University's Stern School of Business.

Article from: www.nationalpost.com