Behind the Global Markets' Meltdown

The action was carefully coordinated for maximum effect. First came an early-morning announcement by the British government that it had crafted a $90 billion rescue package for its banks. Then five central banks from around the world, including the two big ones — the U.S. Federal Reserve and the European Central Bank — announced a cut in interest rates. Jean-Claude Trichet, president of the European Central Bank, described the cuts as an "important mark of confidence" that showed an "intimate cooperation" among monetary authorities around the world. Under normal circumstances, such measures would have bucked up moods and stock prices in financial centers across the globe.

Instead, the big concerted action of Oct. 8 passed with barely a shrug from Wall Street. Stock markets worldwide continued to roil, and banks everywhere remained in the firing line. "Confidence has completely crashed, and it will take a while to rebuild it," says Craig Wright, chief economist at the Royal Bank of Canada, who is nonetheless hopeful that these and other measures will eventually start to work. "But it's hard to hear positives in a thunderstorm of gloom."

The mess caused by fast-and-loose mortgage lending in the U.S. has now blown into a perilous global crisis of confidence that has revealed both the scale and the limitations of globalization. Finance is built on trust, and suddenly that trust has been replaced by fear: fear among depositors from Madrid to Macao over the safety of their money; fear among banks worldwide about lending to one another; and now fear among politicians, central bankers and regulators that they don't have adequate tools to fix the problem.

At the root of the troubles are the "toxic assets" — the highly leveraged securities mainly linked to U.S. mortgages — that banks around the world still have on their books. In its latest estimate this month, the International Monetary Fund (IMF) calculated that losses on these now virtually worthless securities could amount to $1.4 trillion. So far, banks have written off less than half that. Concern about who is still holding dud paper has gummed up credit markets, with banks refusing to lend to one another for fear that the borrowers may default or may have themselves lent to other banks that could default. That in turn is causing solvency problems for some financial institutions that rely on short-term borrowing to fund their operations.

The pain will soon come to Main Street — in Beijing and Brussels as much as in Boise. Economists are already outlining the downward spiral that they predict will follow. Banks will cut back on their lending to households and businesses. Mortgages and car loans will become harder to get. That in turn will stifle consumer spending and crimp investment in companies, leading to production cuts and job losses. Judging by previous crises, it can take about 18 months to two years for a financial squeeze to spread to the rest of the economy, which means that 2009 is shaping up to be a bleak year everywhere.

If the global financial meltdown can be traced to an American export — the subprime mess — the U.S. will import the consequences. As the go-go economies of China and India hit the brakes, so too will demand for American goods and services. That will have a knock-on effect on jobs and the earnings of companies that rely heavily on international sales. (One small silver lining: as their economies have slowed down, China and India have decreased their consumption of oil, contributing to a fall in prices, both globally and at the pump.)

In its latest economic outlook, published on Oct. 8, the IMF predicted that the U.S. economy will grow just 0.1% next year, its worst showing in 18 years. Europe is expected to fare no better, and China, India and other emerging economies that have been critical drivers of global economic growth over the past five years are also expected to slow markedly. That means nobody will be able to take over for the U.S. as the locomotive of the world economy, and everyone will drag down everyone else. Overall, the IMF expects world economic growth to slow to 3% in 2009, from 5% in 2007, and it warns, "The world economy is now entering a major downturn in the face of the most dangerous shock in mature financial markets since the 1930s." Wright of the Royal Bank of Canada predicts, "The U.S. will go into a shallow recession, unfortunately followed by a shallow recovery."

Xu Lejiang says it's already happening. He's chairman of Baosteel, one of China's giant steelmakers, and since August, he has had to cut prices twice as demand suddenly cooled off in what had been a booming industry. The era of rapid growth for Chinese steel "will soon be remembered as history," he says. The Chinese stock market has also been hit hard — it's down about 60% this year — but the nation's banking system has for the moment largely been sheltered from the international storm because it's only partly open to the global capital flows that have circulated so many toxic assets. China's economic growth has been a critical factor for the U.S. because working in tandem, the nations have served as the twin motors of world economic growth: American consumers have snapped up everything that the Chinese have manufactured, from toys to apparel, and in return the Chinese have helped to finance America's deficits by accumulating ever larger amounts of U.S. debt. If their economy hits the brakes, Chinese will buy fewer GM cars, Chinese steelmakers will use less U.S. iron ore, and Beijing may want to use its cash reserves for other purposes, including investment at home to stimulate its own economy rather than to bail out the U.S. Treasury.

China's huge currency reserves and its vast holdings of U.S. securities make it a key player in the U.S. financial markets. If the Chinese decided to shift any of their money out of the U.S. or the dollar, it would cause a huge upheaval, potentially sending the dollar skidding and hurting markets even further. For the moment, though, China hasn't given any hint that it's unhappy about owning rapidly depreciating U.S.-dollar assets. (The greenback has actually strengthened in recent days, but some caution that this is temporary.)

(Click here for pictures of the global financial crisis.)