Fed to the Rescue?

Before today, I had never heard of Professor Nouriel Roubini of New York University’s Stern School of Business, who is reported in the story below from the Financial Times. But readers of my blogs over the past few years will have noticed my similar views about the degenerating American economy. And I have previously mentioned the Financial Times of London, available online at http://www.ft.com/world. This paper, together with The Economist and others, have provided more objective reporting than is available in the mainstream American financial press.

One of my readers has pointed out the sharply declining non-borrowed reserves at the Federal Reserve system. I should warn you that I am a generalist in in economic matters, not a specialist on the banking system. But I have long been aware of the developing credit crunch, which is the result of countless bad loans, as mentioned in my blog of January 21 about the Big Time Debt Crisis.

Very briefly, I want to clarify that I agree that the Fed and the American Government must do whatever is needed to prevent widespread bank failures. However, going beyond that in vainly trying to stave off the necessary contraction of the stock market and housing prices would ultimately lead to a worse outcome (as I pointed out on February 4, 2008).

The banking system and the overall economy need a return to disciplined management, not perpetual bail-outs. The time for adolescent behaviour is past. The government and financial system must grow up and take the necessary medicine. This will not be pleasant, but the alternative is unthinkable. We need a return to sanity and sober economic principles. No government should stand in the way of necessary economic corrections. They provide cleansing for the whole system.

America’s economy risks mother of all meltdowns

By Martin Wolf

Published: February 19 2008 18:21 | Last updated: February 19 2008 18:21

“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

martin.wolf@ft.com

Copyright The Financial Times Limited 2008

Stop the Press: More Fiscal and Monetary Stimulus won’t fix the ailing American Economy

The traditional response to financial problems by Latin American, African and other third world countries has often been to print more and more money on their printing presses, which then unleashed enormous inflation and devalued their currencies. University of Chicago economist Milton Friedman gained worldwide acclaim by proclaiming that central banks must carefully control the growth of money in every country, or else the economy will suffer and stagnate. The Government of Chile imported his theories and gradually transformed their ailing economy into the most successful economy in South America; other countries later followed this proven model.

Surprisingly now however, the Government of the United States is behaving like a 3rd world country in choosing high monetary growth plus record fiscal deficits, desperately hoping to avoid a looming inflation. I believe these policies are a recipe for disaster.

Imagine a patient who goes to his doctor and says: “I want you to keep me healthy and to make me feel good all of the time. The way I know that I am healthy is by always feeling good. So never let me feel bad.”

The doctor obliges this unreasonable patient and at every visit prescribes more and more pills, but ultimately the patient becomes chronically ill. The patient has also stopped feeling good, a long time ago.

The doctor is the American government (Dr. Bush and Dr. Bernanke) and the patient is the American population who elects their government. The pills are fiscal and monetary stimulus.

This is not a perfect metaphor, but it comes close to the actual situation. The doctor has erroneously come to believe that with increasing doses of pharmaceuticals, no patient should ever get unhealthy or need to feel bad. So the doctor has prescribed these magic pills in ever increasing doses; regrettably, the patient is now looking and feeling just awful.

These expansive economic policies are not entirely new. They started gradually under Doctors Clinton and Greenspan at the beginning of the 1990’s. Since then, America’s trade (or current account) deficit went from a balanced position to an annual deficit of $850 Billion. The American federal deficit widened to over $400 Billion, partly to pay for the Iraq war.

A lot has been written on this distressing topic, particularly in one of my favourite economic newspapers, The Financial Times (http://www.ft.com/home/us). Regrettably, the American press is strangely silent about this potential economic nightmare.

Presidential candidates left and right are rushing to join the Stimulus Parade. The exception is Ron Paul, a little noticed Republican candidate, who seems to better understand this evolving economic crisis.

The real issue is no longer how to avoid a major recession in America – that recession regrettably is already inevitable, and it will be a worse one due to these ignorant doctors. The American population had been lulled into a comatose complacency by the previously escalating stock market and huge increases in house prices, which had made Americans feel rich; that false contentment has now given way to fear as housing prices and stock markets are falling.

Meanwhile, inflation has gained momentum and this unchecked rise of inflation will bedevil the US Government and US Federal Reserve years to come. We should pity the winner of the 2008 election, because he or she may get the worst economy since the one President Roosevelt inherited after the 1932 election.

But how does this all relate to the Big Debt Crisis? Very simply, when so much new money was created during the past 5 years at very low interest rates, lenders felt pressured to find a home, any home, for this ocean of excess liquidity. Credit standards were thrown out the window (e.g. subprime loans), since loans against houses were thought to be always collectible, even if the borrower was unable to pay. Now these bad loans are defaulting in catastrophic amounts and the entire financial system is in deepening danger.

Unfortunately, official government statistics are so distorted (please see my blog of June 9, 2007) that it will take a long while to unravel what has actually happened to the American economy. But at a minimum, the mighty American Dollar has been permanently devalued and de-throned as the world’s leading currency. America is now the world’s largest debtor nation, when a few decades back it was the world’s foremost lender.

Lowering interest rates and decreasing taxes will not stop this economic freefall for more than a brief time. The “doctors” are just printing more money and devaluing their currency still further. A far better course would be to take the painful medicine of an economic correction bravely and then to return to more disciplined economic practices.

Sound economic management would involve strictly controlling monetary growth, as has been done in Europe and elsewhere. It would mean encouraging higher personal saving for Americans, who have long had the lowest savings rate among industrial nations. It would also mean reigning in federal deficits. Balanced budgets these days are only political slogans; government projections always show the deficit disappearing in 5 – 10 years, but every year in fact the deficit continues to worsen.

Finally, the international trade balance really matters a lot. It is not good enough to blame this problem on lower wage counties like China and Mexico. Advanced nations have always needed to compete with poorer nations. America should stop whining and start producing goods and services that the world wants to buy.

There is much more to be said about sound management of an economy, but these are some of the core points. These structural changes could take up to a decade to accomplish. But unlike excessive monetary and fiscal stimulus, they would eventually produce a healthy economy.

(Note to readers outside of the USA: while the American recession will affect the whole world, it will not be nearly as intense in Canada, Europe and other soundly managed economies. But we should wish America well, since we will share some of its pain.)