February 20, 2008
America’s economy risks mother of all meltdowns
“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.” Alan Greenspan, The Age of Turbulence.
That used to be Mr Greenspan’s view of the US housing bubble. He was wrong, alas. So how bad might this downturn get? To answer this question we should ask a true bear. My favourite one is Nouriel Roubini of New York University’s Stern School of Business, founder of RGE monitor.
Recently, Professor 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*. At that time, 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”**. The characteristics of this scenario are, he argues: “A vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe.”
Prof Roubini is even fonder of lists than I am. Here are his 12 – yes, 12 – steps to financial disaster.
Step one is the worst housing recession in US history. House prices will, he says, fall by 20 to 30 per cent from their peak, which would wipe out between $4,000bn and $6,000bn in household wealth. Ten million households will end up with negative equity and so with a huge incentive to put the house keys in the post and depart for greener fields. Many more home-builders will be bankrupted.
Step two would be further losses, beyond the $250bn-$300bn now estimated, for subprime mortgages. About 60 per cent of all mortgage origination between 2005 and 2007 had “reckless or toxic features”, argues Prof Roubini. Goldman Sachs estimates mortgage losses at $400bn. But if home prices fell by more than 20 per cent, losses would be bigger. That would further impair the banks’ ability to offer credit.
Step three would be big losses on unsecured consumer debt: credit cards, auto loans, student loans and so forth. The “credit crunch” would then spread from mortgages to a wide range of consumer credit.
Step four would be the downgrading of the monoline insurers, which do not deserve the AAA rating on which their business depends. A further $150bn writedown 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 buy-outs. Hundreds of billions of dollars of such loans are now stuck on the balance sheets of financial institutions.
Step eight would be a wave of corporate defaults. On average, US companies are in decent shape, but a “fat tail” of companies has low profitability and heavy debt. 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. Failures of hedge funds, margin calls and shorting could lead to cascading falls in prices.
Step 11 would be a drying-up of liquidity in a range of financial markets, including interbank and money markets. Behind this would be a jump in concerns about solvency.
Step 12 would be “a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices”.
These, then, are 12 steps to meltdown. In all, argues Prof Roubini: “Total losses in the financial system will add up to more than $1,000bn 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 kind of scenario at least plausible? It is. Furthermore, we can be confident that it would, if it came to pass, end all stories about “decoupling”. If it lasts six quarters, as Prof 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, Prof Roubini gives eight reasons why it cannot***. (He really loves lists!) 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 indeed 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 an ounce.
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.
*A Coming Recession in the US Economy? July 17 2006, www.rgemonitor.com; **The Rising Risk of a Systemic Financial Meltdown, February 5 2008; ***Can the Fed and Policy Makers Avoid a Systemic Financial Meltdown? Most Likely Not, February 8 2008
Andrew Smithers: Martin writes that “Step five would be a meltdown of the commercial property market…..Step eight would be a wave of corporate defaults. On average, US companies are in decent shape, but a “fat tail” of companies has low profitability and heavy debt.” This is the conventional view and is, for example, shared by the OECD in its December 2007 Economic Outlook “The non-financial corporate sector is healthy.” I doubt whether this view is justified.
Comparing ONS data with the Flow of Funds data shows that UK non-financial companies have record high debt and are twice as heavily leveraged as US ones. Today’s comparatively high leverage is a dramatic change from 1989, when UK companies had more conservative balances sheets than those in the US. My own analysis, supported by discussions with staff members at the ONS in the UK and the Federal Reserve in the US, who produce the US Flow of Funds data, suggests that the reason for the apparent disparity between the two sources of data lies in the difference between profits, as defined in national accounts, and profits published by companies. This explains not only the difference between the high and rapidly growing leverage of UK companies shown in the national accounts, but even for the difference between the “official” data for the UK and US, as the latter’s Flow of Funds Accounts adjust the results that they would get if they used the NIPA flow data by massively boosting US net worth by the addition of “statistical discontinuities” and rising property values. If the accumulated value of the statistical discontinuities alone is excluded, then US and UK net debt levels are very similar at just over 50% of net worth at replacement cost and such a similarity accords with anecdotal evidence about corporate balance sheets
The increasing use of marking to market, for corporate P&L and balance sheet data, and the large swings that have occurred in asset prices make it dangerous to compare today’s balance sheets with those of earlier years. It is to assume that today’s apples are good ones by comparison with yesterday’s pears.
The apparent conservative nature of US balance sheets is, moreover, belied by a comparison of debt to output, which is nearly back to the record high of 2002. Either assets are being more highly valued today than in the past, or the capital/output ratio has deteriorated. There seems no support from other economic data for the latter view.
I expect to see an increasing level of concern about company balance sheets and this is perhaps already being reflected in the rise in credit spreads and is also indicated by a recent report in the Financial Times: “The global credit crisis is set to spread beyond the financial industry as companies in other sectors are forced to write down the value of their investments, according to the head of [PwC], the largest global audit firm.” Non-financials have also invested in asset backed and mortgage backed securities “It’s not just in the banks”.
In April 2007, the Bank of England’s Financial Stability Report remarked that “The UK financial system remains highly resilient with banks well capitalised…..” This was the consensus view then. I suspect that the current consensus that non-financial balance sheets are in good shape will prove equally fragile if asset prices fall further. As Martin observes, the risk of company defaults is also increased if, as seems likely, the debt in the corporate sector has a fat-tailed distribution.
This does not of course mean that a major recession is inevitable. I just wished to add a bit of extra cheer to Martin’s comments.
Posted by: Andrew Smithers | February 20th, 2008 at 1:07 pm | Report this commentJim O’Neill: A number of these are now “discounted” and if there is no “decoupling” then why is oil at $100 bucks?
Posted by: Jim O'Neill | February 20th, 2008 at 7:43 pm | Report this commentBrad Setser: Oil’s steady rise amid ongoing evidence that US economy has slowed and a growing risk of a slowdown in Europe is something of a puzzle. Oil at least seems to have decoupled from the conjuncture in the G7.
Part of the answer may be that the impact of a US slowdown on other countries in the dollar zone seems somewhat ambiguous. The pace of growth in China’s exports to the US has slowed, but a US slowdown also means falling US interest rates, and in effect a more expansionary monetary policy throughout the dollar zone, including in those parts that are booming and look to be over-heating. Low real rates are expansionary, and real lending rates in the Gulf and China are likely lower than in the US.
One last point: the United States’ ability to ignore the constraints a debtor typically faces and pursue a counter-cyclical macroeconomic policy hinges in no small part on the willingness of the emerging world to continue to accumulate foreign exchange reserves at a truly incredible pace. The increase in reserve growth over the past year has broadly speaking been stabilizing — the credit crisis hasn’t morphed into a dollar crisis.
But it also has helped to defer the adjustment that Dr Wolf eloquently called for in an earlier column, and has led to a less-than-ideal global policy mix that includes both expansionary policies in the debtor country and contractionary policies (lending curbs and the like) in several creditor countries.
Posted by: Brad Setser | February 21st, 2008 at 1:15 am | Report this commentRobert Wade: I will add to the gloom of Martin’s prediction that “the journey [of adjustment] is likely to be wretchedly uncomfortable”. Consider some international interactions (not much treated in Martin’s argument), in particular US-China.
One of the big questions in situations where large macro adjustments have to be made (as now) is: who takes the hit? In the messy adjustment of the late 1980s, the US basically got Japan to take the hit through the exchange rate: with the Japanese government almost slavishly complying with US requests, the US$ fell sharply against the yen and Japan lent hugely to the US.
In the attempted adjustment of the early 2000s the US against tried to get foreigners to take the hit by letting the $ fall. But China did not play ball. It pegged to the $, built giant surpluses, and bought $ assets to keep the export machine going. Fortunately just at this time securitization technology came on stream to produce an exploding supply of asset-based securities – AAA rated! – for the Asian funds to buy and keep the inflow flowing.
Now this system is unravelling. But China is not Japan, and retains a much stronger bargaining position to reject US demands that China adjust. The US seems to have lost the leverage to induce China to comply, not least because its military complex is busy edifying China-Russia as the post-War on Terror enemy.
Moreover, the crisis also discredits the model of a very liberalized, lightly regulated private financial system – and therefore undercuts the all-important longer-term US project to get China to open its financial system to foreign financial firms, which is key to the US strategy for retaining “primacy” and keeping other states asymmetrically dependent on it.
At the same time, the G7 is fractious and uncooperative – and has no viable way of incorporating China and other “emerging markets” into its forum (the “G7 + 5” formula is not viable). The IMF is nearly bankrupt and preoccupied with steering its way through big budget cuts.
With little international cooperation – notably on exchange rates - the adjustment costs are likely to fall largely on US workers through a prolonged period of stagflation (though the inflation part will show up in the statistics as lower than it really is, because food and energy prices are excluded from the index). How convenient for Republicans that a Democrat will almost certainly be president, and a Democratic administration can be made to take the blame.
Those in the bottom 25% of the US wealth distribution will experience a particularly “wretchedly uncomfortable” journey - a sizable part of the Democrats’ support base. For 25% of US households are (or were, in 1999) in “asset poverty”: they have insufficient wealth (including houses) to survive on their own by spending down their wealth in case their income flow stops (Asena Caner and Edward Wolff, “The tragedy of asset poverty in the U.S.”, Challenge, Jan-Feb 2004.) As Caner and Wolff remark, “economic and financial developments benefited only a relatively small part of the population in the United States in the years 1984-99”.
We can expect a sharp increase in class-based political tensions as not just the bottom 25% but also wealthier middle-class households who were relying on rising house and stock market prices to provide them with an “alternative welfare state” (and were therefore happy to see the public welfare state shrivel in response to applauded tax cuts) try to engineer income redistribution to themselves.
In these circumstances another war might be an attractive White House and Congressional option for keeping domestic discontent in check. The breakdown of the US defence budget does indeed look as though the US military is planning for major state confrontations rather than insurgencies.
Posted by: Robert Wade | February 21st, 2008 at 10:07 am | Report this commentEdward J Dodson (guest): A more complete understanding of the risks associated with ‘housing bubbles’ requires further analysis of the fundamental forces at play. Because housing is shelter and not primarily a liquid asset, the supply of housing tends to be quite elastic — with the affect that housing prices are said to be ’sticky downward’. Homeowners not forced to sell because of unemployment or other financial pressures will generally pull their property off the market and wait until a seller’s market returns.
The situation for homebuilders is rather different, of course, as the homes they construct are inventory (similar to any manufacturing concern). Yet, not all builders are faced with the same degree of financial pressure related to unsold inventories. Those builders who acquired land prior to the most recent run-up in land prices have experienced above-market profit margins as land prices have skyrocketed. Conversely, these builders can continue to sell inventory at a profit even as prices have fallen. Equally important, unlike past land market cycles, few builders have engaged in largescale speculative construction. The most at-risk type of residential construction is (as always) the multi-storied condominium building because of the significant upfront land acquisition and construction costs incurred before unit closings begin to generate cash flow.
We are clearly past the peak of the current land market cycle. A key distinction this time is that land markets (fueled by cheap and, to a significant extent, poorly underwritten credit) have become globally overheated. Rising land prices almost everywhere have stressed the profit margins of many goods producers and even service providers. As Adam Smith taught us, the wealth of a nation grows best when wages are high. The disappearance of housing savings and declines in household disposable income are clear indications that the risk of a depression-like downturn is very high in the U.S., the U.K., Australia and a long list of other nations.
Edward J. Dodson retired in 2005 from Fannie Mae, where he was a Senior Business Manager in the Housing & Community Development group based in Philadelphia, Pa. He is a graduate of Shippensburg and Temple Universities in Pennsylvania.
Posted by: Edward J. Dodson | February 21st, 2008 at 3:55 pm | Report this commentMartin Wolf: I have nothing to add on Andrew Smither’s comments: he is the expert, not me. Obviously, if he is right, then things might be even worse than Nouriel Roubini suggests.
I hope Jim O’Neill is right that a number of these effects are now discounted in the market. I am more suspicious of this view than I was about nine months ago, when I thought the subprime crisis was also discounted. Evidently, this was a serious mistake.
Jim also asks why oil is at $100 a barrel if there is no decoupling. I think that is a really good question. Let me suggest the following: first, markets still do not expect a Roubini-like recession, which is what I was talking about when making the remark about recoupling under these assumptions; second, even if there will be coupling, China and India will still grow very quickly, at, say, 8-9 per cent and 7-8 per cent, respectively; third, given the exceptional resource-intensity of Chinese growth, that may sustain substantial growth in the demand for oil and other commodities, provided the US and European economies do not collapse; and, finally, maybe oil supply is just not going to grow very much or, as peak oil fanatics would argue, it is going to fall. In any case, I want to take a good look at the question whether the change in the structure of global growth now means that commodity demand remains strong even if everybody slows down, because of the shift in the composition of demand towards China.
Brad Setser adds the point that lower US interest rates may prove expansionary in the extended dollar area. In that case, of course, there would be decoupling. I also agree with him on the dangers of the present global policy mix. Essentially, the US and the countries dependent upon it (in significant degree) are trying more of the same. That is also likely to lead, if successful, to more of the same external and internal imbalances. I have already pointed this danger out, on January 29th (Bernanke’s reflation gamble may work too well).
I have little to add to what Mr Dodson says. There is a danger of a long slide in house prices in many countries, with associated freezing of the market. The full macroeconomic effects of this when households are so leveraged are unknown. But they are likely to be highly uncomfortable. Since this was a widely shared housing boom, we are obviously looking at a widely shared bust.
Posted by: Martin Wolf | February 21st, 2008 at 7:51 pm | Report this commentMartin Wolf: I will not follow Robert Wade’s wilder speculations, namely, that the US will launch World War III, or some smaller effort of that kind, in order to conceal its domestic policy bankruptcy. I presume he is envisaging a war against China.
Yet he is right in one important respect. Assume that the current account surpluses of the rest of the world do not shrink, as a result of some combination of real exchange-rate appreciation and increased domestic absorption of resources. Then the US has to spend enough domestically to absorb the external deficit generated at full employment, at the given real exchange rate.
Fortunately for the US, its real exchange rate is depreciating. Unfortunately, it is that of the Europeans (i.e. the eurozone) which is appreciating most. Since the Europeans are unwilling to expand domestic demand, this will merely shift a part of the recession into the eurozone, without reducing US external deficits sufficiently to solve its macroeconomic problem.
What are the solutions to this problem, given what seems to be the inevitable weakness of US private demand in coming years? I can see a combination of three. One is domestic fiscal expansion: the US may end up with a much bigger fiscal deficit than anybody now imagines, so sustaining huge external deficits. Another is a surge in spending by oil exporters. If oil prices remain where they are now, that seems to me to be quite likely, though this is also likely to take quite a few years. The third possibility is increased absorption by China. This would require a combination of faster appreciation and increased domestic spending.
Is this last possibility likely? I cannot judge. But it is surely not impossible for the US to nudge China in the right direction, since it must be increasingly evident to the Chinese themselves that they are now having much too much of a good thing. A new Democratic president may threaten an import surcharge against China. I think that would be rather good politics in the US. It is certainly a possibility the Chinese should take into account.
Anyway, Robert is right on one point. If some combination of these adjustments does not occur, the US economy might be weak for a long time. I cannot see how the domestic US counterparts of current account deficits of 7 per cent of GDP, or so, can now be sustained by the US private sector alone.
Posted by: Martin Wolf | February 24th, 2008 at 6:24 pm | Report this commentNick Sargen (guest): I read with interest your latest article on Nouriel Roubini’s meltdown scenario, where everything goes wrong. While that possibility can’t be ruled out, I posit an alternative scenario in which three key ingredients for stabilization of credit markets are now in place: (1) financial institutions are writing off bad debts faster than in any previous crisis (but still have more to go); (2) easing by the Fed has produced a significant steepening of the yield curve, which will improve interest margins (and profitability) of banks; and (3) investors are now being paid healthy premiums for taking credit risk. Thus, while markets may stay turbulent for a while longer, there are also considerably more opportunities in credit markets today than in the past five years. The challenge for investors is to be in position to ride out the storm.
Nick Sargen is Chief Investment Officer of Fort Washington Investment Advisers.
Posted by: Nick Sargen | February 25th, 2008 at 9:09 am | Report this commentMartin Wolf: I like Nick’s optimism. I am sure some of it is right. In any case, I am going to try to deal with some of this in this coming Wednesday’s column
Posted by: Martin Wolf | February 25th, 2008 at 4:12 pm | Report this commentBrad Setser: Why shouldn’t Europe also take on the challenge of nudging China in the right direction alongside the US? The RMB is at least appreciating in nominal and real terms against the dollar now, while it depreciated in nominal terms v the euro and was at best stable in real terms. Chinese exports to Europe — and China’s bilateral surplus with Europe — are both now growing faster than the comparable measure vis-a-vis the US.
I suspect the oil exporters will eventually raise internal absorption, reducing their external surplus. If oil fell back to where it started 2006, my best guess is that the oil exporters in aggregate would no longer show a surplus. But the price of oil keeps rising faster than domestic spending and investment. That I think poses two risks:
One is that the oil exporters don’t adjust — there is no spending surge, and no surge in government-sponsored mega-projects (a form of spending, though disguised) — and oil remains high. That assures ongoing large surpluses.
The other is that oil exporters do adjust spending, but oil (belatedly) falls. Some oil exporters could manage by drawing on their existing funds. Others would eventually need to adjust.
I personally think the oil exporters need additional tools that could help facilitate the needed adjustment beyond simply adjusting the level of budget spending, whether an exchange rate regime that allows their currencies to move with the price of their key export and thus automatically increases (or decreases) the external purchasing power of existing spending when commodity prices move, or variable oil dividends paid to the citizens of the oil-exporting country. Both of the virtue of facilitating upward and downward adjustment in the face of commodity price volatility.
Posted by: Brad Setser | February 27th, 2008 at 12:55 am | Report this commentMartin Wolf: Brad Setser raises two important issues. One is whether the oil exporters will continue to run huge surpluses. I am inclined to agree with his analysis of that. The second is whether they should have an “oil-price-linked exchange rate”.
My answer to the second is that it must depend on the flexibility of domestic prices. Imagine a country that has oil as its export and buys almost all its labour, goods and non-tradeable services in world markets. In this situation, domestic prices are set in international markets. It may make sense then to link the currency to a basket of international currencies, because of the wild swings among major currencies. But I cannot see the point of an oil link: when oil prices shoot up, domestic prices will then fall in domestic currency. Why should one want that? But if the country is Russia, having a managed float makes lots of sense. The target would be domestic price stability.
Posted by: Martin Wolf | February 27th, 2008 at 6:53 pm | Report this commentBrad Setser: Dr Wolf - Thanks for your response.
I wouldn’t go so far as to argue for pegging to the price of oil. But including oil in a basket so that a rise in the price of oil induces something of a real appreciation relative to a basket of oil-importing economies makes sense to me (a fall in the price of oil would have the opposite effect). That would replicate the moves in floating commodity exporters; the canadian dollar and australian dollar have appreciated relative to a g-3 basket as commodity prices have increased.
Rather than inducing deflation, I suspect - given the tendency of fiscal policy to move with the oil price - the overall effect would be less inflation in good times, and less deflation in bad times.
My read of the experience of Qatar and the UAE - sure two countries that import about as much as can possibly be imported - is that full economic openness, including to imported labor, doesn’t mean that is possible to run an expansionary fiscal policy, an expansionary monetary policy and peg to a depreciating currency without getting more than a bit of inflation.
Posted by: Brad Setser | March 3rd, 2008 at 11:42 pm | Report this comment