The thinkers who predicted early on many aspects of this financial crisis
Nouriel Roubini | May 1, 2009
Time magazine has kindly included me in its annual list of The 100 Most Influential People in the World. I do not know if I deserve to be in such a list as there are so many others who influence so much of our world. But I certainly recognize that there were a small but significant number of economists, thinkers and analysts who – early on – predicted many of the risks and vulnerabilities that eventually led to this crisis. In many ways I simply connected the dot in these different strands of thinking and warnings.
Among a few others Robert Shiller was one of the earliest ones to study in detail and warn about a housing bubble; Kenneth Rogoff and a few other economists warned early on about the unsustainability of the US current account deficits and of the global imbalances; Raghu Rajan presented one of the earliest and sharpest analyses of the agency problems and incentive distortions deriving from compensation schemes in financial institutions; Nassim Taleb and a few other finance scholars stressed the risk of fat tail extreme events in financial markets; Paul Krugman – who received his Nobel for his trade contributions – was the father of currency and financial crisis theories in international macro as at least three generations of currency crisis models were developed from his seminal work; Stephen Roach, David Rosenberg and a few other financial sector analysts warned about the shopped-out, saving-less, bubble-addict and debt-burdened US consumer ; Niall Ferguson provided vivid comparisons between historical episodes of financial crises and current vulnerabilities; Hyun Shin and other scholars in academia provided early modeling of illiquidity and of the perverse effects of leverage during asset bubbles; William White and his colleagues at the BIS were among the first – following the scholarship of Hyman Minsky – to analyze how the “Great Moderation” may paradoxically lead to “Financial Instability”, asset and credit bubbles and financial crises; Gillian Tett and a few other journalists at the Financial Times provided early clear explanations of the arcane complexity of credit derivatives and structured finance and of the systemic risks deriving from these new exotic financial instruments; dozen of serious and deep thinking scholars in academia modeled analytically – and tested empirically - the various aspects of systemic financial crises and the interactions between currency crises, systemic banking crises, systemic corporate and household debt crises and sovereign debt crises.
Given the important work done by these and other scholars and thinkers it was certainly easier for me to connect the analytically and empirical dots and warn early on in the middle of 2006 about the incoming economic and financial tsunami. It is important to recognize that a small but significant number of thinkers were willing to think outside the box and were aware of many risks and vulnerabilities. These thinkers - like myself - were not Dr. Dooms; they were rather Dr. Realists, analytically rigorous and intellectually honest and willing to engage in critical thinking rather than follow the herd of the easy consensus. And even among the policy makers there was a difference in views. Alan Greenspan, Don Kohn and Bernanke repeated the mantra that it is impossible to prick asset bubbles and that monetary policy should do nothing when a bubble was rising and then, asymmetrically, aggressively ease when the bubble was bursting to avoid the collateral damage to the real economy. Instead thinkers at the BIS and policy makers such as Tim Geithner, Jean Claude Trichet and Mervyn King had a more nuanced approach on how monetary and credit policy could be used to contain such bubbles. Tim Geithner devoted his first five speeches as President of the New York Fed to the issue of systemic risk in financial markets; he also warned about the unsustainability of the US twin deficits at the time when Bernanke was blaming it all on the global savings glut caused by China and other surplus countries.
One may also partially agree or disagree with the specific policy actions undertaken by policy makers in managing and resolving this economic and financial crisis. And I do disagree on some specific policy actions, among other on how the banking crisis is being handled. But one should also recognize that the current administration – the President, Geithner, Summers and the rest of the economic team – did a lot to contain and resolve the worst economic and financial crisis since the Great Depression, a crisis that it had inherited from the previous administration. In the first 30 days (not 100) of this administration three major policy actions were undertaken: a $800 billion dollar fiscal stimulus program that is necessary to stimulate aggregate demand; a housing plan that addresses more aggressively the need to slow down defaults and foreclosures; and bank stress tests and a bad assets resolution plan whose initial launch was botched because of the lack of specific details but that was much more favorably received by the markets once its details became clearer. And even monetary policy has become more creative via a zero interest rate policy, quantitative/credit easing and a range of unconventional policy actions aimed at thawing frozen money markets and credit markets. The recent weeks’ improvement in markets and investors’ risk sentiment is partially related to the development of these monetary, fiscal, credit and banking resolution plans.
Given the justifiable rush of getting these policy actions implemented in short order (the three major ones were announced in 30 days) many details, flaws and shortcomings remain. Fiscal policy stimulus should have been more front-loaded in 2009 and ineffective tax cuts (out of last year’s one of $100 billion only 30% was spent and the rest saved) should have been avoided; the foreclosure avoidance plan may require principal value reduction of mortgages as millions of households are underwater rather than mortgage debt payments relief alone; the Geithner plan for dealing with toxic assets has some design flaws that can be fixed and while it can be used to deal with the toxic assets of solvent banks it cannot resolve the capital problems of near insolvent banks. But one should recognize that US policy authorities – as well as the authorities of many other countries looked into the abyss of the risk of a near depression - given the free fall in global economic activity in the last two quarters – and decided to start using most of the weapons in their arsenals – bazookas, missiles, rockets, artillery, etc – in a financial policy equivalent of a Powell doctrine of overwhelming force in order to avoid a near depression. This is why now the risks of an L-shaped near depression – like the one that hit Japan after the bursting of its real estate and equity bubble – have been reduced.
We are still in a severe and deep and protracted U-shaped recession that – unlike the forecast of the current consensus economists – will not be over in Q3 but will last until the beginning of 2010. So there may be finally light at the end of the tunnel but later rather than sooner, in 2010 rather than in the second half of 2009. There are still significant downside risks and while optimists speak about green shoots there are still plenty of yellow weeds; and while second derivatives are becoming positive especially in the US but, partially, also in other countries, they are not positive enough yet to suggest that the recession will bottom out in Q3 – as predicted by the consensus – as opposed to some time in 2010. The toxic mess and damage caused by this leverage-driven financial crisis and economic recession – including a brutal shedding of employment that shows no sign of letting up – will take much longer to truly heal the financial markets, the financial institutions and the real economy.