IN HIS memoir, The Age of Turbulence, former US Federal Reserve governor Alan Greenspan wrote: “I would tell audiences that we were facing not a bubble but a froth — lots of small, local bubbles that never grew to a scale that could threaten the health of the overall economy.”
That used to be Greenspan’s view of the US housing bubble. He was wrong, alas. So how bad might this downturn get? To answer this , we should ask a true bear. My favourite is Nouriel Roubini of New York University’s Stern School of Business.
Recently, Roubini’s scenarios have been dire enough to make the flesh creep. But his thinking deserves to be taken seriously. He first predicted a US recession in July 2006. Then , his view was extremely controversial. It is so no longer. Now he states that there is “a rising probability of a ‘catastrophic’ financial and economic outcome”. Here are his 12 steps to financial disaster.
Step one is the worst housing recession in US history. House prices will, he says, fall by 20%-30% from their peak, which would wipe out between $4000bn and $6000bn in household wealth.
Step two would be further losses, beyond the $250bn-$300bn now estimated, for subprime mortgages. Goldman Sachs estimates mortgage losses at $400bn. But if home prices fell by more than 20%, losses would be bigger.
Step three would be big losses on unsecured consumer debt: credit cards, auto loans, student loans and so forth.
Step four would be the downgrading of the monoline insurers. A further $150bn write down of asset-backed securities would then ensue.
Step five would be the meltdown of the commercial property market, while step six would be bankruptcy of a large regional or national bank.
Step seven would be big losses on reckless leveraged buyouts.
Step eight would be a wave of corporate defaults. Such defaults would spread losses in “credit default swaps”, which insure such debt. The losses could be $250bn. Some insurers might go bankrupt.
Step nine would be a meltdown in the “shadow financial system”. Dealing with the distress of hedge funds, special investment vehicles and so forth will be made more difficult by the fact that they have no direct access to lending from central banks.
Step 10 would be a further collapse in stock prices.
Step 11 would be a drying-up of liquidity in a range of financial markets, including interbank and money markets.
Step 12 would be “a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices”.
In all, argues Roubini: “Total losses in the financial system will add up to more than $1000bn and the economic recession will become deeper, more protracted and severe.” This, he suggests, is the “nightmare scenario” keeping Ben Bernanke and colleagues at the US Federal Reserve awake. It explains why, having failed to appreciate the dangers for so long, the Fed has lowered rates by 200 basis points this year. This is insurance against a financial meltdown.
Is this scenario at least plausible? It is.
Furthermore, we can be confident that it would end all stories about “decoupling”. If it lasts six quarters, as Roubini warns, offsetting policy action in the rest of the world would be too little, too late.
Can the Fed head this danger off? In a subsequent piece, Roubini gives eight reasons why it cannot. These are, in brief: US monetary easing is constrained by risks to the dollar and inflation; aggressive
easing deals only with illiquidity, not insolvency; the monoline insurers will lose their credit ratings, with dire consequences; overall losses will be too large for sovereign wealth funds to deal with; public intervention is too small to stabilise housing losses; the Fed cannot address the problems of the shadow financial system; regulators cannot find a good middle way between transparency over losses and regulatory forbearance, both of which are needed; and, finally, the transactions-oriented financial system is itself in deep crisis.
The risks are high and the ability of the authorities to deal with them more limited than most people hope. This is not to suggest that there are no ways out. Unfortunately, they are poisonous ones. In the last resort, governments resolve financial crises. This is an iron law. Rescues can occur via overt government assumption of bad debt, inflation, or both.
Japan chose the first, much to the distaste of its ministry of finance. But Japan is a creditor country whose savers have complete confidence in the solvency of their government. The US, however, is a debtor. It must keep the trust of foreigners.
Should it fail to do so, the inflationary solution becomes probable. This is quite enough to explain why gold costs $920/oz.
The connection between the bursting of the housing bubble and the fragility of the financial system has created huge dangers, for the US and the rest of the world. The US public sector is now coming to the rescue, led by the Fed. In the end, they will succeed. But the journey is likely to be wretchedly uncomfortable. Financial Times |
