Despite the aggressive action by the Fed and EU leaders over the last few days, Nouriel Roubini thinks a severe recession is still in the cards and worries that the financial system is not out of the woods either. From his latest report (hat tip reader Dwight, boldface ours):
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…
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.