Slowing U.S. economy inflicts pain around the world

Think of the United States as an intrepid adventurer who has stumbled into quicksand. As Uncle Sam struggles to free himself, a good Samaritan — aka "The Rest of The World" — extends a branch from shore and begins pulling him to safety.

Six months into the most serious financial crisis in a decade, that's about where the global economy stands. For now, customers in foreign lands are steadying a U.S. economy laid low by a debilitating credit crunch, which originated with subprime mortgages but has spread a chill throughout the entire banking system. Net exports are about the only bright spot on the economic horizon, adding 0.9 percentage points to U.S. economic growth in the third quarter. That's the biggest boost since 1980.

But now, the question is: What happens next? Will the world complete its rescue of the United States, or will Uncle Sam drag the rest of the world down?

"If it's a really steep downturn, it's going to pull everyone into its vortex," warns Harvard University economist Kenneth Rogoff.

If the United States manages to avoid a recession in 2008, Rogoff and most mainstream economists are sanguine about global prospects. But with U.S. growth in the final quarter of this year expected to be somewhere between anemic and non-existent, oil prices hovering above $80 a barrel and resurgent inflation in developed and developing economies alike, there are plenty of reasons to fret. "This is becoming a global phenomenon," says Sung Won Sohn, chief executive of Hanmi Bank in Los Angeles. "I think probably the worst is yet to come."

Major test of global system

The current crisis represents the first major test of the system of financial globalization that developed since the 1989 fall of the Berlin Wall. It's easy to lose sight of the dramatic changes that have remade global finance in less than two decades. Today, more capital flows around the world than at any time in the past century. Since 1973, cross-border capital flows have grown from 5% of the global economy to 21%, according to Frederic Mishkin, a Federal Reserve governor and author of The Next Great Globalization.

Today's financial links between nations are "like a spider web," says Sohn. "We are no longer alone. I don't think we can control our own destiny, whether in Korea, the U.S., Japan, wherever," he says.

For the USA, what was in 1989 a stream of capital moving in and out of the domestic economy has become a torrent. The value of foreign stocks, bonds and factories owned by Americans at the end of 2006 reached $13.7 trillion, up from just $2.1 trillion in 1989. Likewise, the value of American assets owned by foreign investors hit $16.3 trillion vs. $2.3 trillion in 1989.

These interlocking financial channels, in theory, lead to a more efficient allocation of capital to investments worldwide. But the increasingly complex financial mechanisms also transmit trouble. This year, what began as a problem in one sector of the U.S. housing market — mortgages for borrowers with poor credit histories — has infected credit markets worldwide. That's because global financial institutions repackaged those American mortgages as sophisticated securities and sold them to banks, corporations and local governments around the globe.

"As a direct consequence of cross-border financial integration, local price or liquidity shocks are more likely to spread around the globe. … Distant events can have sharp impacts," said Christian Noyer, governor of the Bank of France, in a Nov. 27 speech.

Amid the ongoing adjustment to the global credit crunch, a new financial landscape also is emerging. The USA, long the leader in global growth, is now limping. Government-owned investment pools in China and the Middle East, called "sovereign wealth funds," are becoming increasingly powerful buyers in many markets alongside private investors. And the trade frictions that long bedeviled Sino-U.S. relations are coming to characterize China's links to Europe.

Paulson: Economy healthy

In an interview Friday, Treasury Secretary Henry Paulson said the United States has a "healthy, fundamentally strong economy, and I believe we're going to continue to grow." Officials are paying close attention to financial markets and are striving to minimize the impact of the turmoil upon the economy. "It's going to take awhile to work through. … But I have confidence in markets and in our financial institutions," Paulson said.

Globalization, of course, also is helping ameliorate the current difficulties. Foreign investors with deep pockets already are emerging as key players in recapitalizing the U.S. financial sector through what Rogoff, former chief economist of the International Monetary Fund (IMF), calls a "cushion of global liquidity." The mortgage implosion has eaten a hole in banks' balance sheets, making it imperative that bankers shore up their capital reserves. That's why Citigroup c last month raised $7.5 billion by selling a 4.9% stake to the state-owned Abu Dhabi Investment Authority.

At the same time, global trade and commerce is buoying U.S. corporations. Profits may be starting to sag here at home, but overseas they are robust. In the third quarter, domestic profits fell 4.2% compared with the same period one year ago while they spiked almost 20% in foreign markets, according to Bank of America bac.

Harold McGraw III, chairman of the Business Roundtable, says CEOs remain optimistic about the economy because their foreign business is doing so well. "The world is fast growing up and is growing at a much better rate, (so) the effect and the influence of one economy on a region or on the world is less today," he says.

But because domestic operations dominate most companies' earnings, total profit growth for the quarter was just 1.2%. "Heading into 2008, the rest of the world better remain on testosterone, or the U.S. earnings crunch will get even uglier," BofA's chief market strategist Joseph Quinlan wrote in a recent note to clients.

The IMF expects the global economic expansion to slow from an annual rate of 5.25% in the third quarter of 2007 to 4.5% by the fourth quarter of 2008. If the global financial body is right, the world would enjoy next year its sixth-consecutive stanza of solid growth thanks to "generally sound fundamentals and the strength in the emerging market economies."

'Decoupling' from the U.S.

The extent to which other economies have "decoupled" from their traditional dependence upon the U.S. economic engine, however, remains a topic of debate. On one hand, three countries — China, India and Russia — accounted for more than half of global economic growth over the past year, according to the IMF. So emerging markets are expected to shoulder principal responsibility for keeping the global economy moving forward in 2008.

But the U.S. economy remains the world's largest, and a sharp fall in demand here for others' goods will reverberate. Canada and Mexico, sending 81% of their exports to the USA, are the USA's top trading partners — and the countries most exposed to a serious U.S. downturn.

Economic weakness in the USA can hit other countries both by unsettling global financial markets, thus curbing access to capital, and by depressing trade. "The U.S. and Asian economies are not decoupled, and a slowdown here is likely to produce ripple effects lowering growth there," says Janet Yellen, president of the Federal Reserve Bank of San Francisco.

Whether the rest of the world can, in fact, shrug off slower U.S. growth remains to be demonstrated. But the remedies central banks are choosing to fight the credit crunch are putting strains on other parts of the global financial system, which could ultimately damage growth in some emerging markets.

Central banks in the USA, United Kingdom and Canada have cut interest rates in recent weeks, trying to counteract banks' reluctance to make new loans. On Tuesday, the Federal Reserve, which already has trimmed the target for its benchmark rate by three-quarters of a percentage point since September, is widely expected to cut rates again.

The Fed's actions ricochet from Beijing to Dubai. Countries such as China and the oil producers of the six-nation Gulf Cooperation Council, which link their currencies to the level of the U.S. dollar to varying degrees, face a choice between setting interest rates according to the needs of their domestic economies or tailoring rates to maintain stable exchange rates.

That means keeping their exchange rates stable against the dollar and importing inflation or raising their interest rates to head off inflation at the cost of seeing their currencies appreciate. So far, the quasi-dollar-linked countries are swallowing higher prices and the potential for overheating. In Qatar, for example, inflation runs at an annual rate of almost 13%.

Current monetary policies and exchange rates are "completely out of kilter with what these countries need and might actually encourage the bubble in emerging markets to get bigger. … It is really only a question of time before we have this regime change in the global monetary system," says George Magnus, senior economic adviser of UBS ubs in London.

That said, most economists expect the global economy to pull through — unless another unexpected shock hits. "We're in this window of vulnerability. If something else comes along, we don't have a lot of padding," says Harvard's Rogoff. "We're very vulnerable."