Nouriel Roubini on How would a Crash Happen and Deflation

All that the bailout did was kick the can down the road, Roubini’s prediction of how a financial crisis could unfold still holds true.  Alice

Feb 15, 2008. The Coming Muni Bonds Default Crisis…and the Monoline Downgrade Saga…

Professor Roubini was one of the early voices concerned about the inevitable consequences of the mad credit expansion.  Here is prediction of a possible twelve steps to financial disaster:

Step one is the worst housing recession in US history. House prices will, he says, fall by 20 to 30 percent from their peak, wiping out between $4,000bn and $6,000bn in household wealth.

Step two would be further losses, beyond the $250bn-$300bn now estimated for subprime mortgages because he says about 60% of all mortgages originating between 2005 and 2007 had “reckless or toxic features”.

Step three would be big losses on unsecured consumer debt, credit cards, auto loans, student loans, etc.

Step four, the downgrading of monoline insurers – [we would comment that recently the market was cheered by the apparent return to safety for the two biggest monoline insurers, Ambac and MBIA, whose AAA status now seems more secure, although that presupposes further deterioration in the US economy won’t re-ignite their problems.]

Step five would be the meltdown of the commercial property market.

Step six, bankruptcy of a large regional or national bank.

Step seven, losses on reckless leveraged buy-outs. [A point made very forcibly this week by Jon Moulton, head of the private equity firm Alchemy Partners. He said that there will be large private equity failures this year.  Absolutely guaranteed.]

Step eight would be a wave of corporate defaults. [Recent widening of credit spreads gives rise to genuine concern that this could be the next key issue.]

Step nine would be a meltdown of the shadow financial system. [In other words, some hedge funds could be in distress.]

Step ten would be a further collapse of stock markets. [We absolutely expect this.]

Step eleven would be a drying up of liquidity of financial markets.

Step twelve would be a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices.

Oct 9, 2008. The world is at severe risk of a global systemic financial meltdown and a severe global depression  

The US and advanced economies’ financial system is now headed towards a near-term systemic financial meltdown as day after day stock markets are in free fall, money markets have shut down while their spreads are skyrocketing, and credit spreads are surging through the roof. There is now the beginning of a generalized run on the banking system of these economies; a collapse of the shadow banking system, i.e. those non-banks (broker dealers, non-bank mortgage lenders, SIV and conduits, hedge funds, money market funds, private equity firms) that, like banks, borrow short and liquid, are highly leveraged and lend and invest long and illiquid and are thus at risk of a run on their short-term liabilities; and now a roll-off of the short term liabilities of the corporate sectors that may lead to widespread bankruptcies of solvent but illiquid financial and non-financial firms.

On the real economic side all the advanced economies representing 55% of global GDP (US, Eurozone, UK, other smaller European countries, Canada, Japan, Australia, New Zealand, Japan) entered a recession even before the massive financial shocks that started in the late summer made the liquidity and credit crunch even more virulent and will thus cause an even more severe recession than the one that started in the spring. So we have a severe recession, a severe financial crisis and a severe banking crisis in advanced economies.

There was no decoupling among advanced economies and there is no decoupling but rather recoupling of the emerging market economies with the severe crisis of the advanced economies. By the third quarter of this year global economic growth will be in negative territory signaling a global recession. The recoupling of emerging markets was initially limited to stock markets that fell even more than those of advanced economies as foreign investors pulled out of these markets; but then it spread to credit markets and money markets and currency markets bringing to the surface the vulnerabilities of many financial systems and corporate sectors that had experienced credit booms and that had borrowed short and in foreign currencies. Countries with large current account deficit and/or large fiscal deficits and with large short term foreign currency liabilities and borrowings have been the most fragile. But even the better performing ones – like the BRICs club of Brazil, Russia, India and China – are now at risk of a hard landing. Trade and financial and currency and confidence channels are now leading to a massive slowdown of growth in emerging markets with many of them now at risk not only of a recession but also of a severe financial crisis.

The crisis was caused by the largest leveraged asset bubble and credit bubble in the history of humanity were excessive leveraging and bubbles were not limited to housing in the US but also to housing in many other countries and excessive borrowing by financial institutions and some segments of the corporate sector and of the public sector in many and different economies: an housing bubble, a mortgage bubble, an equity bubble, a bond bubble, a credit bubble, a commodity bubble, a private equity bubble, a hedge funds bubble are all now bursting at once in the biggest real sector and financial sector deleveraging since the Great Depression.

At this point the recession train has left the station; the financial and banking crisis train has left the station. The delusion that the US and advanced economies contraction would be short and shallow – a V-shaped six month recession – has been replaced by the certainty that this will be a long and protracted U-shaped recession that may last at least two years in the US and close to two years in most of the rest of the world. And given the rising risk of a global systemic financial meltdown the probability that the outcome could become a decade long L-shaped recession – like the one experienced by Japan after the bursting of its real estate and equity bubble – cannot be ruled out.

And in a world where there is a glut and excess capacity of goods while aggregate demand is falling soon enough we will start to worry about deflation, debt deflation, liquidity traps and what monetary policy makers should do to fight deflation when policy rates get dangerously close to zero.

At this point the risk of an imminent stock market crash – like the one-day collapse of 20% plus in US stock prices in 1987 – cannot be ruled out as the financial system is breaking down, panic and lack of confidence in any counterparty is sharply rising and the investors have totally lost faith in the ability of policy authorities to control this meltdown.

This disconnect between more and more aggressive policy actions and easings and greater and greater strains in financial market is scary. When Bear Stearns’ creditors were bailed out to the tune of $30 bn in March the rally in equity, money and credit markets lasted eight weeks; when in July the US Treasury announced legislation to bail out the mortgage giants Fannie and Freddie the rally lasted four weeks; when the actual $200 billion rescue of these firms was undertaken and their $6 trillion liabilities taken over by the US government the rally lasted one day and by the next day the panic has moved to Lehman’s collapse; when AIG was bailed out to the tune of $85 billion the market did not even rally for a day and instead fell 5%. Next when the $700 billion US rescue package was passed by the US Senate and House markets fell another 7% in two days as there was no confidence in this flawed plan and the authorities. Next as authorities in the US and abroad took even more radical policy actions between October 6th and October 9th (payment of interest on reserves, doubling of the liquidity support of banks, extension of credit to the seized corporate sector, guarantees of bank deposits, plans to recapitalize banks, coordinated monetary policy easing, etc.) the stock markets and the credit markets and the money markets fell further and further and at an accelerated rates day after day all week including another 7% fall in U.S. equities today.

When in markets that are clearly way oversold even the most radical policy actions don’t provide rallies or relief to market participants you know that you are one step away from a market crack and a systemic financial sector and corporate sector collapse. A vicious circle of deleveraging, asset collapses, margin calls, cascading falls in asset prices well below falling fundamentals and panic is now underway.

At this point severe damage is done and one cannot rule out a systemic collapse and a global depression. It will take a significant change in leadership of economic policy and very radical, coordinated policy actions among all advanced and emerging market economies to avoid this economic and financial disaster. Urgent and immediate necessary actions that need to be done globally (with some variants across countries depending on the severity of the problem and the overall resources available to the sovereigns) include:

– another rapid round of policy rate cuts of the order of at least 150 basis points on average globally;

– a temporary blanket guarantee of all deposits while a triage between insolvent financial institutions that need to be shut down and distressed but solvent institutions that need to be partially nationalized with injections of public capital is made;

– a rapid reduction of the debt burden of insolvent households preceded by a temporary freeze on all foreclosures;

– massive and unlimited provision of liquidity to solvent financial institutions;

– public provision of credit to the solvent parts of the corporate sector to avoid a short-term debt refinancing crisis for solvent but illiquid corporations and small businesses;

– a massive direct government fiscal stimulus packages that includes public works, infrastructure spending, unemployment benefits, tax rebates to lower income households and provision of grants to strapped and crunched state and local government;

– a rapid resolution of the banking problems via triage, public recapitalization of financial institutions and reduction of the debt burden of distressed households and borrowers;

– an agreement between lender and creditor countries running current account surpluses and borrowing and debtor countries running current account deficits to maintain an orderly financing of deficits and a recycling of the surpluses of creditors to avoid a disorderly adjustment of such imbalances.

At this point anything short of these radical and coordinated actions may lead to a market crash, a global systemic financial meltdown and to a global depression. At this stage central banks that are usually supposed to be the “lenders of last resort” need to become the “lenders of first and only resort” as, under conditions of panic and total loss of confidence, no one in the private sector is lending to anyone else since counterparty risk is extreme. And fiscal authorities that usually are spenders and insurers of last resort need to temporarily become the spenders and insurers of first resort. The fiscal costs of these actions will be large but the economic and fiscal costs of inaction would be of a much larger and severe magnitude. Thus, the time to act is now as all the policy officials of the world are meeting this weekend in Washington at the IMF and World Bank annual meetings.

Thursday midnite update: A few hours after I had written this note the market crash that I warned about is underway in Asia: the Nikkei index in Japan is down 11% and all other Asian markets are sharply down. This reinforces the urgency of credible and rapid policy actions by the G7 financial officials who are meeting in a few hours in Washington and the need to also involve in such global policy coordination the systemically important emergent market economies.


Oct 29, 2008. Get Ready For ‘Stag-Deflation’

Back in January, I argued that four major forces would lead to a risk of deflation– or “stag-deflation,” where a recession would be associated with deflationary forces–rather than the inflation that mainstream analysts have worried about.

They were: (1) a slack in goods markets, (2) a re-coupling of the rest of the world with the U.S. recession, (3) a slack in labor markets, and (4) a sharp fall in commodity prices following such U.S. and global contraction, which would reduce inflationary forces and lead to deflationary forces in the global economy.

How has such argument fared over time? And will the U.S. and global economies soon face sharp deflationary pressures? The answer: Deflation and stag-deflation will, in six months, become the main concern of policy authorities.


First, the U.S. has entered a severe recession that is already leading to deflationary forces in sectors where supply vastly exceeds demand (housing, consumer durables, motor vehicles, etc.). Aggregate demand is falling sharply below aggregate supply. The unemployment rate is up sharply, while employment has been falling for 10 months in a row. And commodity prices are sharply down–about 30% from their July peak–in the last three months, and are likely to fall much more in the next few months as the advanced economies’ recession goes global. So both in the U.S. and in other advanced economies we are clearly headed toward a collapse of headline and core inflation.

Is there any doubt about this ongoing inflation capitulation and the beginning of sharp deflationary forces? Take the current views of the economic research group at JPMorgan Chase. This group was, in 2007-08, the leading voice arguing about the risks of rising global inflation and the associated risks of a global growth reflation, and that policy rates would be sharply increased in 2008-09.

This week, however, the JPMorgan research group published its latest global economic outlook, arguing that we are headed toward a global recession, negative global inflation and sharply lower policy rates in the U.S. and advanced economies–a 180-degree turn from its previous position. What a difference a year makes!

Do you have any further doubt that we’re headed toward a global deflation or–better–a global stag-deflation? Read on: Aggregate demand is now collapsing in the U.S. and advanced economies, and sharply decelerating in emerging markets. There is a huge excess capacity for the production of manufactured goods in the global economy, as the massive, and excessive, capital expenditure in China and Asia (Chinese real investment is now close to 50% of gross domestic product) has created an excess supply of goods that will remain unsold as global aggregate demand falls.

Commodity prices are in free fall, with oil prices alone down over 50% from their July peak (and the Baltic Freight Index–the best measure of international shipping costs–is 90% down from its peak in May). Finally, labor market slack is sharply rising in the U.S., and rising, as well, in Europe and other advanced economies.

Next question: What are financial markets telling us about the risks of stag-deflation?

First, yields on 10-year Treasury bonds have fallen by about 50 basis points since Oct. 14, getting close to their previous 2008 lows. Also, the two-year Treasury yield has fallen by about 150 basis points in the last month.

Second, gold prices–a typical hedge against rising global inflation–are now sharply falling.

Finally, and more important, yields on Treasury Inflation-Protected Securities (TIPS) due in five years or less have now become higher than yields on conventional Treasuries of similar maturity. The difference between yields on five-year Treasuries and five-year TIPS, known as the break-even rate, fell to minus 0.43 percentage points.

This is a record. Since the difference between the conventional Treasuries and TIPS is a proxy for expected inflation, the TIPS market is now signaling that investors expect inflation to be negative over the next five years, as a severe recession is ahead of us.

So goods, labor, commodity, financial and bond markets are all sending the same message: Stagnation/recession and deflation (or stag-deflation) is ahead of us.

Don’t be surprised, then, if six months from now the Fed and other central banks in advanced economies will start to worry–as they did in 2002-03 after the 2001 recession–about deflation rather than inflation. In those years, when the U.S. experienced a deflation scare, Fed Chairman Ben Bernanke wrote several pieces explaining how the U.S. could resort to very unorthodox policy actions to prevent a deflation and a liquidity trap like the one experienced by Japan in the 1990s. Those writings may, very soon, have to be carefully read and studied again.

Finally, while in the short run a global recession will be associated with deflationary forces, some ask whether we should worry about rising inflation in the middle run? This argument–that the financial crisis will eventually lead to inflation–is based on the view that governments will be tempted to monetize the fiscal costs of bailing out the financial system, and that this sharp growth in the monetary base will eventually cause high inflation.

In a variant of the same argument, some posit that–as the U.S. and other economies face debt deflation–it would make sense to reduce the debt burden of borrowers (households and, now, governments taking on their balance sheets the losses of the private sector) by wiping out the real value of such nominal debt with inflation.

So should we worry that this financial crisis and its fiscal costs will eventually lead to higher inflation? The answer to this complex question: likely not.

First, the massive injection of liquidity in the financial system–literally trillions of dollars in the last few months–is not inflationary, as it accommodates the demand for liquidity that the current financial crisis and investors’ panic have triggered. Thus, once the panic recedes and this excess demand for liquidity shrinks, central banks can and will mop up all this excess liquidity.

Second, the fiscal costs of bailing out financial institutions would eventually lead to inflation if the increased budget deficits associated with this bailout were to be monetized, as opposed to financed with a larger stock of public debt. As long as such deficits are financed with debt–rather than by the printing presses–such fiscal costs will not be inflationary, as taxes will have to be increased over the next few decades and/or government spending reduced to service this large increase in the stock of public debt.

Third, to the question raised earlier: Wouldn’t central banks be tempted to monetize these fiscal costs–rather than allow a mushrooming of public debt–and thus wipe out with inflation these fiscal costs of bailing out lenders/investors and borrowers? Not likely in my view. Even a relatively dovish Bernanke Fed cannot afford to let the inflation-expectations genie out of the bottle via a monetization of the fiscal bailout costs. It cannot afford to do that because a rise in inflation expectations will eventually force a nasty and severely recessionary Volcker-style monetary-policy tightening to get the genie back into its bottle.

Fourth, inflation can reduce the real value of debts as long as it is unexpected, and as long as debt is in the form of long-term nominal fixed-rate liabilities. An attempt to increase inflation would not be unexpected: Investors would write debt contracts to hedge against such a risk if monetization of the fiscal deficits does occur.

Also, in the U.S. economy, a lot of debts–of the government, of the banks, of the households–are not long-term nominal fixed-rate liabilities. They are, rather, shorter-term variable-rate debts. Thus, a rise in inflation in an attempt to wipe out debt liabilities would lead to a rapid repricing of such shorter term, variable-rate debt. And thus expected inflation would not succeed in reducing the part of the debts that are now of the long-term nominal fixed-rate form–i.e., you can fool all of the people some of the time (unexpected inflation) and some of the people all of the time (those with long-term nominal fixed-rate claims), but you cannot fool all of the people all of the time.

In conclusion, a sharp slack in goods, labor and commodity markets will lead to global deflationary trends over the next year. And the fiscal costs of bailing out borrowers and/or lenders/investors will not be inflationary, as central banks will not be willing to incur the costs of very high inflation as a way to reduce the real value of the debt burdens of governments and distressed borrowers. The costs of rising expected inflation will be much higher than the benefits of using the inflation tax to pay for the fiscal costs of cleaning up the mess that this most severe financial crisis has created.

Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for

Nouriel Roubini is the cofounder and chairman of Roubini Global Economics, an independent, global macroeconomic and market strategy research firm. He is also a professor of economics at New York University’s Stern School of Business. Dr. Roubini has extensive policy experience as well as broad academic credentials. From 1998 to 2000, he served as the senior economist for international affairs on the White House Council of Economic Advisors and then the senior advisor to the undersecretary for international affairs at the U.S. Treasury Department. He has published over 70 theoretical, empirical and policy papers on international macroeconomic issues and coauthored the books “Political Cycles: Theory and Evidence” (MIT Press, 1997) and “Bailouts or Bail-ins? Responding to Financial Crises in Emerging Markets” (Institute for International Economics, 2004) and “Crisis Economics: A Crash Course in the Future of Finance” (Penguin Press, 2010).

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