Martin Wolf Reads Too Much Roubini and Freaks Out

The normally sober and measured Martin Wolf of the Financial Times is getting worn down by reading too many bearish forecasts, particularly those of Nouriel Roubini. And although Wolf would like to dismiss Roubini’s estimates as extreme, his track record in calling this downturn makes him loath to do so.

From the Financial Times:

What am I bid on financial sector losses from the US subprime mortgage crisis? Do I have advances on the $100bn suggested by Ben Bernanke, chairman of the Federal Reserve, only last July? Yes, I now have $500bn from the gentlemen from Goldman Sachs. Any advances on $500bn? Yes, I have $1,000bn-$2,000bn from Nouriel Roubini of New York University’s Stern School of Business. Any advances? Going, going, gone.

It is easy to be cynical about this ascending auction of scary prognoses. But we cannot ignore them.

In “Why Washington’s rescue cannot end the crisis story” (this page, February 27) I analysed the implications of aggregate financial sector losses of $1,000bn. That figure was in line with estimates by Prof Roubini and George Magnus of UBS.
I concluded that even this would be manageable, if painful, for an economy as big and a government as creditworthy as that of the US. Prof Roubini objects that I have taken the downside too lightly. He now argues that financial losses might amount to $3,000bn.

A trillion dollars here, a trillion dollars there, and pretty soon you are talking real money, even for the US. So does this new bid make sense?

Most of the losses will fall not on the financial sector but elsewhere. As Prof Roubini notes, a 10 per cent fall in house prices (relative to the peak) knocks off $2,000bn (14 per cent of gross domestic product) from household wealth. The first 10 per cent fall has already happened. What he sees as a likely 30 per cent cumulative fall would wipe out $6,000bn, 42 per cent of GDP and 10 per cent of household wealth. Already, falling prices are showing up in declining net household wealth. Prof Roubini also talks of a $5,600bn decline in the value of stocks and the possibility of additional trillions of dollars in losses on commercial property. Total losses might even equal annual GDP.

The principal direct effect of such losses will be on spending, particularly residential investment and household consumption. In the third quarter of last year, personal savings were a mere 2.4 per cent of GDP, while the financial balance of the personal sector (the difference between its income and expenditure) was minus 2.1 per cent. These patterns do not make sense when asset prices are falling. But a sharp rise in household savings would ensure a deep and durable recession.

Worse, the bigger the damage to the financial sector, the more credit-fuelled personal spending is going to dry up. So what might such overall losses mean for financial intermediaries. In Prof Roubini’s 12 steps to meltdown, discussed here on February 20, 2008, he assumed that their losses on mortgages would be $300bn-$400bn, while losses on other assets (consumer debt, commercial real estate loans and so forth) would be another $600bn-$700bn, for a total of $1,000bn. On March 7, Goldman Sachs economists published an even higher estimate of mortgage-related losses, at $500bn, along with $656bn in other losses, for a total of $1,156bn. The mainstream has caught up. But Prof Roubini has moved on.

In reaching its conclusion, Goldman estimated a peak-to-trough house price fall of 25 per cent. In his comments on the FT’s forum, Prof Roubini suggests that, after price falls of 20 per cent from the peak, losses on mortgages could be as much as $1,000bn. With a 40 per cent fall, they could be $2,000bn. He adds another $700bn for other losses, to reach total financial sector losses of close to $3,000bn, or about 20 per cent of GDP.

So how does Prof Roubini reach these much higher figures? The difference between him and Goldman is not so much in assumptions about the house price fall: 25 per cent for Goldman Sachs and 20-40 per cent for Prof Roubini. Both also estimate that lenders would lose half of the loan value after repossession. But Goldman believes that just 20 per cent of households in negative equity would default, while Prof Roubini believes 50 per cent might do so.

For people with poor credit ratings and few assets, apart from their house, walking away does seem to make disturbingly good sense (“Jingle-mail rings alarm bells for lenders”, Financial Times, March 7). Buyers with no equity had an option to walk. Now they are exercising it. This was demented finance. Yet, so long as the economy remains reasonably robust, highly indebted people with good career prospects would surely not wish to wreck their credit rating. Nevertheless, markets are pessimistic: the prices of even AAA tranches of securitised loans are collapsing.

Suppose, then, that Prof Roubini were right. Losses of $2,000bn-$3,000bn would decapitalise the financial system. The government would have to mount a rescue. The most plausible means of doing so would be via nationalisation of all losses. While the US government could afford to raise its debt by up to 20 per cent of GDP, in order to do this, that decision would have huge ramifications. We would have more than the biggest US financial crisis since the 1930s. It would be an epochal political event.

Yet, Goldman argues that, after allowing for loan-loss provisions, the proportion of loss-making loans advanced by the non-leveraged sector and the ability to write off losses against tax, its $1,156bn comes down to $298bn. If a similar magic could be worked on the Roubini numbers, the effective losses to the leverage sector would fall to less than $750bn – huge, but more manageable.

Much will depend on what happens to the economy. Unfortunately, the effectiveness of monetary policy is constrained when the worries are more about insolvency than illiquidity. Concern about credit quality is rampant, not least in the resurgent spreads on interbank lending. Monetary policy is further constrained when lower short-term interest rates fail to translate into long-term rates, partly because of worries about inflation.

Alas, worries are understandable. There are two ways of adjusting the prices of housing to incomes: allow nominal prices to fall or raise nominal incomes. The former means mass bankruptcy and a huge fiscal bail out; the latter imposes the inflation tax. In extreme circumstances inflation must be attractive. Even if it is not the Fed’s choice, it is what a reasonable outsider might fear, with obvious consequences for all asset prices.

I suspect Prof Roubini’s latest estimates are excessively pessimistic. But I am not certain this is so, given his record: just look at the vicious interaction between falling asset prices, financial stress and spending. We must pray that the Fed can clean it all up, without excessive collateral damage. Unfortunately, such prayers often go unanswered.

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  1. Rootless Cosmopolitan

    I would like to object that falling asset prices are not the same as losses. If I buy some good, commodity, house, whatever and the price of the good increases later my nominal wealth will increase. If the asset price falls again afterward it won’t mean I have made a loss equal the difference between peak price and current asset price. However, the article treats this difference as if it were a loss.

    Also, if lenders make $1000bn loss in mortgages it will be a loss for them. Other participants will have made a gain of $1000bn, though, since the money was spent in the economy. It hasn’t just vanished in thin are. There is no loss here integrated over the whole economy. However, the article treats these losses as if they were losses integrated over the whole economy.

  2. Anonymous

    reading too many bearish forecasts

    I have been reading Nouriel Roubini for over year and half now. On a daily basis.

    Sure it is addictive. The truth is that Nouriel has been awfully right.

    Anyone with a judgment on financial matters (and not bonus or career as banker) will admit it.

    Martin belongs to that league. He is not alone. I’ll credit FT time for their reasonable judgement overalll.

    Ben Bernanke has obviously no more control on the situation. He is just making his way in such a way that will require the IMF to drop in at some stage and say:”Stop it Sir”.

    Of course that will not happen. What else can expect that have the gloomy predictions that Nouriel has painted transformed into reality.

    The current US campaigners are not even addressing the issue.

  3. a

    “Worse, the bigger the damage to the financial sector, the more credit-fuelled personal spending is going to dry up.”

    Why is that worse? If anything beneficial comes out of the mess we are in, I hope it’s the disappearance of the idea that “credit-fuelled personal spending” is a good thing. Credit-fuelled personal spending *needs* to dry up, and those holding means of production servicing that spending need to take their losses.

  4. Anonymous

    It is important to bear in mind that the losses we are talking about are accounting losses. Now obviously this affects whether or not one sees a current investment as worth keeping or disposing. It affects ones view of the future. But the real economic losses have already been committed. In fact, the money used to finance these losing propositions is not lost. It is merely redistributed. That is why we are looking at stagflation, perhaps an inflationary recession.

  5. Anonymous

    Ladies and Gentlemen:

    All of this should translate vary nicely into the U S treasury market, (the last bastion of credit worthiness?). Sure…..

    I anticipate a substantial decline in treasury prices, and you can imagine what that will do to the spreads. There is no reason to panic if you hedge properly. Ben has taken the bait, hook, line and sinker…..

    The secret hand giveth and the secret hand taketh away.

    Best regards,


  6. Anonymous

    Over at Mark Thoma’s someone posted a comment citing
    “Measured wealth, real wealth and the illusion of saving
    Keynote speech by Mr William R White, Economic Adviser and Head of Monetary and Economic Department of the BIS”

    which seemed very revealing to me.(but what do I know) Have you read this before? It kinds of fits very well into the theory that most of the “wealth” created in the last decades are illusory

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