Friday, January 2, 2009

The Worst Is Still Ahead

Source : The Business Times, January 2, 2009

While the odds of a systemic financial meltdown have been reduced, severe vulnerabilities remain

THE global financial system in 2008 experienced its worst crisis since the Great Depression of the 1930s. Major financial institutions went bust. Others were bought up on the cheap or survived only after major bailouts. Global stock markets fell by more than 50 per cent from their 2007 peaks. Interest rate spreads spiked. A severe liquidity and credit crunch appeared. Many emerging market economies on the verge of a crisis had to ask for help from the International Monetary Fund.

Gloomy new year: The US is expected to experience its worst recession in decades, a deep and protracted contraction lasting at least through the end of 2009

The global financial system literally went into a cardiac arrest after the Lehman Brothers Holdings Inc collapse and a meltdown was barely avoided through very aggressive policy responses. So what lies ahead in 2009? Is the worst behind us or ahead of us?

Unfortunately, the worst is ahead of us. The entire global economy will contract in a severe and protracted U-shaped global recession that started a year ago. The US will certainly experience its worst recession in decades, a deep and protracted contraction lasting at least through the end of 2009. Even in 2010, the economic recovery may be so weak - one per cent growth or so - that it will feel terrible even if the recession is technically over.

There also will be recessions in the euro zone, the UK, continental Europe, Canada, Japan and the other advanced economies.

A hard landing for emerging market economies may also be at hand. Among the so-called BRICs, Russia will be in an outright recession in 2009. Growth in China will slow to 5 per cent or less, representing a hard landing for a country that needs expansion of close to 10 per cent to move 10 million to 15 million poor rural farmers into the urban industrial sector every year. Brazil will barely grow in 2009. Even India will experience a sharp slowdown.

Most other emerging market economies will suffer a similar hard landing. This severe global recession will morph into a stag-deflation, a deadly combination of economic stagnation/recession and deflation. In the advanced economies, with aggregate demand falling below growing aggregate supply, slack in goods markets will lead to deflationary pressures as companies' pricing power is restrained.

Likewise, rising unemployment will constrain labour costs and wage growth. These factors, combined with sharply falling commodity prices, will cause inflation in advanced economies to ease towards negative territory, raising concerns about deflation.

Deflation is dangerous as it leads to a liquidity trap: nominal policy rates can't fall below zero, so monetary policy becomes ineffective and even quantitative easing may not work.

Vicious circle

Falling prices mean that the real cost of capital is high and the real value of nominal debts rise. This leads to further declines in consumption and investment, thus setting in motion a vicious circle in which incomes and jobs are squeezed, aggravating the fall in demand and prices.

As traditional monetary policy becomes ineffective, other unorthodox policies will continue to be used: policies to bail out investors, financial institutions and borrowers; massive provision of liquidity to banks in order to ease the credit crunch; and even more radical actions to reduce long-term interest rates on government bonds and narrow the spread between market rates and government bonds.

Today's global crisis was triggered by the collapse of the US housing bubble, but it wasn't caused only by it. America's credit excesses were in residential mortgages, commercial mortgages, credit cards, car loans and student loans.

There were also massive excesses in the securitised products that converted these debts into toxic financial derivatives; in borrowing by local governments; in financing for leveraged buyouts that should never have occurred; in corporate bonds that will suffer massive losses as defaults surge; in the dangerous and unregulated credit default swap market.

Moreover, these pathologies weren't confined to the US. There were housing bubbles in many other countries, fuelled by excessive and cheap lending that didn't reflect underlying risks. There was a commodities bubble and private equity and hedge funds bubbles.

We now are seeing the demise of the shadow banking system, the complex of non-bank financial institutions that looked like banks as they borrowed short term and in liquid ways, leveraged a lot, and invested in longer term and illiquid ways. As a result, the biggest asset and credit bubble in financial history is going bust, with overall credit losses likely to be more than US$2 trillion.

Unless governments rapidly recapitalise financial institutions, the credit crunch will become even more severe as losses mount faster than recapitalisation, and banks are forced to constrain credit and lending. Equity prices and other risky assets have plunged from their peaks of late 2007, but there are still significant risks for more declines.

An emerging consensus argues that the prices of many risky assets - including equities - have fallen so much that we are at the bottom and a rapid recovery will occur. But in the next few months, the macroeconomic news, the earnings and profits reports and the financial sector news from around the world will be worse than expected. This will put more pressure on prices of risky assets, with a chance of a 20 per cent fall in global equity prices.

While the odds of a systemic financial meltdown have been reduced by the actions of the Group of Seven and other economies, severe vulnerabilities remain.

Full-blown crisis

The credit crunch will persist and spread beyond mortgages. Deleveraging will continue, as thousands of hedge funds - many of which will go bust - and other leveraged players are forced to sell assets into illiquid and distressed markets, thus causing price declines and driving more insolvent financial institutions out of business. Credit losses will mount as the recession deepens. And a few emerging market economies will certainly enter a full-blown financial crisis.

So 2009 will be a painful year of global recession and further financial stresses, losses and bankruptcies. Currently, the probability of an L-shaped, stag-deflation is now rising to a third, while the probability of a severe U-shaped recession is two-thirds. Only aggressive, coordinated and effective policy actions by advanced and emerging market countries can ensure that the global economy starts to recover - however slowly - in 2010, rather than entering a more protracted period of economic stagnation. -- Bloomberg

Dr Roubini is professor of economics at the Stern School of Business, New York University; and chairman of RGE Monitor (, an economic and financial consultancy. The opinions expressed in this article are his own