[A-List] The world is at severe risk ...

[Bill Totten]

... of a global systemic financial meltdown and a severe global depression

by Nouriel Roubini

RGE Monitor (October 09 2008)


The US and advanced economies' financial system is 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, that is, 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 (US, 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 fand that had
borrowed short and in foreign currencies.

Countries with large current account deficit 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 US 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 US
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 US 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 twenty percent plus in US 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 financial market is scary.
When Bear Stearns' creditors were bailed out to the tune of $30 billion
in March the rally in equity, money and credit markets lasted eight
weeks; when in July the US 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 US government the rally lasted
one day and by the next day the panic has 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 five percent.

Next when the $700 billion US rescue package was passed by the US Senate
and House markets fell another seven percent in two days as there was no
confidence in this flawed plan and the authorities. Next as authorities
in the US 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, et cetera) the stock markets
and the credit markets and the money markets fell further and further
and at an accelerated rates day after day all week including another
seven percent fall in US 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 crack and a systemic
financial sector and corporate sector collapse. A vicious circle of
deleveraging, asset collapses, margin calls, 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. At this stage central banks that are usually
supposed to be the "lenders of last resort" need to become the "lenders
of first and only resort" as, under conditions of panic and total loss
of confidence, no one in the private sector is lending to anyone else
since counterparty risk is extreme. And fiscal authorities that usually
are spenders and insurers of last resort need to temporarily become the
spenders and insurers of first resort. The fiscal costs of these actions
will be large but the economic and fiscal costs of inaction would be of
a much larger and severe magnitude. Thus, 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.

Thursday midnite update: A few hours after I had written this note the
market crash that I warned about is underway in Asia: the Nikkei index
in Japan is down eleven percent and all other Asian markets are sharply
down. This reinforces the urgency of credible and rapid policy actions
by the G7 financial officials who are meeting in a few hours in
Washington and the need to also involve in such global policy
coordination the systemically important emergent market economies.

http://www.rgemonitor.com/roubini-monitor/253973/the_world_is_at_severe_risk_of_a_global_systemic_financial_meltdown_and_a_severe_global_depression


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