According to recent news reports out of the World Bank, China is now the world's number two economy, passing Japan.

China's fast-growing economy has been moving forward at more than 10% a year for many years and is likely to become the world's largest economic superpower, bypassing America by 2025, or maybe even as soon as 2017 as I pointed out recently.

If you think China saw double-digit growth this year, you may also believe swine flu is spread via flying pigs.

The London-based Lombard Group, using energy data from the International Energy Agency -- which we can assume is a bit more accurate than the nonsense printed by the Chinese government -- shows GDP growth may have been just 2% in the first quarter rather than the reported 6.1%. And even that growth is being held up by government stimulus and state banks lending money to anyone and everyone to build capacity no one needs or to invest in Chinese equities no one can fairly value since Chinese accounting is as good as Chinese government data.

It goes without saying that the United States and China have philosophical differences regarding how best to achieve balanced, sustainable global GDP growth.

Further, it's not likely that China will end its fixed-rate currency policy for the yuan: China keeps the yuan pegged at roughly 6.83 yuan to the dollar. U.S. manufacturers charge that the peg artificially undervalues China's exports, giving its companies an unnatural competitive advantage. China counters that the fixed yuan is necessary for its embryonic, vulnerable economy, and that the world benefits from the very cheap goods that stem in part from it.

One aspect of globalization -- basically free markets and the transfer of jobs to lower labor cost production centers -- that remains a high research priority for many economists studying markets is consumer spending. Or, more specifically, where are all the new, international consumers going to come from?

That's because the world in this early stage of the globalization era has an abundance of manufacturers and producers, but it hasn't identified where all the new shoppers will come from for the increased amount of goods.

Economists were both surprised and elated that GDP growth exceeded expectations and rose 3.9% for the third quarter [subscription required]. While the housing and mortgage crisis hurt growth and brought down the GDP, it was more than offset with a 2% increase in consumer spending and a 1% increase in international trade, as exports surged thanks to the falling value of the dollar. Many economists believe it was this strong showing in the GDP that influenced the Fed in its decision to cut interest rates by just one quarter percent rather than one half percent.

The key question now is: will it last? Many economists don't think so. They explain that the the first signs of weakness in the economy were at the end of the quarter in September and the full impact of the housing and credit crisis won't be felt until the fourth quarter. Economists expect the fourth quarter growth rate to be closer to 1%. Consumer confidence dropped in October because of the housing and mortgage mess. Since consumer spending accounted for 2% of that 3.9% growth, if consumers hold back their spending, it will have a significant impact on fourth quarter growth. Escalating food and fuel prices could be another key factor that could hurt growth as could unemployment claims, which edged higher as the impact of the slowing housing market is being felt in other sectors of the economy.

Retailers face the biggest problems as we enter the fourth quarter -- their most important quarter of the year. If holiday sales fall below target, many retailers will be facing a bad year.

Don't start celebrating yet. Economists think we're headed for a drop in the fourth quarter and that will be followed by weaker quarters in the first half of 2008. Where do you think we're headed?

Will Fed Chairman Bernanke base his interest-rate decision on 4% GDP growth in the second quarter, essentially looking through the rear view mirror, or on virtually every other data point that suggests the economy is slowing down?

Bernanke deserves plaudits for his handling of the economy, particularly halting rate increases knowing changes in Fed policy take time to impact the economy. Something Greenspan might not have done.

Bernanke's most important signal on where the economy could be is the 10-year bond that has crashed from 5.2% in late 2006 to 4.47% today. However, Ethan Allen Interiors Inc (NYSE: ETH) CEO Kathwari said yesterday at Goldman's retailer conference "our retail written sales on a comparable store basis were up modestly in June and July. This positive trend has continued in August." This is by no means a glowing review of the economy, but neither is it a sign of an economy in deep despair.

Meanwhile, the pending home sales index crashed 12.2% in July versus June, dropping to the lowest level since September 2001. Since the index tracks existing-home contract signings, not final sales, it is considered a leading indicator and suggests a big drop in home sales in August or September.

From all the evidence, the Fed should start dropping rates. With the drop in the discount having some calming effect, look for the Fed to start with a 25 basis point basis cut followed by two more to finish up the year.

It seems some people are breathing a sigh of relief this morning following the news that the U.S. economy grew 3.4% in the second-quarter, more than the 3.2% forecast by economists polled by Briefing.com and Bloomberg. This growth pace is the most the economy had experienced in more than a year, and it follows a weak 0.6% growth in the first quarter. This is the advanced GDP number for Q2 and will be revised later. Twice.

The reason for this better-than-expected performance? Rising exports (which should surprise no one given the weak dollar), commercial construction (due to a strong manufacturing sector) and government spending. It was consumer spending, however, the sector which had kept the expansion going in previous quarters, that was weak in the last quarter.

Are we facing stagflation -- the dreaded combination of slow growth and high inflation? That's the question that comes to mind in reading this morning's report that first quarter economic growth fell below expectations and inflation jumped higher than it has in 16 years.

I have written about stagflation before but this morning's report is the most dramatic evidence yet that it might be here. GDP growth of 1.3% in the first quarter is well below that of previous quarters -- GDP grew 5.6% in Q1 2006 and 2.6% in the Q4 2006. But the kicker is that inflation -- as measured by the GDP price index -- grew at 4% in the first quarter, the highest rate in 16 years.

If stagflation persists, it could be bad for stocks. During the 1970s, stagflation kept stocks virtually unchanged for an entire decade. The problem is that if the Fed decides to raise interest rates to check inflation, the economy slows down. But if the Fed cuts rates to spur economic growth, prices spin out of control and the dollar drops in value -- following the report the dollar fell to an all-time low against the euro. This forces bond issuers to raise rates to attract foreign investors. And the higher interest rates cut economic growth.

With the U.S. economy so heavily dependent on debt -- both to consumers and to other governments like Japan and China -- the persistence of stagflation could paralyze the economy and the markets for a long time.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter.

According to a piece in today's New York Times, economists expect good but not great things for 2007. Merrill Lynch's Chief Investment Strategist Richard Bernstein projects a 12% rise in the S&P 500. Abby Cohen sees the S&P going up modestly, and UBS's David Bianco expects multiple expansion. Some economists worry about the Fed and others are concerned that investors are too bullish about GDP growth. But all in all, they are expecting it to be a good year.

The problem, according to investors like David Dreman, is that positive sentiment is often a contrarian indicator. In his book Contrarian Investment Strategies, he provides compelling data that show that even the best analysts and economists are often wrong -- and by a problematic amount.

So it may be wise to exercise caution in the face of bullishness. As Warren Buffet often says "The secret is to be fearful when others are greedy and greedy when others are fearful." I hope the analysts are right, but I wouldn't be making investment decisions based on their predictions.