The crash that could come
HISTORICALLY, October has been the month for big financial busts. But this year, October could come early.
Investors and ordinary citizens have good reason to worry about a perfect economic storm: a deepening loss of confidence in the dollar leading to higher interest rates; the higher rates bringing a crashing end to a hedge-fund, private equity, and merger binge that has depended heavily on cheap borrowed money; the boom in bait-and-switch mortgages ending in a morning-after of rising defaults and sinking housing values; inflationary pressures in food, oil, and other commodities leading to still higher interest rates -- all unsettling stock and credit markets and putting a new squeeze on consumers borrowed to the hilt.
The historical parallels aren't comforting. In the years 1971-73, the United States devalued the dollar and went off the gold standard. Oil exporting countries, compensating for a weaker dollar and angry at US support for Israel, hiked the price of oil. This set in motion a decade-long period of stagflation -- high inflation, tight money, sluggish growth, shaky banks.
If anything, the United States is more vulnerable today. In that era, America enjoyed a net inflow of earnings from global investments, ran a trade surplus, and lent far more than it borrowed. As tourists of the 1960s appreciated, visiting Europe on a pittance of $5 a day (in 2007, $5 buys coffee), the dollar was way overvalued relative to Europe's play-money currencies and overdue for a correction.
But today, our trade deficit is more than 6 percent of gross domestic product, and we borrow heavily to finance both private capital needs and government debt. Until lately, optimists insisted that cheap foreign debt-financing would continue indefinitely and prop up the dollar, because it was in China's interest to keep underwriting American purchases of its ever-expanding exports.
But, swollen with dollars, China is behaving more like an activist investor. The Chinese government's investment arm has begun buying not just debt but real assets, including 9.9 percent of the private equity fund Blackstone and a big chunk of Barclays bank. We can't count on China -- or anyone else -- funding America's burgeoning foreign debt at bargain rates indefinitely.
If the dollar slide turns into a crash, the Federal Reserve would face the unhappy choice of either hiking interest rates to raise foreign confidence in the dollar (thus deepening domestic recession) or letting the dollar sink further and increasing imported inflation.
With 3 billion new consumers in Asia putting pressure on oil supplies, oil exporting nations warn that a declining dollar means further price hikes. Food experts, pointing to everything from global warming to diversion of farmland for ethanol production, project rising food prices. Increasing inflation could lead central banks to tighten money generally.
And the prospect of higher credit costs has Wall Street increasingly edgy. The Wall Street Journal recently tallied 21 credit deals ranging from $150 million to $20 billion since mid-June that had to be scrapped or delayed because nervous investors balked at the proposed financial terms.
The unsold homes backlog is at its highest level in 15 years, according to the Financial Times. It reports a 57 percent drop in the stock price of building companies in the past two years. Busted private equity deals and predictions of a deeper housing slump sent the Dow down 520 in two days.
Ironically, what economists call the "real" economy, as opposed to the financial economy, has never been stronger. Every day brings stories of fabulous new uses of the Internet, dazzling applications of advanced technologies, and ingenious new consumer products. But every economic depression since the early 19th century has been the result of excesses in the financial sector undermining the real economy. 1929 was also a banner year for new technologies and nifty consumer products.
When historians sort out what could well be the recession of 2007-08, they will wonder why regulators did not act before the speculative binge in hedge funds, private equity, derivatives, and subprime mortgages pushed the larger economy into a general downward spiral. As always, the details will be complex, but the basic reason is pretty simple -- too many well-connected insiders were making too much easy money.
Personal note: The Globe has graciously published my weekly column since 1985. With a variety of other projects in the works, including magazine articles and two books, I will now be writing columns roughly once a month.
Robert Kuttner is co-editor of The American Prospect and a senior fellow at Demos. 
