Image: Traders work on the floor at Brazil's Mercantile and Futures Exchange in Sao Paulo
Andre Penner  /  AP
Traders work on the floor at Brazil's Mercantile and Futures Exchange in Sao Paulo, Monday, Oct. 6, 2008. Latin American stocks plunged Monday, led by a precipitous drop in Brazilian shares.
By John W. Schoen Senior producer
updated 10/7/2008 12:42:04 PM ET 2008-10-07T16:42:04

For a time, it appeared that the impact of the recent financial panic and ongoing economic downturn might be largely contained to U.S. consumers, businesses and government leaders. No more.

Monday’s global stock market sell-off reinforced fears that the Great American Lending Bubble is now weighing heavily on our major trade partners and the global investors who have been supplying the river of capital that the U.S. economy has come to rely on.

The most immediate impact is being felt by exporters, who have enjoyed something a revival in the past few years as a weak dollar and higher productivity made their products more competitive around the world. But like most businesses those importers rely on credit — both for long-term expansion and short-term funding needs.

Now, as exporters face those home-grown problems associated with the credit drought, their overseas customers are also having tough time borrowing money. As the credit squeeze works its way through the global financial system, trade-related businesses will among the first to get hurt, and exporters are going to take a big hit, according to David Resler, chief economist at Nomura Securities.

“All of our growth in the second quarter was the result of the improvement in our net export position. That’s now over,” he said. “Commerce around the world is ratcheting down, and that feeds on itself. When we buy less from Asia, Asia has less income and fewer jobs to generate(income) to buy from us.”

But the flow of capital across borders dwarfs the flow of goods. That's why the spread of financial turmoil overseas is even more worrisome, according to Chris Varvares, president of Macroeconomics Advisers.

"If foreign investors whose stock values and credit market were functioning well could come in and become buyers and that would support our assets," he said. "If everybody’s going down together, there's nobody out there who’s going step in and provide a floor to these assets. There are no natural buyers. And that’s why we need a coordinated (global) policy response."

On Monday, the panic that began on Wall Street effectively shut down interbank and other loan markets, pushing industrialized countries closer to recession. Even as Sweden, Austria and Denmark followed Germany’s lead by offering guarantees to savers, investors from Tokyo to London continued to slash risk from portfolios and braced for a further tightening of credit and bank lending.

Worldwide turmoilSouth Korea said it wanted crisis talks with Japan and China, and equities crumbled in the Persian Gulf region on concerns the fallout would spread.

Until recently the European Central Bank has been holding interest rates at relatively high levels to keep inflation in check, the ECB’s only official mission. The U.S. Federal Reserve, in contrast, has a dual mission of fighting inflation and maintaining economic growth.

But with the European economy slowing, a European rate cut is looking much more likely, according to Jack Bouroudjian, chairman of Capital Market Technologies.

Major Market Indices

"They’re talking about 7.5 percent unemployment now in the Eurozone," he told CNBC. “They're starting to creep up to levels that are scaring them, even those that are the inflation hawks over there. This is a very important part of the entire puzzle."

Lower rates, especially when coordinated among central banks around the world, have historically had a powerful impact on the markets. But the current downturn is being driven by a force not seen on this scale in 75 years — full-blown panic.

To calm jittery investors and savers, the Federal Deposit Insurance Corp. has raised limits on insured accounts. FDIC Chairwoman Shelia Bair told a group of economists in Washington Monday that the agency's board would consider a measure this week to raise insurance premiums on banks to boost its $45 billion cash reserve. The measure has two goals, Bair said.

“It seems only fair that we shift a greater burden of any increase onto riskier institutions," she told the National Association of Business Economists. "And higher-risk institutions can reduce their premiums by changing their risk profiles.”

But some banks may not be able to change their risk “profiles” fast enough to head off insolvency — especially if they’re strapped for cash just when they’re being asked to pay higher FDIC premiums. That may also help contribute to one of the sources of the widespread uncertainty and anxiety in the markets: No one is really sure which banks are sound and which ones are close to the edge.

That problem is especially pronounced in Europe, where bankers were slower to own up to bad debts because rules are less stringent about “marking to market,” according to Diane Swonk, chief economist at Mesirow Financial. "That means that bad loans may have lingered on the books of Europe banks longer than they did in the U.S."

European bank regulators face an even bigger challenge, she says.

“Unlike the U.S., they have no FDIC, so they're facing this crisis of having to have all these individual countries working together — which have failed to do because they don't want each other's problems," she said. Compounding the problem is that some of the banks are huge.

For a time, economists debated whether the U.S., European and Asian economies had “de-coupled” and were somewhat insulated from regional economic downturns. But like a lot of other assumptions, the global financial panic has laid that idea to rest.

As American policymakers scramble to put out the fire, governments in other regions, including Europe, are finding they’re not as well prepared.

"They’re now realizing they probably need us more than we need them," said Swonk. "They really need us to succeed. Without us succeeding they don’t have the tools. We have a bigger toolbox, and we’re inventing new ones every day."

For months, economists have been debating just how the ongoing downturn will play out — often referring to various alphabet shapes to describe the economy’s trajectory — a “V” shape for a quick turn down and rapid recovery, a “W” shape for a recovery that slides back down again; and “L” for a slump that lasts for some time.

Some economists suggest that if financial panic can be contained and the collateral damage minimized the recovery could come sooner than the current turmoil might indicate.

"My belief is this will be an intense period of contraction, people pulling back," said Brian Wesbury, of First Trust Advisers. "But then we should come through this on the other side by early next year and really come out of this quickly."

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