the end is the begining

The worst of the financial pain may have passed, but the U.S. economic pain could be just starting. Financial markets have rallied since early March, with stocks up and yields on risky corporate and mortgage-backed bonds falling relative to safe U.S. Treasuries. Optimists got an added boost Friday on a government report that U.S. unemployment dipped in April. But history suggests celebration is premature. It is common in a crisis for markets to hit bottom long before the economy does. That is because markets are forward-looking and because economic weakness is the way the underlying imbalances that produced a crisis are corrected. "The financial crisis is usually an expression of broader problems in the economy," says Harvard University economist Kenneth Rogoff who, along with Carmen Reinhart of the University of Maryland, recently wrote a history of financial crises back to the 1300s. "It's a mechanism that exacerbates and deepens the recession, but it's seldom the trigger." The economic fallout from a crisis depends a lot on how much underlying economic factors -- such as consumption, investment and asset prices -- are out of whack with their fundamental determinants. The 1987 stock-market crash and the 1998 near-collapse of hedge fund Long Term Capital Management threatened the heart of the financial system. But the underlying imbalances were largely limited to the financial markets themselves: stocks overvalued relative to earnings in 1987, and excessive hedge-fund borrowing in 1998. Thus, once the U.S. Federal Reserve's rescue operations had mitigated the threat to the financial system, the economic fallout was limited. The current crisis is different. For several years U.S. home prices and home construction kept climbing past levels considered sustainable by rents, incomes and demographics. Homes became the collateral for trillions of dollars in household borrowing. That depressed savings, inflated consumption, fueled rapid lending and loosened lending standards to households, businesses and speculators. When home prices stopped rising, the diciest mortgages began to default, triggering the crisis. But even now, prices are still above most estimates of sustainable levels, and household savings has barely picked up. Even if the Fed's bailout of Bear Stearns Cos. in mid-March proves the apex of the crisis, as some now think, the economy could still contract as consumers adjust to lost wealth and reduced access to credit. For a parallel, the U.S. might look to South Korea. Its financial crisis peaked on Dec. 24, 1997, when its currency, the won, hit its all-time low against the dollar, less than half its value of earlier that year. The International Monetary Fund and the U.S. Treasury orchestrated a rescue and persuaded foreign banks to roll over their loans to Korea. Over the ensuing year, the won rose 63%. But the economy sank into a deep recession. In 13 months the unemployment rate soared to 7.9% from 3%. The economy shrank 6% in 1998, a huge shock to a country accustomed to 8% growth. At first Korea appeared to be an innocent bystander caught in the storm sweeping through Asia. In fact, the economy had been bolstered for years by overinvestment by its chaebols, or industrial conglomerates. They financed extensive capital investment by borrowing heavily from banks on preferential terms, says Kihwan Kim, at the time a key Korean government official managing the crisis and now an adviser to Goldman Sachs Group Inc. The banks in turn borrowed in dollars from overseas. But in early 1997, several chaebols, which had been losing competitiveness to Japan, began to experience financial difficulty. When Korean banks lost their ability to borrow overseas, many failed; those that survived severely cut back lending. The chaebols slashed investment and laid off thousands of workers. Many went bankrupt. Layoffs and recession were a huge shock to Koreans who "were so used to high growth and very low levels of unemployment," recalls Mr. Kim. He and many others believed a "sharp downturn was unavoidable, [though] the people in the government tried to do their best to avoid it." Ted Truman, a scholar at the Peterson Institute for International Economics who worked on the Korean rescue as a Federal Reserve official, says the overexpansion and excessive borrowing of Korea's corporate sector in the run-up to its crisis are analogous to the overexpansion of housing and consumption in the U.S. in its crisis. In both cases, a collapse in the affected sector severely wounded the financial system. Korea's recovery was led by exports, much as exports are proving a cushion to the U.S. now. Korea's recovery began in 1999. But Mr. Kim says capital investment has never fully recovered and that economic growth, while a healthy 4% to 5%, hasn't returned to the precrisis pace. Unemployment is deceptively low, he says, because of hidden unemployment, such as students who can't find jobs staying in school longer. Korea's lesson to the U.S., he says, is that "imbalances must be corrected." A recovery doesn't need a full resolution of those imbalances, he says, only a "convincing sign that change is taking place." The risk for the U.S. is that economic weakness goes beyond the correction of housing excesses and begins to feed back into the financial system and then, again, hurts the wider economy. Korean consumers didn't borrow much, so high unemployment and banking stress didn't feed back on each other. By contrast, Nouriel Roubini, an economist who heads RGE Monitor, a financial- and economic-forecasting service, says the U.S. financial system has so far adjusted only to the losses on mortgage loans. He predicts that a wave of defaults on industrial loans, municipal bonds and consumer credit is coming, which will trigger another wave of financial-system distress. Fed Chairman Ben Bernanke believes such feedback effects are what made the Great Depression great. Between November 1929 and May 1930, stocks rallied about 38% on hopes the recession would be mild. A wave of bank failures beginning in the fall of 1930 dashed those hopes and plunged the U.S. into three more years of contraction. Mr. Bernanke's awareness of such risks is why he cut interest rates last week and, despite signaling a pause in further cuts, is still focused on the risks that the U.S. economy may deteriorate further.