[Marxism] America’s economy risks mother of all meltdowns

[Louis Proyect]

(Most interesting that my friend Doug Henwood would post this to 
LBO-Talk since Doug has been averse to crisis-mongering for the longest 
time.)

Financial Times - February 19, 2008
America’s economy risks mother of all meltdowns
By Martin Wolf

“I would tell audiences that we were facing not a bubble but a froth
– lots of small, local bubbles that never grew to a scale that could
threaten the health of the overall economy.” Alan Greenspan, The Age
of Turbulence.

That used to be Mr Greenspan’s view of the US housing bubble. He was
wrong, alas. So how bad might this downturn get? To answer this
question we should ask a true bear. My favourite one is Nouriel
Roubini of New York University’s Stern School of Business, founder of
RGE monitor.

Recently, Professor Roubini’s scenarios have been dire enough to make
the flesh creep. But his thinking deserves to be taken seriously. He
first predicted a US recession in July 2006*. At that time, his view
was extremely controversial. It is so no longer. Now he states that
there is “a rising probability of a ‘catastrophic’ financial and
economic outcome”**. The characteristics of this scenario are, he
argues: “A vicious circle where a deep recession makes the financial
losses more severe and where, in turn, large and growing financial
losses and a financial meltdown make the recession even more severe.”

Prof Roubini is even fonder of lists than I am. Here are his 12 –
yes, 12 – steps to financial disaster.

Step one is the worst housing recession in US history. House prices
will, he says, fall by 20 to 30 per cent from their peak, which would
wipe out between $4,000bn and $6,000bn in household wealth. Ten
million households will end up with negative equity and so with a
huge incentive to put the house keys in the post and depart for
greener fields. Many more home-builders will be bankrupted.

Step two would be further losses, beyond the $250bn-$300bn now
estimated, for subprime mortgages. About 60 per cent of all mortgage
origination between 2005 and 2007 had “reckless or toxic features”,
argues Prof Roubini. Goldman Sachs estimates mortgage losses at
$400bn. But if home prices fell by more than 20 per cent, losses
would be bigger. That would further impair the banks’ ability to
offer credit.

Step three would be big losses on unsecured consumer debt: credit
cards, auto loans, student loans and so forth. The “credit crunch”
would then spread from mortgages to a wide range of consumer credit.

Step four would be the downgrading of the monoline insurers, which do
not deserve the AAA rating on which their business depends. A further
$150bn writedown of asset-backed securities would then ensue.

Step five would be the meltdown of the commercial property market,
while step six would be bankruptcy of a large regional or national bank.

Step seven would be big losses on reckless leveraged buy-outs.
Hundreds of billions of dollars of such loans are now stuck on the
balance sheets of financial institutions.

Step eight would be a wave of corporate defaults. On average, US
companies are in decent shape, but a “fat tail” of companies has low
profitability and heavy debt. Such defaults would spread losses in
“credit default swaps”, which insure such debt. The losses could be
$250bn. Some insurers might go bankrupt.

Step nine would be a meltdown in the “shadow financial system”.
Dealing with the distress of hedge funds, special investment vehicles
and so forth will be made more difficult by the fact that they have
no direct access to lending from central banks.

Step 10 would be a further collapse in stock prices. Failures of
hedge funds, margin calls and shorting could lead to cascading falls
in prices.

Step 11 would be a drying-up of liquidity in a range of financial
markets, including interbank and money markets. Behind this would be
a jump in concerns about solvency.

Step 12 would be “a vicious circle of losses, capital reduction,
credit contraction, forced liquidation and fire sales of assets at
below fundamental prices”.

These, then, are 12 steps to meltdown. In all, argues Prof Roubini:
“Total losses in the financial system will add up to more than
$1,000bn and the economic recession will become deeper more
protracted and severe.” This, he suggests, is the “nightmare
scenario” keeping Ben Bernanke and colleagues at the US Federal
Reserve awake. It explains why, having failed to appreciate the
dangers for so long, the Fed has lowered rates by 200 basis points
this year. This is insurance against a financial meltdown.

Is this kind of scenario at least plausible? It is. Furthermore, we
can be confident that it would, if it came to pass, end all stories
about “decoupling”. If it lasts six quarters, as Prof Roubini warns,
offsetting policy action in the rest of the world would be too
little, too late.

Can the Fed head this danger off? In a subsequent piece, Prof Roubini
gives eight reasons why it cannot***. (He really loves lists!) These
are, in brief: US monetary easing is constrained by risks to the
dollar and inflation; aggressive easing deals only with illiquidity,
not insolvency; the monoline insurers will lose their credit ratings,
with dire consequences; overall losses will be too large for
sovereign wealth funds to deal with; public intervention is too small
to stabilise housing losses; the Fed cannot address the problems of
the shadow financial system; regulators cannot find a good middle way
between transparency over losses and regulatory forbearance, both of
which are needed; and, finally, the transactions-oriented financial
system is itself in deep crisis.

The risks are indeed high and the ability of the authorities to deal
with them more limited than most people hope. This is not to suggest
that there are no ways out. Unfortunately, they are poisonous ones.
In the last resort, governments resolve financial crises. This is an
iron law. Rescues can occur via overt government assumption of bad
debt, inflation, or both. Japan chose the first, much to the distaste
of its ministry of finance. But Japan is a creditor country whose
savers have complete confidence in the solvency of their government.
The US, however, is a debtor. It must keep the trust of foreigners.
Should it fail to do so, the inflationary solution becomes probable.
This is quite enough to explain why gold costs $920 an ounce.

The connection between the bursting of the housing bubble and the
fragility of the financial system has created huge dangers, for the
US and the rest of the world. The US public sector is now coming to
the rescue, led by the Fed. In the end, they will succeed. But the
journey is likely to be wretchedly uncomfortable.

*A Coming Recession in the US Economy? July 17 2006,
www.rgemonitor.com; **The Rising Risk of a Systemic Financial
Meltdown, February 5 2008; ***Can the Fed and Policy Makers Avoid a
Systemic Financial Meltdown? Most Likely Not, February 8 2008