Is the Boom in Peril?

By Robert J. Samuelson
Wednesday, August 22, 2007

Just a few weeks ago, Fortune magazine pronounced the world to be in "the greatest economic boom ever." This may be, but the turmoil in stock and bond markets poses some unnerving questions. Is the global economy stable? Or might its periodic crises someday lead to a calamity?

Go back a century, to when the world enjoyed another fabulous boom. From 1896 to 1913, trade roughly doubled. Declining steamship and telegraph costs were melding countries together. "There was something close to an integrated world market for most goods," Harvard political scientist Jeffry Frieden writes in his book "Global Capitalism." In 1870, wheat prices in Liverpool were about 60 percent higher than in Chicago; by 1913, the gap was 16 percent. European investors eagerly bought bonds of then-developing societies -- Argentina, Australia, the United States.

Compared with this earlier extravaganza, today's boom still impresses. From 1990 to 2005, trade rose 133 percent. Supply chains are increasingly global. Since 1985, imported components as a share of worldwide manufacturing output have doubled, to almost 30 percent. Cross-border money flows (for stocks, bonds, loans, real estate, entire companies) are huge: $6 trillion in 2005, says the International Monetary Fund. Finally, the boom has reduced acute poverty. The share of the world's population living on $1 a day or less has dropped from 40 percent in 1981 to 18 percent in 2004, the World Bank estimates.

The vast flows of goods, services, technology and money have clearly done much good. But there's a less reassuring comparison with the past. The world economy collapsed during World War I and could not be successfully reconstructed in the 1920s. Britain, which had stabilized the old trading and financial system, was too weak to resume its leading role. The failure to find an alternative abetted the Great Depression of the 1930s.

Today's global economy undeniably faces some big, potentially destabilizing threats, oil being the most obvious. The world now uses 86 million barrels a day; almost a quarter comes from the Persian Gulf. The rise of new trading powers, particularly China, has altered global politics. Conflicts may grow; cooperation may be harder.

Global finance also belongs on the list. Anyone claiming to understand today's world financial system is either delusional or dishonest. There are more financial players (hedge funds, private equity funds) than ever, more types of securities (more "derivatives" and more loans, such as mortgages, bundled into bonds) and more cross-border transactions.

Although subprime U.S. mortgages -- home loans to weak borrowers -- are the center of attention, they're not the real problem. Altogether, the riskiest U.S. mortgages total about $1.7 trillion, reckons Moody's Losses will probably exceed $100 billion. Even at twice that, they're chump change compared with the total value of all global stocks, bonds, securities and bank loans. In 2005, that was $165 trillion ($50 trillion in the United States alone), says the IMF.

The real problem is the unanticipated nature of the losses, which has triggered a broad reappraisal of risk. Investors don't know who holds the bad subprime loans. Some European banks and funds turned out unexpectedly to have suffered large losses. Nor do investors know whether subprime losses foretell other bad credits. So investors are retreating from risk. Many are shunning loans and securities that only recently were considered routine.

The result: a "credit crunch." Last week, outstanding U.S. commercial paper -- a type of short-term business loan -- fell a huge $91 billion. "It was an eye-opener," says economist John Lonski of Moody's. Countrywide Financial, a big mortgage lender, had to tap an $11.5 billion backup bank credit because its regular financing sources (mortgage-backed securities) were drying up. To ease fears, the Federal Reserve cut the interest rate Friday on its "discount window" -- a facility through which banks can borrow from the Fed.

Global capitalism, Frieden writes, survived earlier only until it stopped producing widespread prosperity. No problem, say many economists. The U.S. economy may slow (housing remains a drag), but Europe, Japan and many "emerging market" countries have strengthened. The rest of the world is depending less on U.S. trade deficits, which could subside. Government central banks such as the Federal Reserve will prevent any financial panic. Global Insight, a forecasting firm, predicts world economic growth of 3.6 percent this year and next, down only slightly from 3.9 percent in 2006.

Well, maybe. But there's another view. Economist Joseph Mason of Drexel University argues that the basic financial threat today is "over-borrowing" by investors to buy risky securities. That implies more losses as investors scramble for safety by dumping weak bonds and loans. Given today's global money bazaar -- losses in one market may spill over into others -- the danger would be a worsening "credit crunch" that corrodes confidence and dooms the world boom. As history suggests, there are no guarantees.

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