We Won't Escape the Worst Recession in 40 Years

Thursday, 25 September 2008 13:03 By Virginie Robert Interview Nouriel Roubini and Pierre de Gasquet, Truthout | name.

We Won

    He was the first economist to forecast - in November 2007 - a credit collapse and major financial system crash, as well as the US economy's entry into recession. The New York Times recently nicknamed him "Dr Doom." There is no denying, however, that some of his predictions - notably the crisis in the investment banking model - have proven to be valid. Professor at New York University's Stern School of Business, once a fellow student of American economist Jeffrey Sachs, 50-year-old Nouriel Roubini has forged a solid reputation for himself as a specialist in speculative bubbles and in the anticipation of recessionary movements on the basis of the study of mathematical models and historical analogies. Born in Istanbul of Iranian parents, raised in Italy, a Harvard graduate, this atypical intellectual, who shuns political cant and lives in a loft in a trendy New York TriBeCa neighborhood, loves to present himself as a "global nomad." His economics blog is among the most influential today in academic milieus. Former Treasury adviser in the Clinton administration, he doesn't hide his sympathies for the Democratic side, even though he does not figure in the circle of the Barack Obama campaign's regular experts.

    Les Echos: Does the American government's initiative to create a new vehicle for the sequestration of toxic assets modeled on the Resolution Trust Corporation (RTC) that was used during the savings and loan crisis seem to you to be suited to the situation?

    First, you need to understand the nature of the problem that confronts us. There's a sector of the economy that is overindebted; that's real estate. So, we must either reduce the debt or increase income. That's what was attempted with the tax rebate checks sent out to taxpayers. But they only represented a few hundred dollars per household; that was inadequate. The only solution is to reduce the debt by removing these rotten assets from bank balance sheets and reducing their face value. We've already had recourse to this type of sequestration structure in the past. There was the RTC during the "saving and loans" crisis at the end of the 1980s, but also the Home Owners Loan Corporation (HOLC), which took over doubtful assets during the 1929 crisis, and the Reconstruction Finance Corporation (RFC), which injected public money into banks that were in trouble, but solvent.

    Will that be sufficient to erase the crisis?

    No, we must not stop at simply taking over toxic assets. We must also reduce the face value of these debts, so that households may, in fact, reimburse them. That's what the HOLC did. That's the only way to avoid massive foreclosures. In fact, we need a combination of the three structures I just mentioned. Even more than an RTC to take over failing banks' assets, we need a HOLC to pool the assets of troubled, but still solvent banks, and finally, an RFC to recapitalize banks that have been excessively weakened. The government should inject capital into commercial banks in the form of preferred shares.

    So there are several essential steps?

    Yes, pooling the rotten assets in a sequestration structure is totally useless unless we reduce individuals' debts. Because if they can't pay, we'll have a foreclosure tsunami and banks will go under. And if they go under, the economy will go with them. So, we must avoid liquidation as allowed for in Chapter 7 of the bankruptcy law and restructure the debt as though individuals were placed under Chapter 11.

    What is the final cost of this plan likely to represent for the taxpayer?

    The government must at once buy these assets at a reduced price, but also at one high enough not to strangle the banks. The difference between the two represents the government's real subsidy. So, an asset valued at 100 would be purchased at 85 from the bank, but the debtor would be asked for only 70. The subsidy is 15. Over a total of 1,500 billion dollars of illiquid assets, with 15 cents subsidy on the dollar, that represents a final fiscal cost to the taxpayers of 225 billion dollars.

    There are already close to 6 trillion dollars of real estate loans the government guarantees via Fannie Mae and Freddie Mac, and 6 trillion in the private sector, of which 1.5 trillion are risky loans. In the end, it amounts to nationalizing real estate loans. Because if you don't do that, you'll have to nationalize the banks! Because today only the government is there to bail out the banks.

    And will that restore liquidity to the economy?

    We're already in a recession and a financial crisis. This plan will not avoid a recession that will last about 18 months. Government intervention may transform the "L" shaped curve, which anticipates several years of recession, into a "U" shape, with a more rapid recovery. But it will still be a very bad recession.

    What do you mean by "bad" recession?

    It will last 18 months and, in spite of this plan, we won't avoid the worst recession we've experienced in 10 years. American GDP will decline 3 percent on an annualized basis for the next six quarters. We won't see a technical recovery before the second half of 2009. If you use real data, the recession began in the first quarter of 2008. Little by little, you'll see the official data revised in this direction - except for the second quarter because of the rebate checks that went out. American consumption is wobbling and household confidence is at its lowest point. The Euro zone is already in recession. All developed countries' economies are contracting: 55 percent of global GDP is already in recession! I don't see where the American economy's "resilience" is.

    Do you still think that many banks will disappear?

    I think about 200 banks will go bankrupt. Especially small banks with under 4 billion dollars of assets, and a good share of those being real estate assets. Those which have financed housing or big stores in California or Nevada ... where the real estate crisis has been the worst. Regional banks will also be affected. They are a lot like IndyMac, the California bank that was placed under trusteeship. Washington Mututal and Wachovia are virtually insolvent.

    What future do you see for investment banks?

    No investment bank will remain independent. Those that survive will have to lean on a commercial bank. There are three reasons for that. The first is that there is no more securitization. Now, that represented a significant part of their income and results. The second is that they are going to be more and more regulated like commercial banks, which involves higher levels of capital. The third is that they behave like banks by borrowing very short term and exercising an important leverage effect, but they can't depend on the liquidity deposits bring. Even though Goldman Sachs has been better managed than the others, it bumps up against the same problems. Look what's happened the last six months. Three of Wall Street's five investment banks have disappeared; the fourth is discussing a merger; and Goldman Sachs itself will not escape the movement. They need stable sources of liquidity. You know, investment banks borrow so much money every night that if confidence were to disappear, everything would collapse. If Citigroup, which has made over 50 billion dollars of losses and provisions, hadn't had its deposits, it would no longer be there today.

    Is Bank of America's purchase of Merrill Lynch sensible?

    Yes, in the sense that an investment bank can no longer go without the support of a commercial bank. But Bank of America has unbelievably overpaid for Merrill Lynch and is piling up risks since it had already bought up Countrywide, the premier supplier of real estate credits in the United States. Lehman's history is different. The bank, with many toxic assets, become insolvent. No one could estimate its price.

    Do you approve of the government-assisted rescue of Bear Stearns?

    That was rather more the rescue of Bear Stearns's creditors. No one would have paid for that bank, exactly as in the case of Lehman Brothers, if it meant taking on its toxic assets. The government took those assets and that's why JPMorgan Chase agreed to take over the bank. But it also did so because it was one of Bear Stearns's main counterparties for "credit default swaps." Had Bear Stearns gone under, JPMorgan Chase risked going under along with it. So, it would be more appropriate to talk about the rescue of JPMorgan Chase.

    Why did the government come to the rescue of insurer AIG and not of Lehman Brothers?

    The government was purporting to draw a line in the sand, the moral hazard line. But, in fact, it has saved everybody, Bear Stearns, the money funds, AIG ... But all the same, you need to realize that the Bear Stearns' rescue was practically illegal. The Fed granted itself the power to give liquidity to investment banks, with reference to an old clause dating back to the crisis of 1929. It quite simply went around Congress. It didn't want to take that risk a second time, so it just let Lehman fall.

    Do you think the Fed must reduce the Fed Funds rate to relaunch the economy?

    It was said at one time that it was going to increase rates, which is ridiculous when we're in a recession. But it's obvious it will have to reduce them still further. It didn't do so last week because it knew it was coming to AIG's rescue and it couldn't do both at the same time. It knows that using the monetary policy tool is not very effective at this time. The central bank has already reduced its rates by 325 basis points; it's invented I don't know how many instruments to supply liquidity to the market, but that's made absolutely no difference! As long as the public's confidence is not restored, no monetary policy tool will function.

    What impact could the financial crisis have on the presidential campaign and the candidates' promises for reductions in taxes?

    John McCain wants to make the most recent tax reductions permanent, while Obama wants to create different ones in favor of the middle class. But given the state of the American deficit and debt, even if McCain were elected, he could not maintain the reductions in taxes. All the more so as Congress will stay Democratic and not allow him to do so. In fact, McCain, like Obama, will be forced to take a middle path. Given American finances and the decisions taken to emerge from the financial crisis, everyone knows that it will be necessary to increase tax receipts.

    Will that compromise the candidates' programs, in health and education, for example?

    Obviously. They won't have the resources to do everything.

    Curiously, Obama appears to favor the government's plan more than McCain. Why?

    It's easier for the Democrats to support massive government intervention. But McCain, if he were in power, would certainly be forced to do the same thing. We're in the process of emerging from eight years of a fanatical administration, free market zealots who opposed any financial regulation. Because of their stupidity, we've been plunged into the most serious financial crisis since that of 1929. And now, they're falling into the opposite excess. The government intervenes incessantly, saves Bear Stearns, Fannie Mae, Freddie Mac, AIG ... It goes to war against selling, accepts stocks to guarantee loans, comes to the aid of money funds ... McCain surely does not appreciate all this interventionism, but it's the result of a laissez-faire policy.

    Does that mean you share the criticisms John McCain has leveled against regulators?

    It's the result of a combination of factors. But if you want to blame the regulator, you have to look first to the administration that didn't believe in market supervision. Do you realize?! People gave mortgage loans to people without asking for their pay stubs, with the least documentation possible, without requiring a down payment, drawing them in with highly attractive initial interest rates. This administration supposedly believed in self-regulation. In fact, it really wanted no regulation at all. It believed in market discipline; we've seen that that's meaningless. It talked about risk management, but managers took great care to ignore risks ... We mustn't blame the regulator. The one really responsible is the Bush administration; that's who encouraged this laisser-faire.

    McCain demanded the head of Securities and Exchange Commission (SEC) president, Christopher Cox. A simple scapegoat?

    He should attack Bush, Paulson, Greenspan, Bernanke. They're all responsible.

    Finally, how do you judge the Fed's and the Treasury's efforts to resolve this crisis?

    First of all, they were wrong. A year and a half ago, they said there was a minor problem in the real estate market. You can find their statements on Google. In reality, this "minor problem" turned into the worst recession ever seen since 1929. Then, they assured everyone that the "subprime" crisis was a niche problem and would be limited. We've already seen that everything has been affected: municipalities' debt, student loans ... we've never seen a comparable credit crisis! Finally, they alleged that the collapse of the real estate market - which had contributed a third of new jobs created the last six years - would have no impact on the rest of the economy! Last summer, they were overcome by panic and began reducing the Fed funds rate like crazy. They adopted an ad hoc approach without taking a full measure of the systemic risk. We've never been so close to a complete collapse of the financial system.


    Translation: Truthout French language editor This email address is being protected from spambots. You need JavaScript enabled to view it..

Last modified on Thursday, 25 September 2008 14:20