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14 October 2008

Governments got religion after peering into the systemic meltdown abyss: aggressive and comprehensive policy action is now likely, Nouriel Roubini

...but significant downside risks to markets will remain

I spent the weekend in Washington attending the IMF annual meetings and giving a series of talks in a variety of public and private fora (IADB talk, C-Span interview, Euro 50 Group meeting, IMF panel, etc.). After last week crash in stock markets and financial markets (and it was indeed a crash as during the week equity prices fell as much as the two day crash of 1929) policy makers finally realized the risk of a systemic financial meltdown, they peered into the systemic collapse abyss a few steps in front of them and finally got religion and started announcing radical policy actions (the G7 statement, the EU leaders agreement to bailout European banks, the British plan to rescue – and partially nationalize - its banks, the European countries plans along the same lines, and the Treasury plan to ditch the initial TARP that was aimed only buying toxic assets in favor of plan to recapitalize – i.e. partially nationalize – US banks and broker dealers. While many details of these plans are fuzzy and there will be some national variants the contour of the approach are similar and close to the recommendations that I made in this forum. Here are the main policy actions that will be undertaken:

- Preventing systemically important banks and broker dealers from going bust (i.e. the U.S. made a mistake letting Lehman fail; so Morgan Stanley and other systemically important financial institutions will be rescued) (“Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure” as in the G7 statement )

- Recapitalization of banks and broker dealers via public injections of capital via preferred shares (i.e. partial nationalization of financial institutions as it is already occurring in the UK, Belgium, Netherlands, Germany, Iceland and, soon enough the U.S.) matched by private equity injections (“Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses”)

- Temporary guarantee of bank liabilities: certainly all deposits, possibly interbank lines along the lines of the British approach, likely other new debts incurred by the banking system (“Ensure that our respective national deposit insurance and guarantee programs are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits”)

- Unlimited provision of liquidity to the banking system and to some parts of the shadow banking system to restore interbank lending and lending to the real economy (“Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses”)

- Provision of credit to the corporate sector via purchases of commercial paper (certainly in the US, possibly in Europe)

- Purchase of toxic assets to restore liquidity in the mortgage backed securities market (U.S.) (“Take action, where appropriate, to restart the secondary markets for mortgages and other securitized assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high quality accounting standards are necessary.”)

- Implicit triage between distressed that are solvent given liquidity support and capital injection and non-systemically important and insolvent banks that will need to be closed down/merged/resolved/etc.

- Use of the IMF and other international financial institutions to provide lending to many emerging market economies – and some advanced ones such as Iceland - that are now at risk of a severe financial crisis.

- Use of any other tools that is available and necessary to avoid a systemic meltdown (including implicitly more monetary policy easing as well as possibly fiscal policy stimulus “We will use macroeconomic policy tools as necessary and appropriate.”).

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. Only over time private lending will recover.

While most of the economic and financial damage is already done and the global economy will not be able to avoid a painful recession, financial and banking crisis (i.e. the V-shaped short and shallow 6-month recession is now out of the window and we will experience a severe and more protracted 18 to 24 months U-shaped recession) the rapid and consistent implementation of these and other action will prevent the US, European and global economies from experiencing a systemic financial meltdown and entering in a more severe L-shaped decade long stagnation like the one experienced by Japan after the bursting of its real estate and equity bubble.

Are we close to the bottom of this financial crisis? Today stock markets – and other financial markets - will rally on the news that terrified policy makers peering into the abyss got religion and started to do in a consistent way what is necessary but financial markets will remain volatile with significant downside risks over the next few weeks as:

- details of these plans are still very fuzzy and ambiguous and with uncertain effects on various assets classes (common shares, preferred shares, unsecured debt of financial institutions, etc.);

- macro news will surprise on the downside as the economies sharply weaken and contract while fiscal policy stimulus is lagging;

- earnings news for financial and non financial firms will surprise on the downside;

- the damage done to confidence and to levered investment is already severe and the process of deleveraging of the shadow financial system will continue;

- major sources of future stress in the financial system remain; these include the risk of a CDS market blowout, the collapse of hundreds of hedge funds, the rising troubles of many insurance companies, the risk that other systemically important financial institutions are insolvent and in need of expensive rescue programs, the risk that some significant emerging market economies and some advanced ones too (Iceland) will experience a severe financial crisis, the ongoing process of deleveraging in illiquid financial markets that will continue the vicious circle of falling asset prices, margin calls, further deleveraging and further sales in illiquid markets that continues the cascading fall in asset prices, further downside risks to housing and to home prices.

More aggressive and consistent and rapid implementation of the policy plans will increase the likelihood that risky asset prices will bottom out sooner rather than later and then start recovering. A key policy tool – that is currently missing in the G7 and EU plans is to use fiscal policy to boost aggregate demand. Indeed, given the current collapse of private aggregate demand (consumption is falling, residential investment is falling, non-residential investment in structures is falling, capex spending by the corporate sector was falling already before the latest financial and confidence shock and will now be plunging at an even faster rate) it is urgent to provide a boost to aggregate demand to ensure that an unavoidable two-year recession does not become a decade long stagnation. Since the private sector is not spending and since the first fiscal stimulus plan (tax rebates for households and tax incentives to firms) miserably failed as households and firms are saving rather than spending and investing it is necessary now to boost directly public consumption of goods and services via a massive spending program (a $300 bn fiscal stimulus): the federal government should have a plan to immediately spend in infrastructures and in new green technologies; also unemployment benefits should be sharply increased together with a targeted tax rebates only for lower income households at risk; and federal block grants should be given to state and local government to boost their infrastructure spending (roads, sewer systems, etc.). If the private sector does not spend and/or cannot spend old fashioned traditional Keynesian spending by the government is necessary. It is true that we are already having large and growing budget deficits; but $300 bn of public works is more effective and productive than spending $700 bn to buy toxic assets. Is such fiscal stimulus plan is not rapidly implemented any improvement in the financial conditions of financial institution that the rescue plans will provide will be undermined – in a matter of six months – with an even sharper drop of aggregate demand that will make an already severe recession even more severe. So a fiscal stimulus plan is essential to restore – on a sustained basis – the viability and solvency of many impaired financial institutions. If Main Street goes bust in the next six months rescuing in the short run Wall Street will still lead Wall Street to go bust again as the real economy implodes further.

Moreover, the US government will need to implement a clear plan to reduce the face value of mortgages for distressed home owners and avoid a tsunami of foreclosures (as in the Great Depression HOLC and in my HOME proposal). Households in the US have too much debt (subprime, near prime, prime mortgages, home equity loans, credit cards, auto loans and student loans) while their assets (values of their homes and stocks) are plunging leading to a sharp fall in their net worth. And households are getting buried under this mountain of mounting debt and rising debt servicing burdens. Thus, a fraction of the household sector – as well as a fraction of the financial sector and a fraction of the corporate sector and of the local government sector – is insolvent and needs debt relief. When a country (say Russia, Ecuador or Argentina) has too much debt and is insolvent it defaults and gets debt reduction and is then able to resume fast growth; when a firm is distressed with excessive debt it goes into bankruptcy court and gets debt relief that allows it to resume investment, production and growth; when a household is financially distressed it also needs debt relief to be able to have more discretionary income to spend. So any unsustainable debt problem requires debt reduction. The lack of debt relief to the distressed households is the reason why this financial crisis is becoming more severe and the economic recession - with a sharp fall now in real consumption spending – now worsening. The fiscal actions taken so far (income relief to households via tax rebates) do not resolve the fundamental debt problem because you cannot grow yourself out of a debt problem: when debt to disposable income is too high increasing the denominator with tax rebates is ineffective and only temporary; i.e. you need to reduce the nominator (the debt). During the Great Depression the Home Owners’ Loan Corporation was created to buy mortgages from bank at a discount price, reduce further the face value of such mortgages and refinance distressed homeowners into new mortgages with lower face value and lower fixed rate mortgage rates. This massive program allowed millions of households to avoid losing their homes and ending up in foreclosure. The HOLC bought mortgages for two year and managed such assets for 18 years at a relatively low fiscal cost (as the assets were bought at a discount and reducing the face value of the mortgages allowed home owners to avoid defaulting on the refinanced mortgages). A new HOLC will be the macro equivalent of creating a large “bad bank” where the bad assets of financial institutions are taken off their balance sheets and restructured/reduced.

A large fiscal stimulus plan and a plan to reduce the debt overhang of distressed home owners will also ease the political economy of the financial bailout: as the debate in Congress showed the US public is mad about a system where gains and profits are privatized while losses are socialized, a welfare system for the rich, the well connected and Wall Street. Bernanke and Paulson and the US administration did a lousy job in explaining why partially bailing Wall Street is necessary to avoid severe collateral damage to Main Street in the form of a most severe recession and a risk of an even more severe economic stagnation. At least the redesign of the TARP into a program that will recapitalize banks with public capital (and thus provide the US government and the taxpayer with some upside potential) makes this bailout more socially fair and acceptable.

But the current collapse of private aggregate demand makes it fair, necessary and efficient to directly help Main Street with a direct fiscal stimulus program and with a plan to reduce the debt burden of distressed home owners. Those two additional policy actions are necessary and fundamental – together with the rescue and recapitalization of financial institutions – to minimize the damage to the real economy and to the financial system.

Post-Scriptum: Many many congrats to Paul Krugman for his very well deserved Nobel Prize in economics. While the prize was awarded to Paul for his contributions to trade theory his work in international macro/finance (currency and financial crises, currency target zones, reserve currencies, pass-through of exchange rates to import prices, contractionary effects of devaluations, sovereign debt crises, etc.) is as important and seminal. And his economic commentary is as incisive and deep as his more analytical research work.

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