Warning: More Doom Ahead
"Because the United States is such a huge part of the global economy, there's real reason to worry that an American financial virus could mark the beginning of a global economic contagion." -- Nouriel Roubini, March 2008
Last year’s worst-case scenarios came true. The global financial pandemic that I and others had warned about is now upon us. But we are still only in the early stages of this crisis. My predictions for the coming year, unfortunately, are even more dire: The bubbles, and there were many, have only begun to burst.
The prevailing conventional wisdom holds that prices of many risky financial assets have fallen so much that we are at the bottom. Although it’s true that these assets have fallen sharply from their peaks of late 2007, they will likely fall further still. In the next few months, the macroeconomic news in the United States and around the world will be much worse than most expect. Corporate earnings reports will shock any equity analysts who are still deluding themselves that the economic contraction will be mild and short.
Severe vulnerabilities remain in financial markets: a credit crunch that will get worse before it gets any better; deleveraging that continues as hedge funds and other leveraged players are forced to sell assets into illiquid and distressed markets, thus leading to cascading falls in asset prices, margin calls, and further deleveraging; other financial institutions going bust; a few emerging-market economies entering a full-blown financial crisis, and some at risk of defaulting on their sovereign debt.
Certainly, the United States will experience its worst recession in decades. The formerly mainstream notion that the U.S. contraction would be short and shallow — a V-shaped recession with a quick recovery like the ones in 1990-91 and 2001 — is out the window. Instead, the U.S. contraction will be U-shaped: long, deep, and lasting about 24 months. It could end up being even longer, an L-shaped, multiyear stagnation, like the one Japan suffered in the 1990s.
As the U.S. economy shrinks, the entire global economy will go into recession. In Europe, Canada, Japan, and the other advanced economies, it will be severe. Nor will emerging-market economies — linked to the developed world by trade in goods, finance, and currency — escape real pain.
What constitutes a "recession" will depend on the country in question. For China, a hard landing would mean annual growth falls from 12 to 6 percent. China must grow by 10 percent or more each year to bring 12 to 15 million poor rural farmers into the modern world. For other emerging markets, such as Brazil or South Korea, growth below 3 percent would represent a hard landing. The most vulnerable countries, such as Ecuador, Hungary, Latvia, Pakistan, or Ukraine may experience an outright financial crisis and will require massive external financing to avoid a meltdown.
For the wealthiest countries, a debilitating combination of economic stagnation and deflation might happen as markets for goods go slack because aggregate demand falls. Given how sharply production capacity has risen due to overinvestment in China and other emerging markets, this drop in demand would likely lead to lower inflation. Meanwhile, job losses would mount and unemployment rates would rise, putting downward pressure on wages. Weakening commodity markets — where prices have already fallen sharply since their summer peak and will fall further in a global recession — would lead to still lower inflation. Indeed, by early 2009, inflation in the advanced economies could fall toward the 1 percent level, too close to deflation for comfort.
This scenario is dangerous for many reasons. A number of central banks will be close enough to setting interest rates of zero that their economies fall into a triple whammy: a liquidity trap, a deflation trap, and debt deflation. In a liquidity trap, the banks lose their ability to stimulate the economy because they cannot set nominal interest rates below zero. In a deflation trap, falling prices mean that real interest rates are relatively high, choking off consumption and investment. This leads to a vicious circle wherein incomes and jobs are falling, with demand dropping still further. Finally, in debt deflation, the real value of nominal debts rises as prices fall — bad news for countries such as the United States and Japan that have high ratios of debt to GDP.
As orthodox monetary tools become ineffective, policymakers will turn to unorthodox approaches. We’ll see traditional fiscal policy, in the form of tax cuts and spending increases, but also worldwide bailouts of lenders, investors, and financial institutions, as well as borrowers. Central banks will inject massive amounts of cash into financial systems to unclog the liquidity crunch. More radical actions, such as outright purchases of corporate and government bonds or subsidization of mortgage rates, might also be necessary to get credit markets functioning properly again.
This crisis is not merely the result of the U.S. housing bubble’s bursting or the collapse of the United States’ subprime mortgage sector. The credit excesses that created this disaster were global. There were many bubbles, and they extended beyond housing in many countries to commercial real estate mortgages and loans, to credit cards, auto loans, and student loans. There were bubbles for the securitized products that converted these loans and mortgages into complex, toxic, and destructive financial instruments. And there were still more bubbles for local government borrowing, leveraged buyouts, hedge funds, commercial and industrial loans, corporate bonds, commodities, and credit-default swaps — a dangerous unregulated market wherein up to $60 trillion of nominal protection was sold against an outstanding stock of corporate bonds of just $6 trillion.
Taken together, these amounted to the biggest asset and credit bubble in human history; as it goes bust, the overall credit losses could reach as high as $2 trillion. Unless governments move with more alacrity to recapitalize banks and other financial institutions, the credit crunch will become even more severe. Losses will mount faster than companies can replenish their balance sheets.
Thanks to the radical actions of the G-7 and others, the risk of a total systemic financial meltdown has been reduced. But unfortunately, the worst is not behind us. This will be a painful year. Only very aggressive, coordinated, and effective action by policymakers will ensure that 2010 will not be even worse than 2009 is likely to be.