Before last October I never heard of Nouriel Roubini, but his appearance as a guest on C-SPAN's Washington Journal got my attention.
Since then in the short space of four months his name has become a household word. If you hear someone talking about "Doctor Doom" this is the man to whom they refer, due to his relentless unheard warnings that the national and global economies were cruising for a bruising. Every week and months that passes proves him to have been more right than wrong.
The vocabulary we use to speak of matters economic is becoming more focused. The word "recession" is now more carefully referred to as V-shaped, U-shaped or L-shaped. These handy letters reflect how a recession might appear on a graph. A V-shaped recession is the old-fashioned okay one, starting with a "Bear" market plunging down, followed by a moment in time we once called the "Bottom," after which smart people would jump into the "Bull" market to make a killing on the way up. Listening to the news over the last month or two I notice a lot more references to a "U-shaped" recession. Hmm... Looks like the "Bottom" is becoming more than just a moment in time. If it is, it's the longest "moment" anyone can remember.
Comes now talk of an "L-shaped" recession. This is not a good thing. An "L" on the chart means we don't know when the economy will get better. Early in the discussion of the various "plans" for the government to throw money at the problem, we heard references to Japan's "lost decade," referring, I suppose, to an "L-shaped" recession that turned into a way of life variously called deflation, stagnation or some neologism of both. As I write this the horizontal line of the "L" is getting longer... along with the vertical line, come to think of it. If this is gonna be a "U-shaped" recession it's the biggest upper-case "U" on record. But more and more smart people are calling it "L-shaped."
This post is simply to put Nouriel Roubini's essay in Forbes in an easy to read form for my own handy reference. He's belled the cat with this one, starting with the title. See if there is anything about the title you don't understand.
It is now clear that this is the worst financial crisis since the Great Depression and the worst economic crisis in the last 60 years. While we are already in a severe and protracted U-shaped recession (the deluded hope of a short and shallow V-shaped contraction has evaporated), there is now a rising risk that this crisis will turn into an uglier, multiyear, L-shaped, Japanese-style stag-deflation (a deadly combination of stagnation, recession and deflation).
The latest data on third-quarter 2008 gross domestic product growth (at an annual rate) around the world are even worse than the first estimate for the U.S. (-3.8%). The figures were -6.0% for the euro zone, -8% for Germany, -12% for Japan, -16% for Singapore and -20% for Korea. The global economy is now literally in free fall as the contraction of consumption, capital spending, residential investment, production, employment, exports and imports is accelerating rather than decelerating.
To avoid this L-shaped near-depression, a strong, aggressive, coherent and credible combination of monetary easing (traditional and unorthodox), fiscal stimulus, proper cleanup of the financial system and reduction of the debt burden of insolvent private agents (households and nonfinancial companies) is necessary in the U.S. and other economies.
Unfortunately, the euro zone is well behind the U.S. in its policy efforts for several reasons. The first is that the European Central Bank is behind the curve in cutting policy rates and creating nontraditional facilities to deal with the liquidity and credit crunch. The second is that the fiscal stimulus is too modest, because those who can afford it (Germany) are lukewarm about it, and those who need it the most (Spain, Portugal, Greece, Italy) can least afford it, as they already have large budget deficits. The last reason is that there is a lack of cross-border burden sharing of the fiscal costs of bailing out financial institutions.
With its aggressive monetary easing and large fiscal stimulus putting it ahead, the U.S. has done more. Except for two elements, both key to avoiding a near-depression, which are still missing: a cleanup of the banking system that may require a proper triage between solvent and insolvent banks and the nationalization of many banks, even some of the largest ones; and a more aggressive, across-the-board reduction of the unsustainable debt burden of millions of insolvent households (i.e., a principal reduction of the face value of the mortgages, not just mortgage payments relief).
Moreover, in many countries, the banks may be too big to fail but also too big to save, as the fiscal/financial resources of the sovereign may not be large enough to rescue such large insolvencies in the financial system.
Traditionally, only emerging markets suffered--and still suffer--from such a problem. But now such sovereign risk, as measured by the sovereign spread, is also rising in many European economies whose banks may be larger than the ability of the sovereign to rescue them: Iceland, Greece, Spain, Italy, Belgium, Switzerland and, some suggest, even the U.K.
The process of socializing the private losses from this crisis has already moved many of the liabilities of the private sector onto the books of the sovereign. Among these liabilities are banks, other financial institutions and, soon possibly, households and some important nonfinancial corporate companies.
At some point a sovereign bank may crack, in which case the ability of governments to credibly commit to act as a backstop for the financial system, including deposit guarantees, could come unglued.
Thus the L-shaped, near-depression scenario is still quite possible (I assign it a 30% probability), unless appropriate and aggressive policy action is undertaken by the U.S. and other economies.
This severe economic and financial crisis is now also leading to a severe backlash against financial globalization, free trade and the free-market economic model.
To paraphrase Churchill, capitalist market economies open to trade and financial flows may be the worst economic regime--apart from the alternatives. However, while this crisis does not imply the end of market-economy capitalism, it has shown the failure of a particular model of capitalism. Namely, the laissez-faire, unregulated (or aggressively deregulated), Wild West model of free market capitalism with lack of prudential regulation, supervision of financial markets and proper provision of public goods by governments.
There is the failure of ideas--such as the "efficient market hypothesis," which deluded its believers about the absence of market failures such as asset bubbles; the "rational expectations" paradigm that clashes with the insights of behavioral economics and finance; and the "self-regulation of markets and institutions" that clashes with the classical agency problems in corporate governance--that are themselves exacerbated in financial companies by the greater degree of asymmetric information. For example, how can a chief executive or a board monitor the risk taking of thousands of separate profit and loss accounts? Then there are the distortions of compensation paid to bankers and traders.
This crisis also shows the failure of ideas such as the one that securitization will reduce systemic risk rather than actually increase it. That risk can be properly priced when the opacity and lack of transparency of financial firms and new instruments leads to unpriceable uncertainty rather than priceable risk.
It is clear that the Anglo-Saxon model of supervision and regulation of the financial system has failed. It relied on several factors: self-regulation that, in effect, meant no regulation; market discipline that does not exist when there is euphoria and irrational exuberance; and internal risk-management models that fail because, as a former chief executive of Citigroup put it, when the music is playing, you've got to stand up and dance.
Furthermore, the self-regulation approach created rating agencies that had massive conflicts of interest and a supervisory system dependent on principles rather than rules. In effect, this light-touch regulation became regulation of the softest touch.
Thus, all the pillars of the 2004 Basel II banking accord have already failed even before being implemented. Since the pendulum had swung too much in the direction of self-regulation and the principles-based approach, we now need more binding rules on liquidity, capital, leverage, transparency, compensation and so on.
But the design of the new system should be robust enough to counter three types of problems with rules. A tendency toward "regulatory arbitrage" should be kept in mind, as bankers can find creative ways to bypass rules faster than regulators can improve them. Then there is "jurisdictional arbitrage," as financial activity may move to more lax jurisdictions. And, finally, "regulatory capture," as regulators and supervisors are often captured--via revolving doors and other mechanisms--by the financial industry. So the new rules will have to be incentive-compatible, i.e., robust enough to overcome these regulatory failures.
Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.