Part 1 (1/2)
Crisis economics : a crash course in the future of finance
Nouriel Roubini and Stephen Mihm
Introduction
In January 2009, in the final days of the Bush administration, Vice President dick Cheney sat down for an intervieith the associated Press He was asked why the adest financial crisis since the Great Depression Cheney's response was revealing ”nobody anywhere was sure [it] out,” he declared ”I don't think anybody saw it co”
Cheney was hardly alone in his assessment Look back at the statements that the wise men of the financial community and the political establishment made in the wake of the crisis Invariably, they offered some version of the same rhetorical question: Who could have known? The financial crisis was, as Cheney suggested in this same interview, akin to the attacks of September 11: catastrophic, but next to impossible to foresee
That is not true To take but the most famous prediction made in advance of this crisis, one of the authors of the book-Nouriel Roubini-issued a very clear warning at a mainstream venue in the halcyon days of 2006 On September 7, Roubini, a professor of economics at New York University, addressed a skeptical audience at the International Monetary Fund in Washi+ngton, DC He forcefully sounded a warning that struck many in the audience as absurd The nation's economy, he predicted, would soon suffer a once-in-a-lifeti consumer confidence, and inevitably a deep recession
Those disasters were bad enough, but Roubini offered up an evenscenario As holobal financial system would shudder to a halt as trillions of dollars' worth of e-backed securities started to unravel This yet-to- bust, he concluded, could ”leadto a syste a crisis that could cripple or even take down hedge funds and investovernment-sponsored financial behereeted with serious skepticism by the audience
Over the next year and a half, as Roubini's predictions started co true, he elaborated on his pessimistic vision In early 2008 most econo from a liquidity crunch, but Roubini forecast that a much more severe credit crisis would hit households, corporations, and most dramatically, financial firms In fact, well before the collapse of Bear Stearns, Roubini predicted that two o bust and that the other major firms would cease to be independent entities Wall Street as we know it, he warned, would soon vanish, triggering upheaval on a scale not seen since the 1930s Within months Bear was a distant memory and Lehman Brothers had collapsed Bank of Aan Stanley and Goldulatory oversight, beco companies
Roubini was also far ahead of the curve in spotting the global dimensions of the disaster As market watchers stated confidently that the rest of the world would escape the crisis in the United States, he correctly warned that the disease would soon spread overseas, turning a national econolobal financial pandemic He also predicted that this hypothetical systelobal recession in decades, haht to be impervious to troubles in the United States And while other econoer of inflation, Roubini accurately predicted early on that the entire global econo deflationary spiral, of a sort not seen since the Great Depression
Roubini's prescience was as singular as it was remarkable: no other economist in the world foresaw the recent crisis with nearly the same level of clarity and specificity That said, he was not alone in sounding the alarm; a host of other well-placed observers predicted various elehts helped Roubini connect the dots and lay out a vision that incorporated their prescient insights Roubini's forue at Yale University, Robert shi+ller, was far ahead of alers of a stock market bubble in advance of the tech bust; more recently, he was one of the first econo bubble
shi+ller was but one of the economists and market watchers whose views influenced Roubini In 2005 University of Chicago finance professor Raghurah-profile econo, that the ways bankers and traders were being coe thelobal financial systeures raised a siend James Grant warned in 2005 that the Federal Reserve had helped create one of ”the greatest of all credit bubbles” in the history of finance; William White, chief economist at the Bank for International Settlements, warned about the systemic risks of asset and credit bubbles; financial analyst Nassim Nicholas Taleb cautioned that financial markets oefully unprepared to handle ”fat tail” events that fell outside the usual distribution of risk; econooff warned about the unsustainability of current account deficits in the United States; and Stephen Roach of Morgan Stanley and David Rosenberg of Merrill Lynch long ago raised concerns about consu far beyond their oes on But for all their respectability, these and other econonored, a fact that speaks volumes about the state of economics and finance over recent decades Most people who inhabited those worlds ignored those warnings because they clung to a si entities that are stable, solid, and dependable By this reasoning, the entire edifice of twenty-first-century capitalisled financial innovation-would regulate itself, keeping close to a steady, self-adjusting state of equilibrium
It all seems naive in retrospect, but for decades it was the conventional wisdom, the basis of rand-scale investly, econonificant place Indeed, if crises appeared at all, they were freak events: highly iely unpredictable, and fleeting in their consequences To the extent that crises becaenerally considered to afflict less developed, ”troubled” countries, not economic powerhouses like the United States
This book returns crises to the front and center of economic inquiry: it is, in short, about crisis econo the exception, crises are the nor but in advanced industrial economies Crises-unsustainable booms followed by calamitous busts-have always been with us, and with us they will always reuably predate the rise of capitalism, they have a particular relationshi+p to it Indeed, in many ienoive capitalism its vitality-its powers of innovation and its tolerance for risk-can also set the stage for asset and credit bubbles and eventually catastrophicafterward
Though crises are commonplace, they are also creatures of habit They're a bit like hurricanes: they operate in a relatively predictable fashi+on but can change directions, subside, and even spring back to life with little warning This book sets out the principles by which these economic storms can be tracked andthe recent crisis as an object lesson, it sho it's possible to foresee such events and, no less important, prevent them, weather them, and clean up after them Finally, this book seeks to shoe can rebuild our financial levees so as to blunt the effects of future storh is a taste of what is to coure in our future
To understand ill tackle a host of unresolved, lingering questions about the recent disaster, beginning with the most obvious: Why did the bubble behind the worst financial meltdown in decades first for by financial institutions, ulation and supervision? Or was it the inevitable consequence of excessive government interference in financial markets? These questions cut to the core of very different, even antagonistic ways of understanding financial crises They also point toward radically different remedies
This book also examines why the recent crisis hit when it did Was itof what John Maynard Keynes called the ”animal spirits” of capitalism? Or was it the inevitable consequence of the fact that souably reed and effectively bankrupt? Put differently, did the crisis result from a mere lack of liquidity or from a more profound lack of solvency? If the latter, what does that portend for the future?
From there the questions multiply In the midst of the crisis, central bankers around the world became ”lenders of last resort” for vast swaths of the financial syste? Or will they only encourage excessive risk taking in the future, setting us up for bigger and more destructive bubbles and busts? Likewise, ill be the result of the rush to reregulate? Will it produce a rowth, or will its effects bemore virulent bubbles and crises in the future?
None of these questions are hypothetical John Maynard Keynes, a giant in twentieth-century econohtly observed that ”the ideas of econoht and when they are wrong, are more powerful than is commonly understood Indeed, the world is ruled by little elseMad their frenzy from some academic scribbler of a few years back” Keynes wrote those oft-quoted words o, but they are equally pertinent today Much of our fraenerations derives fro, have nonetheless prevented a full understanding of its origins and consequences
We want to make it clear at the outset that we are not devotees of any particular econo relevant to say about the recent crisis, and our analysis relies on a range of thinkers Keynes has his say, but so do other voices In fact, we believe that understanding andcrises requires a more holistic and eclectic approach than is perhaps custoy at the door and look at matters more dispassionately Crises come in many colors, and orks in one situation matism pervades this book's assess forward, it asks, should orry -teres iency measures undertaken by the Federal Reserve and other central banks? And what is the future of the Anglo-Saxon model of unfettered laissez-faire capitalism? What is the future of the dollar? Does the recent crisisof the end of the A econoovernance in order to e from future crises?
The modest a the recent crisis in the context of others that have occurred over the ages and across the world After all, the past few years conform to a familiar, centuries-old pattern Crises follow consistent trajectories and yield predictable results They are far more common and comprehensible than conventional wisdoes that folloe'llquestions were asked and answered in the wake of previous crises
Along the e'll explain several inti and often e, bank run, regulatory arbitrage, current account deficit, securitization, deflation, credit derivative, credit crunch, and liquidity trap, to name a few We hope our explanations will prove useful not only to financial professionals on Wall Street and Main Street but also to corporate executives at horaduate students in business, economics, and finance; to policy makers and policy wonks in many countries; and most numerous of all, to ordinary investors around the world who no that they ignore the intricacies of the international financial order at their peril
This book follows a straightforward arc, starting with a history of older crises and the economists who analyzed them It then addresses the very deep roots of the most recent crisis, as well as the ways this catastrophe unfolded in a very predictable pattern, confor to time-honored precedents Finally, the book looks to the future, laying outthe likelihood of other crises in the co years Chapter 1 takes the reader on a tour of the past, surveying the many booms, bubbles, and busts that have swept the economic landscape We focus in particular on the relationshi+p between capitalis with the speculative bubble in tulips in 1630s Holland, then ranging forward to the South Sea Bubble of 1720; the first global financial crisis in 1825; the panic of 1907; the Great Depression of the 1930s; and themarkets and advanced econoue, are neither the freak events that modern economics has made them seem nor the rare ”black swans” that other commentators have made them out to be Rather, they are commonplace and relatively easy to foresee and to comprehend Call them white swans
In most advanced economies, the second half of the twentieth century was a period of relative, if uncharacteristic, calrowth that economists dubbed the ”Great Moderation” As a result, nored crises or seen theain acrises of the past, present, and future, one eneration of economists Chapter 2 introduces economic thinkers who can help us do just that Some, like John Maynard Keynes, are reasonably well known; others, like Hyman Minsky, are not
Chapter 3 explains the deep structural origins of the recent crisis Fro, it has been fashi+onable to blaes that solobal financial syste how decades-old trends and policies created a global financial system that was subprime from top to bottom Beyond the creation of ever -standing trends included the rise of the ”shadow banking systee funds, broker dealers, money market funds, and other institutions that looked like banks, acted like banks, borrowed and lent like banks, and otherwise becaulated like banks
This same chapter introduces the problem of moral hazard, in which market participants take undue risks on the assumption that they will be bailed out, indemnified, and otherwise spared the consequences of their reckless behavior It also addresses long-standing failures of corporate governance, as well as the role of governh we do not subscribe to the usual contradictory explanations that the crisis was caused by too ue, is overnment did play a role, as did its absence, but not necessarily in the way that either conservatives or liberals would have you believe
Several subsequent chapters focus on the crisis itself Numerous accounts already exist, but alular, unprecedented event particular to twenty-first-century finance Chapter 4 dispels this naive and siue that the events of 2008 would have been familiar to financial observers one hundred or even two hundred years ago, not only in how they unfolded but in how the world's central banks atte as lenders of last resort The particulars of the crisis differed from those of its predecessors, but inthe old adage that while history rarely repeats itself, it often rhymes
History confirin with the outbreak of a disease that then spreads, radiating outward This crisis was no different, though its origin in the world's financial centers rather than in e markets on the periphery made it particularly virulent Chapter 5 tracks how and why the crisis went global, ha economies as different as Iceland, Dubai, japan, Latvia, Ireland, Gerapore We break with the conventional wisdoinated in the United States Far froued the US financial system idespread-and in some cases, worse-elsewhere in the world The pandemic, then, was not indiscriminate in its effects; only countries whose financial systems suffered from similar frailties fell victim to it
While other books on the financial crisis focus heavily or exclusively on the United States, this one fralobal capitalis international dilobal finance, international macroeconomics, and the cross-border implications of national reat deal about the workings of the global economy in both normal times and not-so-normal times
All crises end, and this one was no exception Unfortunately, the aftershocks will linger on for years if not decades Chapter 6 shohy they do, and why deflation and depression looe in the wake of any crisis In the past, central bankers used monetary policy to counter crises, and now they've revived some of these approaches At the same time, many financial crises force central bankers to innovate on the fly, and the recent crisis was no exception Unfortunately, while these eency measuresthe patient
That's the case with fiscal policies as well In chapter 7 we exaovernment's power to tax and spend in order to arrest the spread of the crisis Some of these tactics were first articulated by Keynes; many more represented a massive, unprecedented intervention in the economy This chapter assesses the future implications of the most radical measures, particularly the risks they may create down the line
The level of intervention necessary to stabilize the systees the sustainability of traditional laissez-faire capitaliser direct and indirect role in the postcrisis global econoulation and supervision Chapters 8 and 9 lay out a blueprint for a new financial architecture, one that will bring new transparency and stability to financial institutions Long-ter the international financial syste regulation and supervision of not just commercial banks but also investe funds; policies to control the risky behavior of ”too big to fail” financial fir financial institutions; and policies to reduce the proble out financial fir question of what future role central banks should play to control and pop asset bubbles
Chapter 10 tackles the serious ilobal economy and the more radical reforms of the international monetary and financial order that may be necessary to prevent future crises Why have so -market economies suffered financial crises in the last twenty years? Why has the United States run massive deficits, while Ger-market economies have run surpluses? Will these current account imbalances-which were one of the causes of the financial crisis-be resolved in an orderly or a disorderly way? Could the US dollar crash, and if so, ould replace it as a global reserve currency? What role can a reforlobal monetary distortions and financial crises? And should the IMF become a true international lender of last resort?
This part of the book recognizes an inescapable truth: the ability of the United States, much less the G-7, to dictate the terlobal econoovernance will play out under the watchful eye of a roup of stakeholders: Brazil, India, China, Russia, and the other countries that ly powerful nations will profoundly shape the handling of future crises; so will a host of new players and institutions in the global financial systen wealth funds, offshore financial centers, and international monetary unions
The final ”Outlook” section surveys the road ahead, taking a hard look at the ave us the Great Recession may be over for now, but potential pitfalls and risks looe What issues will determine the future volatility of the world econolobal econo period of subpar and anerowth? Has the loose monetary policy adopted in the wake of the crisis created a risk of new asset bubbles that will go bust? Hoill the US governovernments deal with the massive aovernh inflation to wipe out the real value of public and private debts, or will deflation pose the bigger danger? What is the future of globalization and of overnment intervention in economic and financial affairs, and ill be the consequences of such a shi+ft? While s to China and that the United States is destined for a long decline, this look to the future sets out various scenarios in which both existing and ele and collapse
More generally, the final chapters of the book wrestle with several open questions: Hoill globalization affect the probability of future crises? Hoe resolve the global imbalances that helped create the recent crisis? How, in other words, e reforlobal capitalis After all, we've been down this road before, many times In 1933 John Maynard Keynes declared, ”The decadent international but individualistic capitalism, in the hands of which we found ourselves after the [First World] war, is not a success It is not intelligent, it is not beautiful, it is not just, it is not virtuous-and it doesn't deliver the goods In short we dislike it, and we are beginning to despise it But onder what to put in its place, we are extremely perplexed”
That perplexity was eventually resolved, and it will be once again This book contributes to that resolution, giving some sense of how to reform a capitalisoods on a consistent and stable basis Indeed, whilemarket economies out of endemic poverty and under-development, the frequency and virulence of econo markets and industrial econoot into this et out-and stay out
Chapter 1
The White Swan
When did the boo real estate, when first-tiht and sold subdivision lots like shares of stock, doubling and tripling their profits in weeks if not days Or possibly things got out of balance when the allure of a new econoy and new industries drew ordinary people to wager their life savings on Wall Street
Politicians and policy et-rich-quick scheed them No less an authority than the president of the United States proclaiovernment should not bother business, while the Federal Reserve did little to stem the speculative tide Financial innovation and experimentation were hailed for their trerowth, and new kinds of financial fired to market little-understood securities to inexperienced investors and to make extensive lines of credit available to millions of borrowers