Moscow's Sinking Ship

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In a sign that the U.S. economy is starting to tank, I find myself discussing economics with people who ordinarily shun such subjects. My professional contacts -- financial advisers, stockbrokers and money managers -- have already been hurt by the financial crisis. Pervasive news coverage of economic problems, such as the collapse of venerable Bear Stearns over the weekend, is getting even ordinary Americans worried.

In Russia, it is still business as usual. Even top executives remain sanguine. Even as the dollar fell below the Swiss franc for the first time ever and Bear Stearns disappeared, oil hit $111 per barrel and gold surpassed $1,000 per ounce. On top of continued inflows of petrodollars, Russia has hard currency reserves of more than $486 billion and a stabilization fund of roughly $156 billion. Why should anybody in Russia be concerned with an esoteric corner of the U.S. mortgage market?

People tend to think of the economy as a collection of isolated segments. There is the housing market and there is Wall Street -- and they have their place of employment, which has no link to the other two. Why, many Russians wonder, should the U.S. financial crisis affect their jobs, especially if it happens to be on the other side of the globe? It is as though a fire in the Konkovo district of Moscow forced an evacuation at the Metropolitan Opera in New York.

In reality, the modern economy is a single, seamless entity linked across national borders and nourished by the global financial system. We are probably witnessing the early stages of the crisis of the financial system, which will be felt everywhere around the world, from Astrakhan to Zurich and points in between.

In this decade, monetary conditions have been unusually lax. The U.S. Federal Reserve, led first by Alan Greenspan and then Ben Bernanke, kept dollar interest rates artificially low. The surfeit of money ended up on corporate balance sheets and at banks. Easy credit and plentiful liquidity created price bubbles in a variety of markets, from stocks to art and commodities, funding a dramatic rise in real estate prices and a leveraged buyout spree.

The dollar is the world reserve currency, and when the Federal Reserve prints too many dollars, there is little foreign central banks can do to limit money supply at home. Americans paid dollars for imported goods and natural resources, which meant that the rest of the world also became oversaturated with liquidity. Much like the rest of the world, Russia experienced an explosion of lending. Russia's consumer loans rocketed over the past five years, from around $5 billion in 2003 to more than $100 billion last year.

The U.S. subprime mortgage market is not an isolated segment but an integral part of the worldwide credit pyramid and natural outgrowth of easy credit. Banks like to lend to U.S. homeowners. Mortgages have been a consistently profitable business for banks, since few homeowners default, houses provide solid collateral and an efficient system exists for selling mortgages as asset-backed securities. Cheap mortgages flooded the U.S. real estate market, and house prices rocketed. Rising house prices, in turn, made mortgage lending seemingly risk-free. Seeking new customers, it was only a matter of time before lenders hit upon an underserved population -- the poor. True, they couldn't afford their homes, but if house prices kept rising, it didn't seem to matter.

A mortgage to a single mother in Wichita, Kansas, and a car loan to a hard-drinking plumber in Perm both stemmed from decisions made by U.S. central bankers in the first half of the 2000s. They were both weak links of the financial system. The only difference is that the U.S. subprime mortgage market was big enough to start a chain reaction that is dragging down world financial markets.

Price is the language in which markets communicate with market participants. By distorting the value of money, the Federal Reserve caused markets to send wrong messages. The bubble in the housing market boosted the U.S. economy by creating a construction boom. The ability to borrow against appreciating homes -- and the willingness by banks to lend -- stimulated consumer demand. To produce goods and services to meet inflated U.S. demand, China, India and other producers around the world began to invest, especially since investment funds were so cheap.

When the subprime crisis hit and banks became wary of lending, the situation changed swiftly. Credit is now harder to come by, and U.S. demand is sagging. Banks are starting to price their loans more realistically, taking into account real credit risk. The result is sudden rigor mortis in the financial system.

And there is more to come. The Federal Reserve has slashed interest rates and is pumping billions of dollars into banks in the hope of encouraging them to lend. That has not happened. U.S. house prices continue to weaken and stocks are falling. Looking elsewhere to invest, investors have poured money into commodities. Unlike the 1970s, most commodities are now traded on futures markets. A speculative bubble of massive proportions has developed in oil, copper and gold, as well as in food and agricultural commodities. Market players note with concern that commodity prices are rising even as underlying demand for them weakens.

This is a recipe for disaster. Commodity prices may continue to rise on speculative demand, but they will eventually tumble. Rather than having a salutary effect on the world economy, a drop in commodities will trigger another leg of the financial crisis, exacerbating the credit crunch.

Economist Robert Reich, who was labor secretary under U.S. President Bill Clinton, recently said a U.S. recession would have little impact on developing nations. Oil producers in the Middle East and Russia are flush with petrodollars. China has what he calls sino-dollars. Their capital spending, Reich noted approvingly, is still growing at double-digit rates.

Investment is a good thing, but only if the goods and services it provides can recoup the value of investment. When there is overproduction, as seems to be the case now, additional investment is not only bad -- it is potentially catastrophic. When producers can't repay the money they have borrowed, they create additional problems for the financial system by slashing their prices and thus bringing down their competitors.

As for the trillions of dollars accumulated at central banks and sovereign funds around the world, including in Russia, there is something that should be kept in mind: Since mid-2007, world central banks have pumped hundreds of billions of dollars into their financial systems. In a financial crisis, money tends to flow like water in the desert sand.

The United States is not only the world's largest consumer, absorbing one-third of its resources, it is the linchpin of the world economy. The dollar is central to the global financial system. To hope that the rest of the world can survive a U.S. downturn unscathed is like saying that a high-stakes poker game can go on uninterrupted on the top deck of the Titanic while its hull is taking in water.

Alexei Bayer, a native Muscovite, is a New York-based economist.