Friday, October 28, 2011

GUEST POST: Nouriel Roubini on how to avoid a depression

A very important piece from Nouriel Roubini, the man who predicted the 2008 financial meltdown, about what should be done to avoid a deep recession/depression. He knows what he is talking about. Miss reading this one at your peril:

  • Data suggest that developed and emerging markets alike are heading for a massive slowdown in growth, with advanced economies already slumping to stall speed.
  • The risks ahead are not merely of a mild double dip, but rather are of another severe recession that could turn into an economic depression and a severe financial crisis in most advanced economies.
  • What can be done to minimize the economic and financial fallout and reduce the tail risks of a severe economic and markets downturn? Any plan would include a combination of some or all of the following broad policy responses: Avert front-loaded fiscal austerity and provide short-term stimulus; ease monetary policy; provide liquidity to illiquid but solvent sovereigns and private agents; restructure unsustainable private and public debts in an orderly manner; recapitalize banks; restore the competitiveness of struggling economies, possibly through exits from monetary union; invest in workers and long-term productivity growth; encourage emerging markets to pull their weight and help global rebalancing.

The latest macro data indicate that most advanced economies—the U.S., most of the eurozone (EZ), the UK, Japan —are falling back into recession, while stress in the financial system and markets is reaching levels not seen since the collapse of Lehman Brothers. At the same time, hopes that strongly growing emerging markets (EMs) can decouple from the G7 downturns are now being dashed: The latest global PMIs suggest a massive slowdown of growth in EMs from China, Taiwan and South Korea in Asia to Brazil in Latin America and Turkey and Russia in emerging Europe. It is clear that we are at stall speed in the global economy and, as with an airplane that decelerates rapidly and stalls, there are only two options: Either the plane—the global economy—rapidly reaccelerates to return to escape velocity or it starts to free fall.

The coming economic contraction could be more severe than that of 2007-09, for several reasons:

  • Then, the problems were limited to private sector debt and leverage; they have now extended to government debts and leverage;
  • Then, all policy bullets were available; now, most monetary and fiscal ammunition is spent;
  • Then, governments could backstop and bailout banks; now, the political backlash against banks and their bailouts is strong and sovereign risk is a source of banking risk as most bonds of near-insolvent sovereigns are held by banks, especially in Europe;
  • Then, policy makers reacted rapidly and ahead of the curve after the collapse of Lehman; now, there is dithering and muddling through and kicking the can down the road, in the context of the mistaken belief that a double dip is unlikely.

Therefore, the risk of a worse economic and financial crisis (now involving weak and near-insolvent sovereigns rather than just the private sector) than the previous one is significant. We are already behind the curve as regards the policy response to the coming global storm and the time to take bold action is now, if not yesterday. What can be done to minimize the economic and financial fallout of the now highly likely economic contraction?

First: Avoid Front-Loaded Fiscal Austerity and Provide Short-Term Fiscal Stimulus

First, fiscal austerity, while necessary to prevent a medium-term fiscal train wreck, has severely negative effects on output in the short run as raising taxes and reducing subsidies and government spending—even unproductive spending—has adverse effects on aggregate demand and disposable income. So, if EZ periphery countries are forced to implement fiscal austerity, other countries that are able to provide short-term stimulus should do so and postpone credible austerity to the medium term: This includes the U.S., the UK, Germany and the EZ core, Japan and other sound advanced economies. In this context, infrastructure banks should be created and capitalized to provide sorely needed financing to public projects—possibly in the form of public-private partnerships.

In the EZ periphery, where fiscal austerity is unavoidable as it is effectively imposed by bond vigilantes forcing discipline, the short-run effects of such austerity on growth are severe, as recent data from Greece, Spain and Portugal confirm. Thus, back-loading (as opposed to front-loading) fiscal austerity—while legislating fiscal policy changes to achieve medium-term fiscal discipline—may be necessary, with official resources providing some fiscal breathing space for countries that have lost or are at risk of losing market access. At the same time, infrastructure projects financed at the EU level—rather than through national balance sheets—could help to restore growth in EZ periphery members that are now falling into a vicious circle of ever-deepening austerity and recession.

If some short-term austerity is needed, it should start only with more progressive taxation of income and wealth as sharply rising income and wealth inequality—now as high in the U.S. as at the dawn of the Great Depression in 1929—has become a serious source of social and political instability (both in advanced economies and EMs) and is depressing aggregate demand. Corporations flush with trillions of dollars of profits and cash are not holding off from spending or hiring as a result of high taxes or regulatory risks; rather, they are not spending because their cost-slashing in the form of job cuts has led to a sharp fall in labor income and final demand that can only be reversed by redistributing income back to lower-income households and workers (see P. Loungani et al., 2011). Overall, aside from more progressive taxation, fiscal austerity can wait until later as a severe recession or depression will widen deficits and debt much more than short-term stimulus that prevents a global depression.

Second: Ease Monetary Policy, Preferably in the Form of Credit Easing

Second, while monetary policy has a limited impact when the problems are those of excessive debt and insolvency rather than illiquidity, appropriate monetary easing can be helpful. The ECB should rapidly reverse its stubborn and mistaken decision to hike rates that made the problems of the EZ periphery—sovereign, banking, competitiveness and growth risks—much worse. The Fed should embark on another round of quantitative easing (QE3); the Bank of England should also ease as inflation crests and recedes. Ditto the Bank of Japan and the Swiss National Bank.

Inflation will soon be the last and least of the problems that central banks will have to face as renewed slack in goods, labor, real estate and commodity markets will lead—like in 2008—to rapidly disinflationary (if not outright deflationary) pressures. And rather than traditional QE, which is not very effective as it leads to excess reserve hoarding by banks already flush with liquidity, central banks now need to resort to outright credit easing (CE) in the form of central bank purchases of private claims that are farther out than government bonds in the credit chain. CE is more effective as it reduces spreads on private debts that weigh on crunched households and corporate firms.

Third: Provide Liquidity to Illiquid but Solvent Sovereigns and Private Agents

Third, the provision of large amounts of liquidity to agents (governments and others in the private sector) that are illiquid but solvent—conditional on adjustment, fiscal austerity and structural reforms—is absolutely necessary to prevent a self-fulfilling spike in spreads and a loss of market access that would turn illiquidity into insolvency. Even with policy changes, it takes time for governments to restore their credibility and, until then, markets will keep up pressure on spreads, making a self-fulfilling crisis likely. This issue is now critical for Spain and Italy, which are too big to fail (TBTF), but also too big to be saved. Even if the proposed changes to the European Financial Stability Facility (EFSF) are rapidly approved (with the result that the ECB’s current program of purchases of Italian and Spanish bonds is phased out and the baton is passed to the EFSF), the current €440 billion envelope of resources is not sufficient to prevent a self-fulfilling run on Italy and Spain.

Thus, in rapid order, a doubling or tripling of the EFSF must be ratified as a step toward the eventual approval of E-bonds, which will take much longer given the legal constraints of a Europe-wide Treaty change (necessary for the introduction of such bonds). If it takes too much time to approve E-bonds or a much larger EFSF, the ECB will have to resume its current backstopping (lender-of-last-resort support) of Italy and Spain. The credit risk that the ECB would undertake in doing that—in the event of either country turning out to be insolvent, rather than just illiquid, even after austerity and reforms—should be dealt with by relevant EZ sovereigns committing to fully recapitalize the ECB under that scenario. There may be also room for the IMF to support a backstopping of TBTF Italy and Spain, but that would require a rapid reactivation of the New Agreements to Borrow, which would provide an envelope of US$580 billion of funds from the IMF.

Fourth: Restructure Unsustainable Private and Public Debts in an Orderly Manner

Fourth, problems of unsustainable debts that cannot be resolved with growth (as potential and actual growth is low), with savings (as the paradox of thrift implies that front-loaded spending cuts by private and public agents reduces output and makes such debts even more unsustainable) or with inflation (as this option is not currently feasible, likely or desirable) have to be resolved with orderly debt restructuring, debt reductions and the conversion of debt into equity. This is the way to tackle insolvent governments, households and financial institutions. Kicking the can down the road and turning private debts into public debts and public debts into super-national debts (IMF, ECB, EFSF, European Financial Stabilization Mechanism) is not a solution for insolvent (as opposed to illiquid) agents: No one is coming from Mars or the Moon to bailout the ECB or the EFSF if Germany eventually loses its triple-A rating in the event of insolvent governments/banks being back-stopped permanently.

Specifically, the recent decision to allow a restructuring of Greek debt with only a modest haircut for private creditors—a 21% net present value debt reduction—was insufficient; a much deeper haircut of the order of 40-50% is required for Greece. Similarly, it is likely that both Portugal and Ireland will require public debt restructuring. Ireland could avoid that path only if it were to rapidly reverse its wrong-headed decision to socialize the losses of its banking system; either the senior and junior bond creditors of its banks must receive haircuts or, eventually, the sovereign will become insolvent.

In general, creditors of insolvent banks—with the exception of insured depositors—must accept losses. Thus, mechanisms to perform orderly debt reductions for banks and financial institutions need to be designed. And EZ banks need to be recapitalized (possibly with public money) if, after shareholders and bond creditors are hit, more capital is needed to make a bank solvent and properly capitalized.

Similar deep debt restructuring is necessary for insolvent households in the U.S. and other countries burdened by too much household (mortgage and consumer) debt: Rapid, radical across-the-board debt-servicing reductions are necessary to stop an ever more vicious spiral of mortgage defaults, foreclosures and further home price deflation. A triage between agents who can afford mortgages when given appropriate debt relief and those who would lose their homes on the basis of insolvency under any likely state of the world will suffice to reduce moral hazard and allow the housing market to bottom out. Similar triage is necessary for governments and banks along the lines of which are illiquid, given adjustment, and which are insolvent.

Fifth: Recapitalize Banks, Possibly via Public Equity Injections

Fifth, banks and banking systems in the EZ that are under-capitalized should be rapidly recapitalized with public capital in a EU-wide version of the U.S. TARP; and this time, government officials should sit on the boards of banks to prevent aggressive credit deleveraging that reduces credit growth. And to prevent a further credit crunch as banks deleverage, some degree of short-term forbearance of capital and liquidity should be given to banks to jump-start credit creation. The EZ approach to bank recapitalization has been, so far, a denial of the problem. It does not matter whether the small EU estimates or the much larger IMF estimates of EZ banks’ capital needs are correct: Markets and investors do not believe the results of two rounds of stress tests that have not considered the implications of massive losses for banks from orderly or disorderly public debt restructurings in the EZ. Thus, a rapid and front-loaded massive recapitalization of EZ banks—like the U.S. TARP program—is necessary. Some national authorities (for example, Germany) may have the fiscal resources to recapitalize their own banks, but some (for example, in the EZ periphery) do not; thus, a pan-European recapitalization program is urgently necessary. To avoid stigma—as with TARP—most financial institutions should be required to accept the public capital. In time (like in the U.S.), those with better balance sheets and profitability would phase out public capital once they prove that they have the earnings and capital to thrive without public equity support.

Even in the U.S., another economic crisis could lead to another banking crisis, and thus a systemic financial crisis. Delusions that TBTF banks can be orderly resolved are just that—delusions. So, now is the time to break up TBTF financial supermarkets such as Bank of America and Citigroup—and eventually even Goldman Sachs and JP Morgan, which have become, as it were, even more TBTF—with banking consolidations following the 2008 crisis. Since the financial system is still unlikely to provide credit to small and medium-sized enterprises (SMEs) that are suffering from a credit crunch, the direct provision of credit by governments to solvent but illiquid and crunched SMEs is of paramount importance. Entirely reasonable worries about not creating other government-sponsored monstrosities should be left to the medium term, when the current emergency has passed.

Sixth: Restore Competitiveness, Possibly Through Orderly Exit from the Eurozone

Sixth, even if Greece and other insolvent members of the EZ periphery were to be given significant relief on their public debt burdens, they would not return to growth unless their competitiveness is rapidly restored. And, without a rapid return to growth, more defaults, as well as social and political turmoil, cannot be avoided. There are only four options to restore competitiveness and growth:

1) A sharp weakening of the euro toward parity with the U.S., which is unlikely to occur as the U.S. is weak, thus exerting downward pressure on the U.S. dollar, while Germany is uber-competitive;

2) A rapid reduction in unit labor costs via the acceleration of structural reforms (a rapid increase in productivity growth above wage growth—the German solution), which is also unlikely as it took 15 years for Germany to restore its competitiveness via that process;

3) A rapid five-year cumulative 30% deflation in prices and wages, which is unlikely to be feasible as it would be associated with (a socially unacceptable) five years of ever-deepening depression; also, even if feasible, such deflation would make the country undertaking it more insolvent, given a 30% increase in the real value of its debts;

4) If the first three options cannot restore competitiveness, the only other option left is the exit of Greece and some other current EZ members from the monetary union. Only a return to a national currency and a sharp depreciation of that currency would quickly restore competitiveness and growth, as with Argentina. The trade losses for the EZ core that a return to national currencies in Greece or Portugal would entail would be extremely modest as the total GDP of Greece and Portugal is barely 3% of the EZ total, while their trade with Germany and the rest of the EZ represents an even smaller share of GDP.

The most significant losses that an exit of some periphery members would entail are the capital losses for core financial institutions resulting from the balance sheet effects of a return to national currencies: Overnight, the foreign liabilities in euros of an exiting country’s government, banks, corporate firms and households would surge by a percentage amount equal to the rate of first the nominal and then the real depreciation of the new national currency. Then, only two options are available: A coercive conversion of such liabilities from euros into the new national currency at an exchange rate different from the new floating rate of the new national currency; or, a default and then a negotiated reduction of euro debts. The first option would be legal for liabilities issued in a domestic legislation; the second option would be available for liabilities incurred cross-border in a foreign jurisdiction. This is what Argentina did in 2001 when it moved off its currency board—pesification of dollar debts; and what the U.S. did in 1993 when it depreciated the dollar by 69% and repealed the gold clause. A similar unilateral “drachmatization” of euro debts would be necessary and unavoidable.

Then, the losses that core EZ banks and investors would suffer from such a capital levy on their euro claims on the Greek government, banks and corporate firms could be large but manageable if core EZ financial institutions are properly and aggressively recapitalized and proper forbearance used to spread such losses over time. And an orderly case-by-case negotiated reduction of euro debts issued in a foreign jurisdiction (say Frankfurt or Paris) by Greek agents would be manageable as the number of banks and corporates with such liabilities is modest. Avoiding a banking system implosion after an EZ exit would entail, unfortunately, the imposition of Argentine-style measures—such as bank holidays and capital controls—to prevent a disorderly fallout; realistically, lots of collateral damage would occur, but this could be managed and limited. Some private sector estimates that the cost of exit from EMU could be as high as 40-50% of GDP for the exiting countries appear to be vastly exaggerated; losses could be much smaller if debts are orderly converted into the new local currency and if a sharp currency depreciation rapidly restores economic growth. In conclusion, some EZ members may need to exit the monetary union and can do so in an orderly fashion—i.e. limiting the collateral damage that this would imply—if mechanisms are implemented to limit losses for core creditors and ensure that the domestic banking system does not implode.

Seventh: Invest in Workers and Long-Term Productivity Growth

Seventh, the reasons for the high unemployment rate and the anemic growth recovery—and the risk of another downturn—in advanced economies are structural, not just cyclical, in two important ways: First, the burden of too much private and public debt and the painful multi-year deleveraging process; second, the consequences of globalization, especially EMs joining the global economy, for advanced economies that are experiencing a hollowing out of their manufacturing sectors first and of their tradable services sectors next. Having 2.3 billion Chindians (Chinese and Indians) joining the global labor force (as well as another billion Asians, Latin Americans and other workers in EMs) was likely to be disruptive first of the jobs and wages of blue collar, unskilled workers in advanced economies and next of jobs and wages that are offshore-able—white collar jobs in lower-skilled traded services sectors.

Of course, the appropriate response to such massive structural change in the global economy is not to erect protectionist walls that would damage both advanced economies and EMs, but rather to invest in increasing the skills and productivity of workers in advanced economies to provide them with the tools to be able to compete in this globalized economy. This is an issue that cannot be resolved over a cyclical horizon. So, critics of cyclical responses—more monetary and fiscal stimulus to boost growth and jobs might not resolve structural problems—have a very valid point: We rather need a medium- to long-term plan to restore competitiveness and jobs in advanced economies via massive new investment in high-quality education, job training and human capital improvements, infrastructure, the green economy and alternative/renewable energy. Such investment will require massive fiscal resources that can be fiscally sustainable only if taxes are raised in under-taxed economies—such as the U.S.—and if tax systems are made more progressive in Anglo-Saxon economies that have traditionally had less regressive taxation. Still, while traditional macro policies—monetary and fiscal easing—cannot restore high employment and GDP growth and sharply reduce unemployment unless such structural reforms are implemented, avoiding another depression requires short-term macro stimulus in tandem with investments to restore medium-term growth on a more structural basis.

Eighth: Encourage EMs to Pull Their Weight and Help Global Rebalancing

Eighth, EMs should do their share to support the global economy. As their balance sheets are mostly stronger and they have more policy bullets left than advanced economies, they should ease monetary and fiscal policy and provide—as needed—liquidity support to their financial systems. The IMF and World Bank—possibly armed with the greater amounts of capital that are now needed—can provide lender-of-last-resort support to those EMs at risk of losing market access, conditional on appropriate policy reforms. Swap lines between advanced economies’ central banks and between these and central banks in EMs should be rapidly activated as needed. And countries relying excessively on net exports for growth—such as China and other EMs—should rapidly accelerate reforms that boost domestic demand and consumption, including allowing more rapid currency appreciation. Sticking with unsustainable export-led growth models based on weak currencies will become unsustainable once G3 economies double dip. Thus, it is in the urgent interest of China to accelerate reforms that, for the very first time after a lost decade of idle talk and little action, increase the consumption share in GDP rather than reduce it.


The risks ahead are not just of a mild double dip, but rather another severe recession that may turn into another depression and financial crisis. Wrong-headed policies in the Great Depression led to currency and trade wars; disorderly debt defaults; deflation, followed at times by inflation when insolvent sovereigns massively monetized deficits after losing market access; increased income and wealth inequality, populism, poverty and social desperation; and finally, social and political instability that paved the way for authoritarian and aggressive regimes (from Germany to Italy, Spain and Japan) and eventually led to World War II. The risks of a repeat of the 1930s cannot now be underestimated. Thus, the time for bold and aggressive global policy action is now.

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The Intelligent Investor: The Definitive Book on Value Investing. A Book of Practical Counsel (Revised Edition) by Benjamin Graham
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