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The world is at severe risk of a global systemic financial
meltdown and a severe global depression
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Delicious Digg Facebook reddit Technorati Nouriel Roubini | Oct
9, 2008
The US and advanced economies’ financial system is now headed
towards a near-term systemic financial meltdown as day after day
stock markets are in free fall, money markets have shut down
while their spreads are skyrocketing, and credit spreads are
surging through the roof. There is now the beginning of a
generalized run on the banking system of these economies; a
collapse of the shadow banking system, i.e. those non-banks
(broker dealers, non-bank mortgage lenders, SIV and conduits,
hedge funds, money market funds, private equity firms) that,
like banks, borrow short and liquid, are highly leveraged and
lend and invest long and illiquid and are thus at risk of a run
on their short-term liabilities; and now a roll-off of the short
term liabilities of the corporate sectors that may lead to
widespread bankruptcies of solvent but illiquid financial and
non-financial firms.
On the real economic side all the advanced economies
representing 55% of global GDP (US, Eurozone, UK, other smaller
European countries, Canada, Japan, Australia, New Zealand,
Japan) entered a recession even before the massive financial
shocks that started in the late summer made the liquidity and
credit crunch even more virulent and will thus cause an even
more severe recession than the one that started in the spring.
So we have a severe recession, a severe financial crisis and a
severe banking crisis in advanced economies.
There was no decoupling among advanced economies and there is no
decoupling but rather recoupling of the emerging market
economies with the severe crisis of the advanced economies. By
the third quarter of this year global economic growth will be in
negative territory signaling a global recession. The recoupling
of emerging markets was initially limited to stock markets that
fell even more than those of advanced economies as foreign
investors pulled out of these markets; but then it spread to
credit markets and money markets and currency markets bringing
to the surface the vulnerabilities of many financial systems and
corporate sectors that had experienced credit booms and that had
borrowed short and in foreign currencies. Countries with large
current account deficit and/or large fiscal deficits and with
large short term foreign currency liabilities and borrowings
have been the most fragile. But even the better performing ones
– like the BRICs club of Brazil, Russia, India and China – are
now at risk of a hard landing. Trade and financial and currency
and confidence channels are now leading to a massive slowdown of
growth in emerging markets with many of them now at risk not
only of a recession but also of a severe financial crisis.
The crisis was caused by the largest leveraged asset bubble and
credit bubble in the history of humanity were excessive
leveraging and bubbles were not limited to housing in the US but
also to housing in many other countries and excessive borrowing
by financial institutions and some segments of the corporate
sector and of the public sector in many and different economies:
an housing bubble, a mortgage bubble, an equity bubble, a bond
bubble, a credit bubble, a commodity bubble, a private equity
bubble, a hedge funds bubble are all now bursting at once in the
biggest real sector and financial sector deleveraging since the
Great Depression.
At this point the recession train has left the station; the
financial and banking crisis train has left the station. The
delusion that the US and advanced economies contraction would be
short and shallow – a V-shaped six month recession – has been
replaced by the certainty that this will be a long and
protracted U-shaped recession that may last at least two years
in the US and close to two years in most of the rest of the
world. And given the rising risk of a global systemic financial
meltdown the probability that the outcome could become a decade
long L-shaped recession – like the one experienced by Japan
after the bursting of its real estate and equity bubble – cannot
be ruled out.
And in a world where there is a glut and excess capacity of
goods while aggregate demand is falling soon enough we will
start to worry about deflation, debt deflation, liquidity traps
and what monetary policy makers should do to fight deflation
when policy rates get dangerously close to zero.
At this point the risk of an imminent stock market crash – like
the one-day collapse of 20% plus in US stock prices in 1987 –
cannot be ruled out as the financial system is breaking down,
panic and lack of confidence in any counterparty is sharply
rising and the investors have totally lost faith in the ability
of policy authorities to control this meltdown.
This disconnect between more and more aggressive policy actions
and easings and greater and greater strains in financial market
is scary. When Bear Stearns’ creditors were bailed out to the
tune of $30 bn in March the rally in equity, money and credit
markets lasted eight weeks; when in July the US Treasury
announced legislation to bail out the mortgage giants Fannie and
Freddie the rally lasted four weeks; when the actual $200
billion rescue of these firms was undertaken and their $6
trillion liabilities taken over by the US government the rally
lasted one day and by the next day the panic has moved to
Lehman’s collapse; when AIG was bailed out to the tune of $85
billion the market did not even rally for a day and instead fell
5%. Next when the $700 billion US rescue package was passed by
the US Senate and House markets fell another 7% in two days as
there was no confidence in this flawed plan and the authorities.
Next as authorities in the US and abroad took even more radical
policy actions between October 6th and October 9th (payment of
interest on reserves, doubling of the liquidity support of
banks, extension of credit to the seized corporate sector,
guarantees of bank deposits, plans to recapitalize banks,
coordinated monetary policy easing, etc.) the stock markets and
the credit markets and the money markets fell further and
further and at an accelerated rates day after day all week
including another 7% fall in U.S. equities today.
When in markets that are clearly way oversold even the most
radical policy actions don’t provide rallies or relief to market
participants you know that you are one step away from a market
crack and a systemic financial sector and corporate sector
collapse. A vicious circle of deleveraging, asset collapses,
margin calls, cascading falls in asset prices well below falling
fundamentals and panic is now underway.
At this point severe damage is done and one cannot rule out a
systemic collapse and a global depression. It will take a
significant change in leadership of economic policy and very
radical, coordinated policy actions among all advanced and
emerging market economies to avoid this economic and financial
disaster. Urgent and immediate necessary actions that need to be
done globally (with some variants across countries depending on
the severity of the problem and the overall resources available
to the sovereigns) include:
- another rapid round of policy rate cuts of the order of at
least 150 basis points on average globally;
- a temporary blanket guarantee of all deposits while a triage
between insolvent financial institutions that need to be shut
down and distressed but solvent institutions that need to be
partially nationalized with injections of public capital is
made;
- a rapid reduction of the debt burden of insolvent households
preceded by a temporary freeze on all foreclosures;
- massive and unlimited provision of liquidity to solvent
financial institutions;
- public provision of credit to the solvent parts of the
corporate sector to avoid a short-term debt refinancing crisis
for solvent but illiquid corporations and small businesses;
- a massive direct government fiscal stimulus packages that
includes public works, infrastructure spending, unemployment
benefits, tax rebates to lower income households and provision
of grants to strapped and crunched state and local government;
- a rapid resolution of the banking problems via triage, public
recapitalization of financial institutions and reduction of the
debt burden of distressed households and borrowers;
- an agreement between lender and creditor countries running
current account surpluses and borrowing and debtor countries
running current account deficits to maintain an orderly
financing of deficits and a recycling of the surpluses of
creditors to avoid a disorderly adjustment of such imbalances.
At this point anything short of these radical and coordinated
actions may lead to a market crash, a global systemic financial
meltdown and to a global depression. At this stage central banks
that are usually supposed to be the "lenders of last resort"
need to become the "lenders of first and only resort" as, under
conditions of panic and total loss of confidence, no one in the
private sector is lending to anyone else since counterparty risk
is extreme. And fiscal authorities that usually are spenders and
insurers of last resort need to temporarily become the spenders
and insurers of first resort. The fiscal costs of these actions
will be large but the economic and fiscal costs of inaction
would be of a much larger and severe magnitude. Thus, the time
to act is now as all the policy officials of the world are
meeting this weekend in WashinStayInvest Law Firm on at the IMF and World Bank
annual meetings.
Thursday midnite update: A few hours after I had written this
note the market crash that I warned about is underway in Asia:
the Nikkei index in Japan is down 11% and all other Asian
markets are sharply down. This reinforces the urgency of
credible and rapid policy actions by the G7 financial officials
who are meeting in a few hours in WashinStayInvest Law Firm on and the need to
also involve in such global policy coordination the systemically
important emergent market economies.
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