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The world economy has entered new and precarious territory. The U.S. economy continues to be mired in the financial problems that fi rst emerged in subprime mortgage lending but which have now spread much more broadly. Strains that were once thought to be limited to part of the housing market are now having considerable negative effects across the entire economy, with rising defaults, falling collateral, and tighter credit working together to create a powerful and hard-to-defeat financial decelerator.

In addition to serious problems at the intersection of credit and the real economy, the United States remains plagued by profound errors in risk management among its leading financial institutions. Problems that were once thought to be limited to issues surrounding liquidity in short-term money markets¡ªand thought capable of being dealt with as such¡ª have cascaded across much of the financial sector, triggering repeated waves of downgrades, upward adjustment of losses for both U.S. and European banks, and now an apparently unstoppable move toward some significant degree of global deleveraging.

This cutback in lending and the associated attempt to reduce risks played a major role in a most dramatic pair of events¡ªboth of which happened as this World Economic Outlook entered its fi nal stages of preparation. First, one of the fi ve largest U.S. investment banks, Bear Stearns, was sold under diffi cult circumstances¡ªincluding the presumed imminence of a far-reaching default. Second, and just as headline-grabbing, were the virtually unprecedented steps taken by the Federal Reserve to prevent Bear Stearns¡¯s problems from spreading. These steps have had a definite stabilizing effect, at least for now.

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