A2 Macro: Back to Roubini - a Year On!

Almost a year ago I headed to the LSE to hear Nouriel Roubini launch a new book “Crisis Economics”. The notes that I took at the time are reprised below and reading through them again, I am struck by just how accurate the Roubini assessment was of where the next phase of the financial and economic crisis would move. Many of the remarks are relavant to students preparing for the OCR F585 paper for June 2011 and also for other A2 macro students wanting some evaluative comments on the international economic crisis.

I have repeated my comments from the May 2010 blog and they appear below. There has been some minor editing and I have supplemented the blog with some charts drawn from the team at Timetric.

Nouriel Roubini on the Global Financial Crisis

The LSE was packed tonight for a talk and discussion with Nouriel Roubini. It was an occasion to help launch his latest book “Crisis Economics” and Roubini started by arguing that financial crises are now more common than is supposed. Economics textbooks pay lip-service to crises and the conventional wisdom is that systemic crises in the markets are irregular and few and far between. Dr Doom takes a completely different stance believing that the sorts of crises that have dominated the headlines in recent years are best described as White Swans rather than the Black Swans beloved of Nicholas Taleb.

The Roubini lecture is now available on video using this link

Crises come in many different guises:

* Currency systems coming under strain and eventually breaking down
* Systemic crises of confidence and liquidity in the banking systems
* Sovereign debt crises often involving partial or complete defaults on loans
* Corporate and property borrowing bubbles

Sometimes a crisis can include all of the above! And these are not random events - instead they flow from deep-rooted policy mistakes. Roubini argues that we have just finished the 1st stage of the current crisis and that there are huge risks in the second stage. Excessive private sector leverage in the first bubble (US home-owners treated their properties as an ATM machine!) has been followed by a massive re-leveraging of the public sector. Household and corporate sector debt has stabilised, although at huge levels.

But the starkest danger now flows from the enormous increase in sovereign debt issued by national governments. The Greek debacle is the tip of the iceberg of the sovereign debt crisis.

Budget deficits have grown to astounding levels for three main reasons:

1/ Allowing the natural automatic stabilisers of fiscal policy to work through when an economy goes into recession

2/ The deliberate (and - according to Roubini correct) use of Keynesian fiscal stimulus policies and a remarkable easing of monetary policy (lower policy rates and Quantitative Easing)

3/ The socialising of losses of the private banks through bail-outs and partial or whole nationalisation

This intervention has prevented the free-fall descent of the world economy into a severe deflationary depression and but the stimulus never was and never could be a free lunch. We are now starting to pay the price.

Countries such as the USA and the UK can (for now) monetise the debt by getting their central banks to create money (expand the size of the monetary base) and act as buyer of first resort for new issues of government debt. The greatest risk here is that the huge increase in the supply of money will eventually create much higher rates of inflation and an unprecedented transfer of real wealth from creditors to debtors.

For emerging economies the only realistic option for countries with an insolvency problem (public debt in excess of 100% of GDP and annual fiscal deficits greater than 10% of GDP) is default - perhaps through leaving a fixed exchange rate regime or forcing creditors to take a 10-20% hair cut on their existing loans.

Roubini is (surprise surprise) deeply pessimistic about Greece.

Data from Timetric.

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Greece Real GDP Change from Previous Year from Timetric

Greece - like countries such as Spain and Portugal - are on the periphery of the EU single market and have allowed their economies to lose competitiveness as well as accumulate staggeringly high levels of debt. The country is in a classic debt-growth trap. It cannot really deliver the fiscal austerity needed to cut the debt because that would send the economy into the kind of depression that will bring social and political chaos.

Data from Timetric.

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Greece, General government debt, Public finance sustainability (G… from Timetric

The three standard routes to better competitiveness are clear:

1/ Price and wage deflation - but this will lead to a severe and continued recession

2/ Structural economic reforms - eg to labour markets - but these take many years to show through (as the Germans have found)

3/ Exiting the single currency (devaluation implies a kind of default on loans) or hoping that the Euro will fall sufficiently against other currencies to restore some competitiveness for the Greeks against lower labour cost countries outside the EU

None of these are easy, none are likely save for Greece becoming insolvent and forcing creditors to cut their losses on loans.

Unsustainable public debt

Roubini argues that the debt of the public sector in developed countries is becoming unsustainable and that this will severely limit the freedom to act if the developed world goes into a double-dip recession. Policy-makers are running out of bullets. Many banks merged in the immediate fall-out from the credit crunch and many are now too big to be saved. Bond market vigilantes are waking up to this and attacking countries whose debts are unsustainable. The political will in most European countries and also in the USA does not appear to be strong enough for the tough fiscal choices to be made.

Breaking up the banks

Financial reform is an essential component of the Roubini prescription. In a vivid part of his talk Roubini argued that mega banks are now so complex that proper risk management is mission impossible. Not even the smartest CEO of a bank operating in the financial supermarket can even hope to oversee and manage the activities of hundreds of inter-twined arms and activities. This is the extreme form of the classic principle-agent problem!

Roubini argues for breaking up the banks - it is unfair on ordinary tax payers to pay across several generations for the losses of the financial institutions. The economies of scale and scope from banking expansion have been much less than claimed - the risks have been many times higher.

Nouriel Roubini’s new book is entitled Crisis Economics