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CRUNCH TIME.
The economy narrowly avoided a meltdown. But the road ahead isn't pretty either.

THE GOVERNMENT’S MASSIVE RESCUE OF THE FINANCIAL INDUSTRY MAY HAVE SPARED THE COUNTRY A RERUN OF THE GREAT DEPRESSION. BUT THE U.S. ECONOMY IS STILL IN FOR A ROUGH COUPLE OF YEARS.

The government’s aid package aimed to help banks that invested in the home-mortgage business, which soured after a wave of foreclosures. To reduce the burden on banks—so that they can continue to make loans for homes, cars, business expansion and education—the government agreed to buy those soured investments and shoulder the risk. Without such a move, experts said, our economy, which relies heavily on credit, would have ground to a halt.

But despite the passage of the rescue and many more frantic steps by the government to shore up the financial system, lending by banks remained largely frozen for weeks because of lingering fears that loans won’t be paid back. And the rescue bill did little to solve some fundamental problems in the economy, which was already weakened by falling housing prices, higher food and energy prices over the summer, slowing consumer spending and steep job losses.

If credit remains tight, business spending is likely to be choked off and layoffs would grow. Consumer spending is likely to turn negative, as households feel the pinch of job cuts and decreased purchasing power.

The prospect of such a future, along with the persistent credit freeze, has led to sharp declines recently on the stock market, which further eroded the wealth and confidence of Americans. People with college-savings accounts and retirement-savings accounts tied to the stock market have been hit hard.

All of this poses a serious challenge for the next president, who will likely take over a country in the midst of a deep recession, even if the credit crisis begins to ease. According to economists surveyed by The Wall Street Journal, the U.S. economy has already sunk into a recession. “We’re in the middle of a very dark tunnel,” says economist Brian Fabbri. “Each day we see another crack in the system.”

GLOBAL IMPACT

Indeed, the major pillars of U.S. economic growth— consumer and business spending, government spending, and exports—are crumbling, and the effects are rippling throughout the world. Foreign demand for

U.S. goods, which has helped U.S. factories stay afloat this year, is expected to dry up as the world’s major economies flirt with recession and fast-growing developing nations lose momentum.

Already, in oil-rich Russia, the easy credit that powered consumer spending is now starting to contract. In India, outsourced jobs from Western financial companies are dwindling, and retailers are bracing for tough times. In Brazil, prices for the commodity exports the country relies on are falling. And in China, a stock-market collapse and deflating property prices are causing consumers to think twice about major purchases.

In Shanghai, China, businessman Yan Jian says his business exporting toys and clothing has been hurt by fewer orders from the U.S. So he postponed the renovation of the new apartment he bought last year. “Things may get even worse in the near future,” he says. “I have to hold back as much spending as possible.”

If this attitude spreads, it’s bad news for the global economy. Although consumers in the big four emerging economies are still relatively poor compared with Americans, their growing appetite for refrigerators, cars and flat-screen TVs has been almost as important to the global economy recently as U.S. consumers.

Two related factors are at the heart of the U.S. economy’s troubles today: a downturn in the housing market, which strikes at the core of most Americans’ wealth, and a “credit crunch,” or a lack of money available for consumers and businesses to borrow. Economy.com estimates that banks made 15 million sketchy home-mortgage loans from 2004 to 2007, and that ultimately 10 million of those will be in default—meaning borrowers will stop making payments. Those defaults are forcing down home prices, and causing banks to crack down harder on borrowers, contributing to still more defaults and even lower home prices.

It’s not just households that got in trouble with debt. Banks did as well; they borrowed money from one another and lent it back out at higher interest rates, pocketing the difference in profits. Those profits grew strongly for a while. But with more borrowers defaulting, those profits are offset by big losses. Without money to lend—or confidence in their borrowers— banks can’t do business. And without access to credit, businesses can’t stock merchandise, hire staff, order materials, expand or meet payrolls.

Across the U.S., companies are cutting staff and scrimping on everyday expenses to deal with the squeeze. In Rhode Island, yacht builder Hinckley has shed 49 workers, or about 9% of its workforce, citing a sudden slowdown. “The tipping point really was the last 30 days,” says Edward A. Roberts, vice president of marketing. Customers who negotiated contracts to buy boats were suddenly unwilling to sign, he says.

DEBT, DOLLAR, DEFLATION

One significant risk in this type of downturn is that government debt tends to soar, as safety nets and bailouts kick in. In the U.S., government debt is still relatively low in proportion to the overall economy. But it’s sure to soar in the aftermath of this crisis, as the government borrows more to prop up failing financial companies. The government could ultimately realize a profit from its moves, but in the meantime, the heavy borrowing could constrain future administrations as they seek to tackle budget problems such as Social Security, Medicare and Medicaid.

Some economists are discussing a worse scenario: Foreign investors’ confidence in the U.S. financial system could diminish and they could cut their investments in U.S. stocks and bonds. These investments are what makes the country’s deficit spending possible. The inflow of funds helps to fill the growing gap between what the U.S. collects in taxes and what it spends.

If foreigners stopped buying U.S. assets, or started selling them, our markets would fall further, the dollar would lose value, and U.S. interest rates would jump, hurting the economy further.

Another risk to the economy is deflation, or a decline in prices. When borrowers run into trouble, they need to raise money, and try to sell assets as quickly as they can. That tends to force the prices of those assets lower. A slowing economy also puts downward pressure on prices, as demand for goods declines.

Deflation brings its own set of problems. If people and businesses expect prices to fall, they have an incentive to put off spending, further weakening the economy.

A HAPPY ENDING?

The disaster scenarios are scary, but maybe no more plausible than a happy ending. The U.S. economy has just gone through a 26-year period with only two short and relatively shallow recessions—despite two wars in Iraq, a technology-stock crash, terrorist attacks, an oil-price surge and many other shocks.

One reason is that policy makers in recent decades have been able to react rapidly to changing circumstances; with more information available to them, they can anticipate crises and deal with them before they happen—or at least before they get worse—by adjusting interest rates, changing laws or intervening in the market, all of which they did in recent months.

Another reason is technology. During the 2001 recession, many companies insulated themselves by using technology to squeeze more output from their existing work forces. It proved painful for workers, who suffered through a protracted job downturn, but set the stage for a profit boom that helped to drive the economic recovery.