[R-G] Warning: More Doom Ahead

[Anthony Fenton]

Warning: More Doom Ahead
By Nouriel Roubini
http://www.foreignpolicy.com/story/cms.php?story_id=4591	

January/February 2009
“Because the United States is such a huge part of the global economy,  
there’s real reason to worry that an American financial virus could  
mark the beginning of a global economic contagion.” – Nouriel Roubini,  
March 2008

Last year’s worst-case scenarios came true. The global financial  
pandemic that I and others had warned about is now upon us. But we are  
still only in the early stages of this crisis. My predictions for the  
coming year, unfortunately, are even more dire: The bubbles, and there  
were many, have only begun to burst.

The prevailing conventional wisdom holds that prices of many risky  
financial assets have fallen so much that we are at the bottom.  
Although it’s true that these assets have fallen sharply from their  
peaks of late 2007, they will likely fall further still. In the next  
few months, the macroeconomic news in the United States and around the  
world will be much worse than most expect. Corporate earnings reports  
will shock any equity analysts who are still deluding themselves that  
the economic contraction will be mild and short.

Severe vulnerabilities remain in financial markets: a credit crunch  
that will get worse before it gets any better; deleveraging that  
continues as hedge funds and other leveraged players are forced to  
sell assets into illiquid and distressed markets, thus leading to  
cascading falls in asset prices, margin calls, and further  
deleveraging; other financial institutions going bust; a few emerging- 
market economies entering a full-blown financial crisis, and some at  
risk of defaulting on their sovereign debt.

Certainly, the United States will experience its worst recession in  
decades. The formerly mainstream notion that the U.S. contraction  
would be short and shallow—a V-shaped recession with a quick recovery  
like the ones in 1990–91 and 2001—is out the window. Instead, the U.S.  
contraction will be U-shaped: long, deep, and lasting about 24 months.  
It could end up being even longer, an L-shaped, multiyear stagnation,  
like the one Japan suffered in the 1990s.

As the U.S. economy shrinks, the entire global economy will go into  
recession. In Europe, Canada, Japan, and the other advanced economies,  
it will be severe. Nor will emerging-market economies—linked to the  
developed world by trade in goods, finance, and currency—escape real  
pain.

What constitutes a “recession” will depend on the country in question.  
For China, a hard landing would mean annual growth falls from 12 to 6  
percent. China must grow by 10 percent or more each year to bring 12  
to 15 million poor rural farmers into the modern world. For other  
emerging markets, such as Brazil or South Korea, growth below 3  
percent would represent a hard landing. The most vulnerable countries,  
such as Ecuador, Hungary, Latvia, Pakistan, or Ukraine may experience  
an outright financial crisis and will require massive external  
financing to avoid a meltdown.

For the wealthiest countries, a debilitating combination of economic  
stagnation and deflation might happen as markets for goods go slack  
because aggregate demand falls. Given how sharply production capacity  
has risen due to overinvestment in China and other emerging markets,  
this drop in demand would likely lead to lower inflation. Meanwhile,  
job losses would mount and unemployment rates would rise, putting  
downward pressure on wages. Weakening commodity markets—where prices  
have already fallen sharply since their summer peak and will fall  
further in a global recession—would lead to still lower inflation.  
Indeed, by early 2009, inflation in the advanced economies could fall  
toward the 1 percent level, too close to deflation for comfort.

This scenario is dangerous for many reasons. A number of central banks  
will be close enough to setting interest rates of zero that their  
economies fall into a triple whammy: a liquidity trap, a deflation  
trap, and debt deflation. In a liquidity trap, the banks lose their  
ability to stimulate the economy because they cannot set nominal  
interest rates below zero. In a deflation trap, falling prices mean  
that real interest rates are relatively high, choking off consumption  
and investment. This leads to a vicious circle wherein incomes and  
jobs are falling, with demand dropping still further. Finally, in debt  
deflation, the real value of nominal debts rises as prices fall—bad  
news for countries such as the United States and Japan that have high  
ratios of debt to GDP.

As orthodox monetary tools become ineffective, policymakers will turn  
to unorthodox approaches. We’ll see traditional fiscal policy, in the  
form of tax cuts and spending increases, but also worldwide bailouts  
of lenders, investors, and financial institutions, as well as  
borrowers. Central banks will inject massive amounts of cash into  
financial systems to unclog the liquidity crunch. More radical  
actions, such as outright purchases of corporate and government bonds  
or subsidization of mortgage rates, might also be necessary to get  
credit markets functioning properly again.

This crisis is not merely the result of the U.S. housing bubble’s  
bursting or the collapse of the United States’ subprime mortgage  
sector. The credit excesses that created this disaster were global.  
There were many bubbles, and they extended beyond housing in many  
countries to commercial real estate mortgages and loans, to credit  
cards, auto loans, and student loans. There were bubbles for the  
securitized products that converted these loans and mortgages into  
complex, toxic, and destructive financial instruments. And there were  
still more bubbles for local government borrowing, leveraged buyouts,  
hedge funds, commercial and industrial loans, corporate bonds,  
commodities, and credit-default swaps—a dangerous unregulated market  
wherein up to $60 trillion of nominal protection was sold against an  
outstanding stock of corporate bonds of just $6 trillion.

Taken together, these amounted to the biggest asset and credit bubble  
in human history; as it goes bust, the overall credit losses could  
reach as high as $2 trillion. Unless governments move with more  
alacrity to recapitalize banks and other financial institutions, the  
credit crunch will become even more severe. Losses will mount faster  
than companies can replenish their balance sheets.

Thanks to the radical actions of the G-7 and others, the risk of a  
total systemic financial meltdown has been reduced. But unfortunately,  
the worst is not behind us. This will be a painful year. Only very  
aggressive, coordinated, and effective action by policymakers will  
ensure that 2010 will not be even worse than 2009 is likely to be.

Nouriel Roubini is professor of economics at New York University’s  
Stern School of Business and chairman of RGE Monitor  
(www.rgemonitor.com), an economic and financial consultancy.