Dump and Run; The easy money is gone. Goldilocks has vanished. And the result, a frenzied sell-off in global markets, may be the harbinger of something worse to come.

Byline: Karen Lowry Miller

The United States had enjoyed a Goldilocks economy: not too hot, and not too cold, but just right. Growing, but not so fast as to spark inflation. Then the May mayhem ended that fairy tale. Emerging markets tanked, commodities plummeted and stocks in the United States and Europe gyrated on fear that central bankers may have to continue to raise interest rates to fight inflation. If rates go too high, the economy could cool off fast. "Goldilocks has gone missing," says London market strategist Pelham Smithers.

This turmoil also marks the end of another fantasy of sorts: the easy money created by years of historically low interest rates. After the dot-com bubble burst in 2000, the U.S. Federal Reserve cut rates to 1 percent by June 2003, unleashing a torrent of super cheap loans that sent money sloshing into one asset class after another--stocks, bonds, real estate, commodities. Even after the Fed started steadily raising rates the following June, commercial rates stayed low, and the buying binge continued. Morgan Stanley chief fixed-income economist Joachim Fels says the amount of money in excess of what the real economy needs to grow has soared by about 50 percent in the past decade. Only in the last two quarters has that mounting pile of cash finally peaked and begun to fall. Fels believes it will shrink further as central banks (including those in Europe and Japan) push rates higher. "We're seeing the end of easy money," says Berkeley financial historian Barry Eichengreen. "Hopefully it will be the happy conclusion of the story."

Ironically, markets are unnerved largely because the world of money is threatening to return to normal. Money managers had it easy when then Fed chairman Alan Greenspan measured out predictable rate hikes. "Will rates stay stable, go up, go down--we now don't know," says Jesper Koll, chief economist for Merrill Lynch in Japan. "We're in a trendless world, so people have to learn how to invest again, and that creates volatility." Similar concerns dog the U.S. economy: will it grow too fast (sparking inflation) or too slowly (if higher rates choke off growth)?

Even normalization can be risky. As central banks make money more expensive by raising the rates they charge to banks, bond yields also go up. This makes it harder for companies to borrow and for consumers to obtain cheap mortgages and credit cards. The weak will be exposed. As Warren Buffet once said, only when the tide goes out can you see who is swimming naked. If a shock comes--from oil or China or who knows where--and a heavily leveraged bet takes down a big bank or hedge fund, "then people will begin to worry about the stability of the financial system," notes Eichengreen.

Of course, the most critical link in the system is the United States and its mounting deficits, which have reached a staggering 7 percent of GDP. Pessimists have been warning about this for years to no avail. But after the April 22 meeting of the Group of Seven top industrial countries, the concluding statement had a surprise: the leaders acknowledged for the first time that currencies have to adjust to help rebalance the world economy. Put simply, the United States needs a cheaper dollar to pay its dollar debts. The rule of thumb is that the dollar has to fall 10 percent to cut the current account deficit by 1 percentage point of GDP, which means another 30 to 4o percent to cut the deficit in half. The trick will be for the markets and policymakers to produce a smooth decline, not a mad scramble out of the dollar. "We need to suck out liquidity without slipping into recession," warns Joseph Quinlan, chief market strategist for Bank of America.

No single crisis triggered the sudden shift in mood: there ...