Did you foresee the sub-prime credit crisis becoming such a big issue here in the U.S.?
I don’t think anyone really did, certainly not its pervasiveness that is now evident. When we first started seeing the effects, most people thought we’d feel just a pinch. Even the Federal Reserve and top academic economists didn’t foresee this becoming the huge issue that it is today. It’s had a much larger impact because these sub-prime loans were bundled into securities whose value couldn’t be readily accounted for. Starting roughly with the summer of 2007, a cooling real estate market initiated defaults of these “high loan to value” loans, which in turn soured the demand for these “derivative” securities devaluing them essentially to an uncertain degree. This created uncertainty as to the health of many financial institutions holding these securities. Besides, reducing the appetite for risk, this eventually triggered massive write-offs at Citibank, UBS, and others that we’ve heard so much about.

Why has this crisis in the U.S. affected the rest of the world differently than in the past?
First and foremost – though not exclusively – the rise of China and India as emergent economic powers means they are less reliant on the U.S. economy and so don’t feel the effects as much.

But isn’t China sending us all of their exports? So aren’t they going to feel the impact since we won’t be buying as many goods from them?
It will slow down their exports, yes, but they’ve also developed strong domestic demand for their products. They certainly have money in their own pockets, enough so that they’ll keep their economies humming much more than they would have if the U.S. faced such a downturn a decade ago.

What about credit around the world? Why won’t the rest of the world feel the same credit crunch that we have here in the U.S.?
In the past, the U.S. and its banks were the financiers of the world, coming to the rescue if there were ever any international economic crises like the ones we saw in Asia in the late ’90s or Mexico in 1994. Today, though, some of these other countries, awash in profits from rising oil revenues, are bankers for the rest of the world. Money is certainly flowing more freely, and these days a lot of that comes from sovereign wealth funds.

What role do sovereign wealth funds play?
A sovereign wealth fund is owned by a government rather than a private company or individuals. In 1970, the total amount of capital in sovereign wealth funds was about $500 billion. Today, it’s $2 to $3 trillion – a four- to six-fold increase. The U.S. has sovereign wealth funds. So does Russia, Norway, and many other European countries. But everyone associates these funds with the Middle East, because 75 percent of the funds are built on oil and gas revenues. These are largely held by countries hugging the oil-rich Persian Gulf. The impact is that the credit channels around the world are buffered because the world no longer needs to rely on the U.S. for financing. These countries have become the bankers for the rest of the world even siphoning capital into some hard hit financial institutions in the U. S. such as Citigroup.

How might the weaker U.S. dollar impact this crisis?
The lower dollar is going to actually help us, because it’s going to increase our exports. It will help shore up the economy when we need it most. But imports become more expensive with a weaker dollar so there is some danger of “imported” inflation. So the Fed has to do a balancing act to avoid “stagflation” – stagnation of the economy and inflation at the same time. The irony of the benefits of increased exports from a weaker dollar is that there’s a negative psychological effect brought on by a weaker dollar.

What do you mean, a “psychological effect” from a weaker dollar?
People have this image that a strong currency always means a strong country. It’s this somewhat unwarranted “macho” attachment. So when we have a weaker dollar, it makes people feel vulnerable and thus reduces consumer spending, which is two-thirds of GDP.

What about the psychological impact of a U.S. downturn abroad? How does a lack of confidence in the U.S. economy cross borders?
That’s the one primary thing that stays the same. A lack of confidence in the economy at home still creates a crisis of confidence in economies around the world. That speaks to the fact that the U.S. is still a huge player on the world stage, even if it is not as big as it was in the past.

Where do you think this downturn will end?
The last recession in the U.S. lasted eight months from peak to trough. It was, however, somewhat shorter than the recessions we saw before World War II when most recessions lasted 10 to 11 months. Of course, there was the Great Depression, where recession lasted 43 months. The current downturn is gearing up to be a relatively sharp one. 2008 certainly looks like it will be a wash. However, early- to mid-2009 should see the economy move to an upswing, in part, because the uncertainties of a presidential election year will be behind us, and the current monetary and fiscal stimulus will have fully made their impact known. But it’s important to recognize that the way these things are evaluated is by looking in the rearview mirror. It’s only when you’re coming out of a recession or a downturn that you can look back and say, “Oh, we just went through a recession.”

If we go into a recession, how do you think this will affect the rest of the world?
Most likely, countries around the world will be bruised, but not mortally wounded by the U.S. economy’s downturn. However, if we do go into a deep recession, then you will see that buffer begin to break down to a much greater degree and the U. S.’s “sneeze” may still induce a world-wide cold.