World Markets Catch a US Cold

A former chairman of the Federal Reserve Board famously described his job as "taking the punch bowl away just when the party is getting good." Current Fed chief Ben Bernanke wishes it were so. With stock markets around the world reeling, and with a deep housing slump in the United States crippling growth in the world's largest economy, Bernanke's Fed is now frantically ladling the punch out — even though almost everyone already has a brutal hangover. The Fed's surprise January 22nd rate cut — it slashed its key interest rate three quarters of a percentage point, and signaled that another half point cut could come as soon as next week — arrested, at least temporarily, the rout in equity markets around the world, which had hit Asia's bourses particularly hard. In the trading day before the rate cut, Hong Kong's Hang Seng had declined 8%, Tokyo's Nikkei 5.7% and Mumbai's Sensex 12 percent.

Asia's markets rebounded smartly on Wednesday, after the Fed's move, but the fact remained that investors worldwide were finally absorbing an unavoidable truth: the United States, still the biggest market for the world's exports, appears to be in real economic trouble. Most economists now believe the U.S. is either already — or soon will be — in its first recession since 2001, and that this one could be a doozy. "The asset bubbles underpinning the US economy have started to unwind the other way," says Stephen Roach, Chairman of Morgan Stanley Asia. "This recession was triggered by the bursting of the housing bubble and the bursting of the credit bubble and those developments will run their course [even with the rate cuts]."

Rapid growth in China, India and other emerging markets had spurred a lot hopeful talk about how they had "decoupled" from the world's traditional growth engine, the U.S. South Korea, for example, now exports more to China than it does to the United States. But developing nations have been anything but safe havens in the recent turmoil, indicating that the decoupling theory will now be tested with a vengeance. "There's no question the slump in the US will have hurt [Asia's] exports," says Shanghai-based economist Andy Xie. Morgan Stanley's Roach believes decoupling is "one of those nice theories you hear at the top of market bubbles." The fact is, Roach argues, "that Asian consumers are too small to make up for the void created by U.S. consumption."

How badly Asia will feel the effects of the U.S. slump depends on its depth and duration. A mild, relatively short U.S. downturn might not be entirely a bad thing in the country that's become the world's second growth engine: China. Most economists believe inflation remains China's biggest risk going forward, and a slow down in the export sector — now unavoidable — could actually do the People's Bank of China's work for it: cool the economy a bit without the need for another rise in interest rates. (The PBOC raised rates six times in 2007).

But it's not at all clear that mild and short is what the U.S. will get. Merrill Lynch & Co. put out a chilling forecast on Jan. 22, saying that the U.S. housing debacle has a long way to run. According to Merrill, nationwide home prices could fall 25 to 30 percent from present levels, which, if true, would put U.S. consumption on ice for a prolonged period.

How long? Economists at Morgan Stanley believe the Fed rate cuts — past and future — are part of what it calls the "Great Global Monetary Easing of 2008," which will begin to spur a new round of worldwide growth next year. But getting from here to there is going to be painful. Demand for everything from iron ore mined in western Australia to toys manufactured in southeastern China is already slowing, because for the first time in decade, the "key driver of the global economy, the U.S. consumer, seems to have finally thrown in the towel," says Xie. If that's true — if the American consumer's decade long, credit-driven party is really over — then soon enough they're not going to be the only ones suffering from a hangover.