Roubini: Recession Might Not Be Half Way Over

Dr. Doom, Professor Nouriel Roubini is the man who predicted the current financial crisis and yesterday he said the U.S. recession could drag on for years without drastic action. He says that this recession could last 36 months. As we are in the 15th month of a recession this is not good.

This is a nation of shopped-out and debt-burdened consumers who just lost their ability to keep over spending. They lost their resilience and started to give up on spending in the third quarter of 2008. This was when for the first time in two decades, personal consumption contracted. With personal consumption making up for over two-thirds of aggregate demand for the U.S. economy, the outlook for the U.S. is not good for 2009. Consumers are still at the center of the dynamics that will play out in the real economy in 2009.

Professor Roubini told CNBC in a live interview:

"Growth is going to be close to zero and unemployment rate well above 10 percent into next year."

Professor Roubini also said he sees:

"There is no hope for the recession ending in 2009 and will more than likely last into 2010."

Last he again pushed the idea of bank nationalization of at least the four major banks:

"Most of the U.S. financial institutions are entirely insolvent."

"The market friendly view for the banks is nationalization."

"Temporarily take over the banks, clean them up and get them working again."

According to Professor Roubini, unfortunately, Tim Geithner's Financial Stability plan won't solve our financial woes because it assumes that the system is solvent, while nationalization is the only option that would permit us to solve the problem of toxic assets in an orderly fashion and allow lending finally to resume.

Should The US Consider Nationalizing Banks That Are In Trouble

Professor Nouriel Roubini of Global EconoMonitor, who is also known as Dr. Doom (because he for years was warning of the on-coming financial crisis) has given several interviews over the lasy week to Business New Europe, Charlie Rose, Wall Street Journal, Bloomberg, Reuters, ABC, NBR and CNBC.

In his CNBC interview, he strongly advocates a Swedish-style bank nationalization to repair the ailing financial system and prevent banks from turning into 'zombie banks' like were in Japan.

"If you don't nationalize them on a temporary basis the fiscal commitments will be bigger. The alternative is actually a dangerous debt spiral.”

The Swedish-style bank nationalization is where the government of Sweden in 1992 had to deal with the collapse of a real estate bubble and had to take control of two of that country's largest banks, Nordbanken and Gota. The government stripped the banks of their bad assets, which it kept in a pair of new companies known as "bad banks." The remnant "good banks" were then merged into a single company and launched back into the marketplace.

Even Conservatives like Alan Greenspan and Senator Graham have publicly suggested that the idea of nationalization may be needed. Professor Roubini has pointed to this in a number of interviews like the one he had with Tunku Varadarajan in Wall Street Journal.

The biggest barrier to nationalization is the negative public image as 'Bolshevik' rather than 'pragmatic.' But this is stupid, and the result of idiots like Hannerty, Limbaugh, and Republican politicians who toss out accusations of socialism and communism without consideration. Nationalizing troubled banks would allow the government to take distressed assets without having to set a price.

For those who are scared of the word 'nationalization' you should consider the example of IndyMac, a bank that was nationalized and quickly re-privatized in less than a year. IndyMac was an example of a company that needed to be seized.

During a discussion of the banking crisis on ABC's This Week with George Stephonopilis that featured Professor Roubini, Professor Paul Krugman and George Will, and they discussed a temporary nationalization. Professor Krugman suggested calling nationalization “pre-privatization” to sugarcoat the program. Krugman also points out that in 2009 we have already nationalized 14 banks. Similarily the Federal government took control of mortgage finance companies Fannie Mae and Freddie Mac in early September of 2008.

Administration officials say they are determined to maintain the appearance, and in important respects the reality, that banks remain under private ownership. I do not agree with this, the current leadership of these banks are the major problem. The Obama administration argues that they have a responsibility to pursue the least costly solution, and that they continue to believe smaller steps than nationalization can resolve the crisis. They are wrong.

Another argument against nationilzation is that the U.S. Banking system is larger than Swedens, and while the problem is spread across many of the nation's 8,300 banks, the bulk of the problem is in a concentrated few. Fix these mega banks like Citi and Bank of America and you have taken the largest concentration of troubled assets. Nationalize these mega banks, and break them up, no bank should ever be 'too big to fail.'

No one is arguing that the banks should be nationalized on a permanent basis. Those who are arguing against that are attacking straw men.

Obama and his economic team need to step-up as leaders and whether they call it Nationalization or not (it will most probably be called receivership or conservatorship) and take over those major banks that have dragged the economy down.

Geithner's Plan Falls Flat

Yesterday Treasury Secretary Timothy Geithner presented the Obama’s administration’s Financial Stability Plan to deal with the financial system’s toxic asset overhang and ease, if not reverse, the ongoing decline in bank lending to households and corporations.

To say that it went over like a lead balloon would be an understatement.

Out of the three broad strategies that most economists say are available - nationalization, ‘good / bad bank’, backstop guarantee on ring-fenced toxic assets - the administration plan offers elements of all three.

I am always wary of a plan that offers a little bit of everything.

Geithner’s first program involves a mandatory ‘stress test’ for all banks with $100bn-plus assets which should also shed some clarity on the individual banks exposures and valuations of toxic assets. This I like because there is still too much we do not know about the financial crisis. A major part of this whole economic meltdown has been fear of the unknown. Safe investments and secure loans have been damaged by fear of toxic assets.

According to the plan Geithner laid out yesterday, after the stress test the Treasury’s Capital Assistance Program would stand ready with preferred shares / warrants injections where needed, only this time with clear lending requirements and strict limits on dividends, stock repurchases and acquisitions next to a $500,000 compensation cap. This solves some of the problems with the original $350 billion that Paulson injected into the financial markets late last year.

Geithner claims that any capital investments made by Treasury under the CAP would be placed in the Financial Stability Trust. However, Geithner left unclear what other options are there for institutions that are severely undercapitalized or fail to attract public capital on a recurring basis (Bank of America and Citigroup are two examples) Yes the program aims at ensuring that there is full transparency disclosing all relevant information on capital recipients at www.FinancialStability.gov; but is that enough to give Geithner our trust?

The second program Geithner spoke about was the Public-Private Investment Fund (PPP). This program aims at setting up a new lending/guarantee facility (the so called Bad Bank solution). This program would work by leveraging an initial private capital commitment with government funds to an initial scale of up to $500 billion (and if you look at the fine print it can be expanded to a maximum of $1 trillion.) The aim of this idea is to involve private capital on a large scale that sits currently on the sidelines while also allowing private market forces to determine the price for currently troubled and illiquid assets.

Personally I think yesterday’s tanking of the Dow was because Geithner mentioned using private capitol in his plan.

A similar experiment was tried before with the private sector sponsored M-LEC vehicle that ultimately proved unviable due to asymmetric toxic asset exposures of participating banks and due to still unresolved asset valuation issues. Commentators agree that for a similar plan to work this time, the government will have to assume a potentially substantial downside in order to induce otherwise unwilling investors to participate in view of the size of potential losses.

Renowned distressed debt experts such as Edward Altman and Martin Fridson note that the best time to invest in distressed debt is when default rates peak. Mind that high-yield default rates are set to rise to 15-20% sometime in 2010 from currently 4-5% due to very bad credit quality at the outset of the cycle.

Yet this again is putting all the risk on the public and all the reward for those who got us in this message.

The third program put forth by Secretary Geithner is an expanded version of the previously $200bn Federal Reserve Term Asset Backed Securities Loan Facility (TALF) program aimed at unclogging the markets for auto, student and other consumer loans. That initiative may expand to as much as $1 trillion, using $100 billion from the Treasury's rescue funds, and include aid for commercial real estate markets.

Geithner points out that securitization created about 40% of the demand for new loans extended to consumers, students, and auto buyers. The decline of securitized lending to the tune of $1.2 trillion between 2006 and 2008 leaves a hole that needs to be filled if a severe lending contraction should be prevented.

Economist Nouriel Roubini in his latest writing It Is Time to Nationalize Insolvent Banking Systems argues that, ultimately, nationalization may be a more market friendly solution of a banking crisis: it creates the biggest hit for common and preferred shareholders of clearly insolvent institutions and – possibly – even the unsecured creditors in case the bank insolvency is too large; it provides a fair upside to the tax-payer. Moreover, it bypasses the asset valuation issue as any overpayment goes back into taxpayers pockets. “With the government starting stress tests to figure out which institutions are so massively undercapitalized that they need to be taken over by the FDIC the administration is putting in place the steps for the eventual and necessary takeover of the insolvent banks.” This might well explain some of the negative market reaction.

The Treasury has stressed that while the ongoing price correction will stimulate home demand, there is a need to reduce foreclosures, which otherwise adding to the excess overhang of homes pose the risk of price over-correction, pushing more homeowners into negative equity. The Treasury plans to announce a Housing Program in the next few weeks to help refinance mortgages and contain foreclosures by reducing monthly payments for homeowners. The program will be financed by using $50 billion from the remaining TARP funds. To increase lender participation, the plan makes it compulsory for banks using government funds under the Financial Stability Plan to participate in foreclosure mitigation. In order to stimulate home demand and help the current homeowners refinance, the Treasury and Fed will continue with their November 2008 plans use $600 billion to buy MBSs and debt of the GSEs using and reduce mortgage rates to the 4-4.5% range. More importantly, the plan will increase flexibility to modify loans under the Hope Now and FHA Programs started in 2007-08 to help increase participation and foreclosure prevention.

Efforts to stimulate demand reducing mortgage rates and offering tax incentives will be largely ineffective as they are a small factor in determining home demand relative to factors such as tighter lending standards, changing dynamics for households - job and income loss, wealth erosion, rising savings rate, and low expectations of income or asset appreciation. These factors will constrain home demand in the short run while potential buyers await further price correction and banks don’t see the viability in offering mortgage for a house whose value is expected to fall.

As a result, the government needs to focus on the supply side of the market by refinancing at-risk mortgages and preventing foreclosures that will only add to the existing overhang of houses. Moreover, government’s loan modification program should reduce mortgage principal rather than just reducing the mortgage rate or extending the loan maturity, which has been the case in past government programs. Unless the problem of insolvency among a large number of households is addressed, default on modified mortgages will also continue. Also, given the large number of homeowners with negative home equity, the program will need much larger funds - over $600 billion to $1 trillion though the actual cost might be much less, since the government will receive a share from future home appreciation. Monetary incentives for servicers are also low and ineffective. Even the number of homeowners the program plans to target, 1.5-2 million is a very small fraction of the over 12 million homeowners with negative equity. In fact, several Democrats are pushing a legislation to allow bankruptcy judges to change mortgage terms that would allow lenders to reduce the mortgage principal for primary homes and bring down monthly payments. To increase participation, they support offering monetary incentives for servicers while lenders will be entitled to a share if the homeowner sells the house and also have the government share any losses on the modified mortgage.

Looking at the shortcomings of past government programs such as the Hope Now, Housing Retention and FDIC programs, the new program should be mandatory for lenders in order to increase participation.

The government will also need to share the cost of modifying the loan, by matching the principal or the interest rate cut in a proportionate or less than proportionate amount. By guaranteeing the loans, the government will be the senior debt holder. The new interest rate should be based on the risk assessment of the borrower and all three parties – homeowner, lenders and servicers, and the government should share the cost of modification. However, determining the extent of principal reduction based on the true value of the house, and dealing with second lien mortgages and the diverging interests of mortgage servicers will be challenging.

Under the new guidelines for compensation issued by the Treasury, firms receiving federal aid will be subject to shareholder say on pay and will be required to cap executive compensation at $500,000 with any additional compensation given out in restricted stocks which can be cashed only after the government has been repaid or the bank has satisfied repayment obligations, and met lending and stability standards. Moreover, bonuses and compensation for other top executives will also be reduced. At the very least the Treasury is going to require disclosure of the compensation structure and strategy, and expenditure on luxury items. Still, while the government's intervention is warranted, the compensation reform being put forward does little to align risks with rewards. Sadly reports are that Geithner fought for real compensation reform.

A large share of the compensation can and will be given out in restricted stocks including compensation for several traders and funds managers who are not under the lenses of the current plan. These measures also give a green light to those who have already received large compensation and severance packages at the troubled banks. More importantly, the measures might act a disincentive in attracting credible executive talent to these troubled institutions in the future who can help deal with the bank losses and overhaul. Wall Street compensation is determined in a competitive market with CEOs joining a firm offering the most attractive pay packages and perks. Many banks are already reluctant to seek capital injection from the Treasury or are contemplating to payback past borrowings in order to avoid government scrutiny over their compensation packages. There is too much voluntary action on the part of the banks. The government needs to be much more forceful. These companies caused the financial crisis, and should not have the luxery of choosing to take part in this package.

To reduce excessive risk-taking in the short-run, compensation, bonuses and even severance packages should be based on the long-term performance of the employee relative to the risk undertaken with large part of the payments given out in restricted stocks that can be redeemed over a longer period of time.

Roubini: US Banking System is Insolvent

Nouriel Roubini, of RGE Monitor, was one of the first people to predict the housing crisis, and now he has come out and said that "the US Banking System is Insolvent." While at Davos Nouriel Roubini said he believes this because expected losses for the US banking system will be about $2 trillion, which far exceeds bank capital of about $1.5 trillion. Roubini has also said that he believes total financial system losses could hit $3.6 trillion.

Because of this fact Roubini does not believe the government plan for buying the toxic assets of US banks may not work.

Instead Nouriel Roubini suggests that the Obama administration should look towards Sweden's plan of nationalizing all insolvent banks, cleaning them up and then selling off the good assets to the private sector.

I can just hear the Republicans howling now.

20 Reasons Why the U.S. Consumer is Capitulating, thus Triggering the Worst U.S. Recession in Decades

By Nouriel Roubini

Today’s news about October retail sales (-2.8% relative to the previous month and now down in real terms for five months in a row) confirm what this forum has been arguing for a while, i.e. that the U.S. has entered its most severe consumer-led recession in decades. At this rate of free fall in consumption real GDP growth could be a whopping 5% negative or even worse in Q4 of 2008. And this is not a temporary phenomenon as almost all of the fundamentals driving consumption are heading south on a persistent and structural basis. Consider the many severe negative factors affecting consumption. One can count at least 20 separate or complementary causes that will sharply reduce consumption in the next several years:

• The US consumer is shopped-out having spent for the last few years well above its means.
• The US consumer is saving-less as the already low household savings rate at the beginning of this decade went to zero/negative by 2006 and has now to raise to more sustainable levels.
• The US consumer is debt burdened with the debt to disposable income having increased from 70% in the early 1990s to 100% in 2000 and to 140% in 2008.
• Not only debt ratios are high and rising but debt servicing ratios are also high and rising having gone from 11% in 2000 to almost 15% now as the interest rate on mortgages and consumer debt is resetting at higher levels.
• The value of housing wealth is now sharply falling by over $6 trillion as home price depreciation will soon be 30% and reach a cumulative fall of over 40% by 2010. Recent estimates of this wealth effect suggest that the effect may be closer to 12-14% rather than the historical 5-7%. And with home prices falling over 30% about 40% of all households with a mortgage (or 21 million out of 50 who have a mortgage) will be
  under water (negative equity in their homes) with a huge incentive to walk away from their homes.
• Mortgage equity withdrawal (MEW) is collapsing from $700 billion annualized in 2005 to less than $20 in Q2 of this year. Thus, with falling housing wealth and collapsing MEH US households cannot use their homes anymore as ATM machines borrowing against them.
• The value of the equity wealth of US households has fallen by almost 50%, another ugly wealth effect on consumption.
• The credit crunch is becoming more severe as the recent Q2 flow of funds data and the Fed Loan Officers’ Survey suggests: it is spreading from sub-prime to near prime to prime mortgages and home equity loans; and from mortgages to credit cards, auto loans and student loans. Both the price and the quantity of credit are sharply tightening.
• Consumer confidence is down to levels not seen since the 1973-75 and 1980-82 recessions.
• Real wage growth and real income growth has been stagnant in the last few years as income and wealth inequality has been rising. And now with GDP and real incomes falling real consumption will fall sharply.
• The Fed is reaching the zero-bound on interest rates as the economy gets close to deflation given the slack in goods, labor and commodity markets. Deflation means that consumers will postpone consumption as future prices are lower than current prices, as real rates are positive and rising and as debt deflation increases the real value of the households nominal debts
• Employment has been falling for 10 months in a row and the rate of job losses is now accelerating. In the last recession in 2001 that was short and shallow (8 months from March to November 2001 with a cumulative fall in GDP of only 0.4%) job losses continued all the way until August 2003 with a job loss recovery and a total cumulative loss of jobs of over 5 million from the peak. In this cycle job losses have been so far “only” slightly over 1 million while labor market conditions are severely worsening based on all forward looking indicators such as initial and continuing claims for unemployment benefits. Massive job losses and concerns about job losses will
  further dampen current and expected income and further contract consumption.
• Tax rebates of over $100 billion failed to stimulate real consumption earlier in 2008. Only 25% of the tax rebate was spent as US consumers are worried about jobs and need to use funds to pay their credit card and mortgage. The tax rebate was supposed to boost consumption all the way through September 2008: in reality real retail sales and real personal spending rose only in April and May while starting in June and all the way in July, August, September, October and now into the holiday season real retail spending and real personal spending are down month after month. Thus, another general tax rebate would be as ineffective as the first one in boosting consumption.
• The 1990-91 and 2001 recessions were not global; this time around the IMF is
  forecasting a global recession for 2009.
• The recent rise in inflation – that is only now slowing down – reduced real incomes even further for lower income households who spend more than the average households on gas, transportation, energy and food. The recent sharp fall in gasoline and energy prices will increase real incomes by a modest amount (about $150 billion) but the losses of real disposable income and thus falling consumption from other
  sources (wealth, income, debt servicing ratios) are much larger and more significant.
• The trade weighted fall in the value of the U.S. dollar since 2002 has worsened the terms of trade of the US and reduced further real disposable income and the purchasing power of US consumers over foreign goods.
• With consumption being over 71% of GDP a sharp and persistent contraction of consumption all the way through at least Q4 of 2009 implies a more severe recession than otherwise. Consumption did not fall even a single quarter in the 2001 recession and one has to go back to 1990-91 to see a single quarter of negative consumption growth. But the worsening balance sheet of US consumers in 1990-91 (debt ratios, debt servicing ratios, employment contraction, wealth effects of housing and stock markets) was much less severe than the current downturn.
• Monetary easing will not stimulate durable consumption and demand for residential housing as demand for such capital goods becomes interest rate insensitive when there is a glut of capital goods; monetary policy becomes like pushing on a string. In the previous recession the Fed cut the Fed Funds rate from 6.5% to 1% and long rates fell by 200bps. In spite of that capex spending of the corporate sector fell by 4% of GDP between 2000 and 2004 as there was a glut of tech capital goods and it took years to work out such a glut. Today there is a glut of housing, consumer durables and autos/motor vehicles; so it will take years to work out this glut and monetary
  policy is becoming ineffective to resolve that glut.
• While policy rates are sharply falling the nominal and real rates faced by households are rising rather than falling: rising mortgage rates (and event near lack of any mortgage financing at even higher rates for sub-prime and jumbo loans), rising rates on credit cards, auto loans and student loans together with less availability of credit are severely dampening the ability of households to borrow and spend.
• To bring back the household savings rate to the level of a decade ago (about 6% of GDP) consumption will have to fall – relative to current GDP levels – by almost a trillion dollar. If all of this adjustment were to occur in 12 months GDP would contract directly by 7% and indirectly (including the further collapse of residential and corporate capex spending in a severe recession) by 10%, an exemplification of the Keynesian “paradox of thrift”. If such an adjustment were to occur over 24 months rather than 12 months you would still have negative GDP growth of 5% for two years in a row with a cumulative fall in GDP from its peak of 10% (note that in the worst US recession since WWII such cumulative fall in GDP was only 3.7% in 1957-58). One can thus only hope that this adjustment of consumption and savings rates occurs only slowly over time – four years rather than two. Even in that scenario the cumulative fall of GDP could be of the order of 4-5%, i.e. the worst US recession since WWII. Note that the cumulative fall in GDP in the 2001 recession was only 0.4% and in the
  1990-9 recession was only 1.3%. So, the current recession may end up being three times as long and at least three times as deep (in terms of output contraction) than the last two and worse than any other post WWII recession.

Preventing a global slump must be the priority

Financial Times columnist Martin Wolf wrote an interesting article about the world economic meltdown, and what needs to be done to right the ship.

Preventing a global slump must be the priority

by Martin Wolf

Give credit where credit is due: Nouriel Roubini of New York University’s Stern School of Business was right. On February 20 2008, I wrote a column entitled “America’s economy risks the mother of all meltdowns”, based on his analysis of the 12 steps to disaster. Alas, not only has the US taken those steps, but it has also – with help from others, including the UK – dragged the world behind it.

In a more recent note, Professor Roubini predicts a combination of stagnation and deflation*. In doing so he points, with some glee, to the most recent analysis of the global outlook from JPMorgan Chase, once among the most bullish of analysts. Now, under the rubric “A bad week in hell”, JPMorgan states that: “Once again, we have taken an axe to near-term growth forecasts for the developed world and will likely follow up with additional downward revisions for emerging economies in the coming weeks. Already, our forecasts suggest that global gross domestic product will contract at a near 1 per cent annual rate” in the fourth quarter of 2008 and the first quarter of 2009.

JPMorgan expects shrinkage this quarter at an annualised rate of 4 per cent in the US, 3 per cent in the UK and 2 per cent in the eurozone. It is forecasting 0.4 per cent global growth in 2009, with advanced countries shrinking 0.5 per cent and emerging ones growing 4.2 per cent.

Given the near-disintegration of the western world’s banking system, the flight to safe assets, the tightening of credit to the real economy, collapsing equity prices, turmoil on currency markets, continued steep declines in house prices, rapid withdrawal of funds from hedge funds and ongoing collapse of the so-called “shadow banking system”, these forecasts even look quite optimistic. The outcome next year could be far worse.

If western governments had not intervened to guarantee and recapitalise banking systems, it would surely have been worse. Yet, as the charts show, even this has not halted the turmoil. Consider just two statistics: the capitalisation of world stock markets has halved; and, according to the Bank of England’s latest Financial Stability Report, mark-to-market losses on vulnerable debt instruments now amount to a massive $2,800bn (€2,240bn, £1,790bn)**.

So what should be done? Some would argue: nothing at all. The view is widely held, particularly in the US, that the world needs a big purge of past excesses. Recessions, on this line of argument, are good. People who hold this view also argue that governments caused all the mistakes. The market would, they insist, be incapable of the errors we have seen. To them, Alan Greenspan’s confession last week that “I made a mistake in presuming that the self-interest of organisations, specifically banks and others, was such that they were best capable of protecting their own shareholders” was about as welcome as Brutus’s knife was to Caesar.

Intriguingly, the Bank’s Financial Stability Report provides some support for this view: back in 1900, US banks had four times as much capital, relative to assets, as they do today. Similarly, the liquidity of the assets held by UK banks has collapsed over the past half-century. Implicit and explicit guarantees from governments have indeed made the financial system more dangerous than before. The combination of such guarantees with deregulation has proved lethal. Moral hazard is far from meaningless.

Yet the idea that a quick recession would purge the world of past excesses is ludicrous. The danger is, instead, of a slump, as a mountain of private debt – in the US, equal to three times GDP – topples over into mass bankruptcy. The downward spiral would begin with further decay of financial systems and proceed via pervasive mistrust, the vanishing of credit, closure of vast numbers of businesses, soaring unemployment, tumbling commodity prices, cascading declines in asset prices and soaring repossessions. Globalisation would spread the catastrophe everywhere.
Many of the victims would be innocent of past excesses, while many of the most guilty would retain their ill-gotten gains. This would be a recipe not for a revival of 19th-century laisser faire, but for xenophobia, nationalism and revolution. As it is, such outcomes are conceivable. Choosing to risk such an outcome would be like deciding to let a city burn in order to punish someone who smoked in bed. Risking huge damage now in the hope of lowering moral hazard later is mad.

Everything possible must be done to prevent the inescapable recession from turning into something worse. Many of the needed actions were laid out in an article on the FT’s Comment page this week by Columbia University’s Jeffrey Sachs. I would stress five points.

First, as Oxford university’s John Muellbauer argues, deflation is a real danger***. Yet deflation is lethal for indebted economies. Today, short-term interest rates look far too high in the eurozone and the UK. Central banks need to look at their economies afresh and cut rates by at least 1, and ideally 2, percentage points.

Second, the only way to let the private sector deleverage, without mass bankruptcy and huge falls in spending, is by substituting the asset everybody wants: government debt. Contrary to Professor Sachs, I think tax cuts are indeed part of the solution.

Third, it is crucial that lending be sustained both inside and among economies. Having gone to such trouble to recapitalise banks, governments should insist that their money be used to sustain credit lines to those likely to remain solvent. If banks are unwilling to do this, central banks will have to replace them, as the Federal Reserve is now doing.

Fourth, it is in the vital self-interest of the affected high-income countries to keep hard-hit emerging economies afloat through the crisis.

Finally, it is equally evident that the world will not return to equilibrium if countries in strong financial positions do not expand domestic demand. The day of the housing bubbles and huge current account deficits in high-spending high-income countries is gone. Those who rely on current account surpluses to sustain demand must think again.

Decisions made over the next few months may well shape the world for a generation. At stake could be the legitimacy of the open market economy itself. Those who view liquidation of past excesses as the solution fail to understand the risks. The same is true of those dreaming of new global orders. Let us first get through the crisis. The danger remains huge and time is short.

LibertyAir Blog

Worst Is Yet to Come.

Economist Nouriel Roubini warns that the worst in markets and economies is yet to come. On October 23rd, Nouriel predicted the potential shutdown of financial markets. A day later U.S. stock futures suspended trading after declines of more than 6% at opening tripped the circuit breakers. Nonetheless, Nouriel does not expect another Great Depression, but states that policymakers must act quickly and wisely.

Here are the main elements of Nouriel’s outlook: Tsunami of corporate defaults; 2-year U-shaped U.S. recession that threatens to turn into an L-shaped one if policymakers do not regain control of the financial system; global re-coupling to the U.S. will advance from non-U.S. markets to non-U.S. real economies – not even the strongest emerging markets such as Brazil and China will escape global re-coupling; vicious cycle of deflation in goods markets, labor markets, commodity markets, financial markets, corporate and household earnings, and aggregate demand; de-leveraging to reduce excess debt in municipalities, households and some firms; U.S. stock markets declining another 20-30%, bottoming fall 2009 at the earliest, then moving sideways for years post-recession if growth remains anemic as it did in Japan after its 1990s real estate and equities bust; U.S. unemployment rise to reach 8-9%; the demise of the shadow banking system.

According to Nouriel, USD assets, commodities, U.S. and international equities, housing, and the USD are quite risky right now. Seek safety in cash or cash-like instruments such as T-bills and bonds of safe, large governments. Though he believes the U.S. dollar will retain its reserve currency status for decades, its status will gradually erode.

Given the size of the expected contraction in private aggregate demand (likely to be about $450 billion in 2009 relative to 2008), Nouriel argues that a fiscal stimulus to the order of $300 billion minimum (and possibly as large as $400 billion) will be necessary to partially compensate for the sharp fall in private aggregate demand. Here is Nouriel’s testimony before the Joint Economic Committee.

Nouriel Roubini: The world is at severe risk of a global systemic financial meltdown

On Thursday, October 09, 2008, Nouriel Roubini – Chairman of RGE Monitor and Professor of Economics at the NYU Stern School of Business – lays out his latest views on the global economic and financial crisis and the urgent necessary actions that need to be undertaken globally.

Nouriel Roubini: The world is at severe risk of a global systemic financial meltdown and a severe global depression

The U.S. and advanced economies’ financial systems are now headed towards a near-term systemic financial meltdown as day after day stock markets are in free fall, money markets have shut down while their spreads are skyrocketing, and credit spreads are surging through the roof. There is now the beginning of a generalized run on the banking system of these economies; a collapse of the shadow banking system, i.e. those non-banks (broker dealers, non-bank mortgage lenders, SIV and conduits, hedge funds, money market funds, private equity firms) that, like banks, borrow short and liquid, are highly leveraged and lend and invest long and illiquid, and are thus at risk of a run on their short-term liabilities; and now a roll-off of the short term liabilities of the corporate sectors that may lead to widespread bankruptcies of solvent but illiquid financial and non-financial firms.

On the real economic side, all the advanced economies representing 55% of global GDP (U.S., Eurozone, UK, other smaller European countries, Canada, Japan, Australia, New Zealand, Japan) entered a recession even before the massive financial shocks that started in the late summer made the liquidity and credit crunch even more virulent and will thus cause an even more severe recession than the one that started in the spring. So we have a severe recession, a severe financial crisis and a severe banking crisis in advanced economies.

There was no decoupling among advanced economies and there is no decoupling but rather recoupling of the emerging market economies with the severe crisis of the advanced economies. By the third quarter of this year global economic growth will be in negative territory signaling a global recession. The recoupling of emerging markets was initially limited to stock markets that fell even more than those of advanced economies as foreign investors pulled out of these markets; but then it spread to credit markets and money markets and currency markets bringing to the surface the vulnerabilities of many financial systems and corporate sectors that had experienced credit booms and that had borrowed short and in foreign currencies. Countries with large current account deficits and/or large fiscal deficits and with large short-term foreign currency liabilities and borrowings have been the most fragile. But even the better performing ones – like the BRICs club of Brazil, Russia, India and China – are now at risk of a hard landing. Trade and financial and currency and confidence channels are now leading to a massive slowdown of growth in emerging markets with many of them now at risk not only of a recession but also of a severe financial crisis.

The crisis was caused by the largest leveraged asset bubble and credit bubble in the history of humanity where excessive leveraging and bubbles were not limited to housing in the U.S. but also to housing in many other countries and excessive borrowing by financial institutions and some segments of the corporate sector and of the public sector in many and different economies: an housing bubble, a mortgage bubble, an equity bubble, a bond bubble, a credit bubble, a commodity bubble, a private equity bubble, a hedge funds bubble are all now bursting at once in the biggest real sector and financial sector deleveraging since the Great Depression. At this point the recession train has left the station; the financial and banking crisis train has left the station. The delusion that the U.S. and advanced economies contraction would be short and shallow – a V-shaped six month recession – has been replaced by the certainty that this will be a long and protracted U-shaped recession that may last at least two years in the U.S. and close to two years in most of the rest of the world. And given the rising risk of a global systemic financial meltdown, the probability that the outcome could become a decade long L-shaped recession – like the one experienced by Japan after the bursting of its real estate and equity bubble – cannot be ruled out.

And in a world where there is a glut and excess capacity of goods while aggregate demand is falling, soon enough we will start to worry about deflation, debt deflation, liquidity traps and what monetary policy makers should do to fight deflation when policy rates get dangerously close to zero.

At this point the risk of an imminent stock market crash – like the one-day collapse of 20% plus in U.S. stock prices in 1987 – cannot be ruled out as the financial system is breaking down, panic and lack of confidence in any counterparty is sharply rising and the investors have totally lost faith in the ability of policy authorities to control this meltdown.

This disconnect between more and more aggressive policy actions and easings, and greater and greater strains in the financial market is scary. When Bear Stearns’ creditors were bailed out to the tune of $30 bn in March, the rally in equity, money and credit markets lasted eight weeks; when in July the U.S. Treasury announced legislation to bail out the mortgage giants Fannie and Freddie, the rally lasted four weeks; when the actual $200 billion rescue of these firms was undertaken and their $6 trillion liabilities taken over by the U.S. government, the rally lasted one day, and by the next day the panic had moved to Lehman’s collapse; when AIG was bailed out to the tune of $85 billion, the market did not even rally for a day and instead fell 5%. Next when the $700 billion U.S. rescue package was passed by the U.S. Senate and House, markets fell another 7% in two days as there was no confidence in this flawed plan and the authorities. Next, as authorities in the U.S. and abroad took even more radical policy actions between October 6th and October 9th (payment of interest on reserves, doubling of the liquidity support of banks, extension of credit to the seized corporate sector, guarantees of bank deposits, plans to recapitalize banks, coordinated monetary policy easing, etc.), the stock markets and the credit markets and the money markets fell further and further and at accelerated rates day after day all week, including another 7% fall in U.S. equities today.

When in markets that are clearly way oversold, even the most radical policy actions don’t provide rallies or relief to market participants. You know that you are one step away from a market crash and a systemic financial sector and corporate sector collapse. A vicious circle of deleveraging, asset collapses, margin calls, and cascading falls in asset prices well below falling fundamentals, and panic is now underway.

At this point severe damage is done and one cannot rule out a systemic collapse and a global depression. It will take a significant change in leadership of economic policy and very radical, coordinated policy actions among all advanced and emerging market economies to avoid this economic and financial disaster. Urgent and immediate necessary actions that need to be done globally (with some variants across countries depending on the severity of the problem and the overall resources available to the sovereigns) include:

• another rapid round of policy rate cuts of the order of at least 150 basis points on average globally;
• a temporary blanket guarantee of all deposits while a triage between insolvent financial institutions that need to be shut down and distressed but solvent institutions that need to be partially nationalized with injections of public capital is made;
• a rapid reduction of the debt burden of insolvent households preceded by a temporary freeze on all foreclosures;
• massive and unlimited provision of liquidity to solvent financial institutions;
• public provision of credit to the solvent parts of the corporate sector to avoid a short-term debt refinancing crisis for solvent but illiquid corporations and small businesses;
• a massive direct government fiscal stimulus packages that includes public works, infrastructure spending, unemployment benefits, tax rebates to lower income households and provision of grants to strapped and crunched state and local government;
• a rapid resolution of the banking problems via triage, public recapitalization of financial institutions and reduction of the debt burden of distressed households and borrowers;
• an agreement between lender and creditor countries running current account surpluses and borrowing, and debtor countries running current account deficits to maintain an orderly financing of deficits and a recycling of the surpluses of creditors to avoid a disorderly adjustment of such imbalances.

At this point anything short of these radical and coordinated actions may lead to a market crash, a global systemic financial meltdown and to a global depression. The time to act is now as all the policy officials of the world are meeting this weekend in Washington at the IMF and World Bank annual meetings.

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Read more of Nouriel’s views on the current economic situation on Nouriel Roubini’s Global EconoMonitor at http://www.rgemonitor.com/blog/roubini.

For RGE Monitor's Complete Coverage of the Global Financial Crisis click here.