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 d.i.c.k Cheney sat down for an interview with the a.s.sociated Press. He was asked why the administration had failed to foresee the biggest financial crisis since the Great Depression. Cheney's response was revealing. ”n.o.body anywhere was smart enough to figure [it] out,” he declared. ”I don't think anybody saw it coming.”

Cheney was hardly alone in his a.s.sessment. 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 Was.h.i.+ngton, D.C. 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-lifetime housing bust, a brutal oil shock, sharply declining consumer confidence, and inevitably a deep recession.

Those disasters were bad enough, but Roubini offered up an even more terrifying scenario. As homeowners defaulted on their mortgages, the entire global financial system would shudder to a halt as trillions of dollars' worth of mortgage-backed securities started to unravel. This yet-to-materialize housing bust, he concluded, could ”lead . . . to a systemic problem for the financial system,” triggering a crisis that could cripple or even take down hedge funds and investment banks, as well as government-sponsored financial behemoths like Fannie Mae and Freddie Mac. His concerns were greeted with serious skepticism by the audience.

Over the next year and a half, as Roubini's predictions started coming true, he elaborated on his pessimistic vision. In early 2008 most economists maintained that the United States was merely suffering 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 major broker dealers (that is, investment banks) would go bust and that the other major firms would cease to be independent ent.i.ties. 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 America absorbed Merrill Lynch, and Morgan Stanley and Goldman Sachs were eventually forced to submit to greater regulatory oversight, becoming bank holding 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 economic illness into a global financial pandemic. He also predicted that this hypothetical systemic crisis would spark the worst global recession in decades, hammering the economies of China, India, and other nations thought to be impervious to troubles in the United States. And while other economists were focused on the danger of inflation, Roubini accurately predicted early on that the entire global economy would teeter on the edge of a potentially crippling 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 elements of the financial crisis, and their insights helped Roubini connect the dots and lay out a vision that incorporated their prescient insights. Roubini's former colleague at Yale University, Robert s.h.i.+ller, was far ahead of almost everyone in warning of the dangers of a stock market bubble in advance of the tech bust; more recently, he was one of the first economists to sound the alarm about the housing bubble.

s.h.i.+ller was but one of the economists and market watchers whose views influenced Roubini. In 2005 University of Chicago finance professor Raghuram Rajan told a crowd of high-profile economists and policy makers in Jackson Hole, Wyoming, that the ways bankers and traders were being compensated would encourage them to take on too much risk and leverage, making the global financial system vulnerable to a severe crisis. Other well-respected figures raised a similar warning: Wall Street legend 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 a.s.set and credit bubbles; financial a.n.a.lyst Na.s.sim Nicholas Taleb cautioned that financial markets were woefully unprepared to handle ”fat tail” events that fell outside the usual distribution of risk; economists Maurice Obstfeld and Kenneth Rogoff 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 consumers in the United States living far beyond their means.

The list goes on. But for all their respectability, these and other economists and commentators were ignored, 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 simple, quaint belief: that markets are self-regulating ent.i.ties that are stable, solid, and dependable. By this reasoning, the entire edifice of twenty-first-century capitalism-aided, of course, by newfangled 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 momentous policy decisions and the rationale for grand-scale investment strategies. In this paradigm, not surprisingly, economic crises had little or no significant place. Indeed, if crises appeared at all, they were freak events: highly improbable, extremely unusual, largely unpredictable, and fleeting in their consequences. To the extent that crises became the object of serious academic study, they were generally 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 economics. It shows that far from being the exception, crises are the norm, not only in emerging but in advanced industrial economies. Crises-unsustainable booms followed by calamitous busts-have always been with us, and with us they will always remain. Though they arguably predate the rise of capitalism, they have a particular relations.h.i.+p to it. Indeed, in many important ways, crises are hardwired into the capitalist genome. The very things that give capitalism its vitality-its powers of innovation and its tolerance for risk-can also set the stage for a.s.set and credit bubbles and eventually catastrophic meltdowns whose ill effects reverberate long afterward.

Though crises are commonplace, they are also creatures of habit. They're a bit like hurricanes: they operate in a relatively predictable fas.h.i.+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 and monitored and, within reason, forecast and even avoided. Using the recent crisis as an object lesson, it shows how 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 show how we can rebuild our financial levees so as to blunt the effects of future storms. For what we just lived through is a taste of what is to come. Crises will figure in our future.

To understand why, we will 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 form? Was it a function of excessive risk taking by financial inst.i.tutions, made possible by lax regulation 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. .h.i.t when it did. Was it merely a collapse of confidence, a withering of what John Maynard Keynes called the ”animal spirits” of capitalism? Or was it the inevitable consequence of the fact that some portions of the economy were (and arguably remain) excessively leveraged 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 system. Did their actions prevent something worse from happening? Or will they only encourage excessive risk taking in the future, setting us up for bigger and more destructive bubbles and busts? Likewise, what will be the result of the rush to reregulate? Will it produce a more robust and resilient financial system and more stable growth, or will its effects be merely cosmetic, incapable of preventing more virulent bubbles and crises in the future?

None of these questions are hypothetical. John Maynard Keynes, a giant in twentieth-century economics, once rightly observed that ”the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. . . . Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.” Keynes wrote those oft-quoted words more than seventy years ago, but they are equally pertinent today. Much of our framing and understanding of the worst financial crisis in generations derives from a set of a.s.sumptions that, while not always wrong, 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 economist's thought; almost every school of economics has something relevant to say about the recent crisis, and our a.n.a.lysis relies on a range of thinkers. Keynes has his say, but so do other voices. In fact, we believe that understanding and managing crises requires a more holistic and eclectic approach than is perhaps customary. It's necessary to check ideology at the door and look at matters more dispa.s.sionately. Crises come in many colors, and what works in one situation may not work in another.

That same pragmatism pervades this book's a.s.sessment of the financial system's future. Going forward, it asks, should we worry more about inflation or deflation? What will be the long-term consequences of policy measures like the stimulus packages implemented by many countries, never mind the emergency 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 crisis mark the beginning of the end of the American empire, and the rise of China and other emerging economies? Finally, how can we reform global economic governance in order to mitigate the damage from future crises?

The modest ambition of this book is to answer these questions by placing 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 wisdom would lead you to believe. In the pages that follow, we'll move between past and present, revealing how the foregoing questions were asked and answered in the wake of previous crises.

Along the way we'll explain several intimidating and often misunderstood concepts in economics: moral hazard, leverage, 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 home and abroad; to undergraduate and graduate 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 now know 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 a.n.a.lyzed 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, conforming to time-honored precedents. Finally, the book looks to the future, laying out much-needed reforms of the financial system and addressing the likelihood of other crises in the coming 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 relations.h.i.+p between capitalism and crisis, beginning 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 the many crises that plagued emerging markets and advanced economies from the 1980s onward. Crises, we argue, 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, calm, culminating in a halcyon period of low inflation and high growth that economists dubbed the ”Great Moderation.” As a result, mainstream economics has either ignored crises or seen them as symptoms of troubles in less developed economies. To gain a more expansive way of viewing and understanding crises of the past, present, and future, one must go back to an earlier generation 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. From the beginning, it has been fas.h.i.+onable to blame it on recently issued sub-prime mortgages that somehow infected an otherwise healthy global financial system. This chapter challenges that absurd perspective, showing how decades-old trends and policies created a global financial system that was subprime from top to bottom. Beyond the creation of ever more esoteric and opaque financial instruments, these long-standing trends included the rise of the ”shadow banking system,” a sprawling collection of nonbank mortgage lenders, hedge funds, broker dealers, money market funds, and other inst.i.tutions that looked like banks, acted like banks, borrowed and lent like banks, and otherwise became banks-but were never regulated like banks.

This same chapter introduces the problem of moral hazard, in which market partic.i.p.ants take undue risks on the a.s.sumption 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 government itself, though we do not subscribe to the usual contradictory explanations that the crisis was caused by too much government or too little. The reality, we argue, is much more complicated and counterintuitive: government 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 almost all have painted it as a singular, unprecedented event particular to twenty-first-century finance. Chapter 4 dispels this naive and simplistic view by comparing it to previous crises. We argue 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 attempted to defuse them by serving as lenders of last resort. The particulars of the crisis differed from those of its predecessors, but in many ways it stuck to a familiar script, amply ill.u.s.trating the old adage that while history rarely repeats itself, it often rhymes.

History confirms that crises are much like pandemics: they begin 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 emerging markets on the periphery made it particularly virulent. Chapter 5 tracks how and why the crisis went global, hammering economies as different as Iceland, Dubai, j.a.pan, Latvia, Ireland, Germany, China, and Singapore. We break with the conventional wisdom that the rest of the world merely caught a disease that originated in the United States. Far from it: the vulnerabilities that plagued the U.S. financial system were widespread-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 frames it as a broad crisis in twenty-first-century global capitalism. By tracing its sometimes surprising international dimensions, chapter 5 uncovers truths about global finance, international macroeconomics, and the cross-border implications of national monetary and fiscal policy. The crisis can tell us a great 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 shows why they do, and why deflation and depression loom large 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 emergency measures may work, they can, like any untested remedy, end up poisoning the patient.

That's the case with fiscal policies as well. In chapter 7 we examine how policy makers used the government'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 ma.s.sive, unprecedented intervention in the economy. This chapter a.s.sesses 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 system challenges the sustainability of traditional laissez-faire capitalism itself; governments may end up playing a much larger direct and indirect role in the postcrisis global economy, via increased regulation 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 inst.i.tutions. Long-term reforms necessary for stabilizing the international financial system include greater coordination among central banks; binding regulation and supervision of not just commercial banks but also investment banks, insurance companies, and hedge funds; policies to control the risky behavior of ”too big to fail” financial firms; the need for more capital and liquidity among financial inst.i.tutions; and policies to reduce the problem of moral hazard and the fiscal costs of bailing out financial firms. These chapters also grapple with the vexing question of what future role central banks should play to control and pop a.s.set bubbles.

Chapter 10 tackles the serious imbalances in the global economy and the more radical reforms of the international monetary and financial order that may be necessary to prevent future crises. Why have so many emerging-market economies suffered financial crises in the last twenty years? Why has the United States run ma.s.sive deficits, while Germany, j.a.pan, China, and a host of emerging-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 U.S. dollar crash, and if so, what would replace it as a global reserve currency? What role can a reformed IMF play in reducing global 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 terms of these reforms is limited. These changes in global economic governance will play out under the watchful eye of a much more extensive group of stakeholders: Brazil, India, China, Russia, and the other countries that make up the ascendant G-20. These increasingly powerful nations will profoundly shape the handling of future crises; so will a host of new players and inst.i.tutions in the global financial system, like sovereign wealth funds, offsh.o.r.e financial centers, and international monetary unions.

The final ”Outlook” section surveys the road ahead, taking a hard look at the many dangers that await the world economy. The crisis that gave us the Great Recession may be over for now, but potential pitfalls and risks loom large. What issues will determine the future volatility of the world economy and its financial system? Will the global economy return to high growth, or will it experience a long period of subpar and anemic growth? Has the loose monetary policy adopted in the wake of the crisis created a risk of new a.s.set bubbles that will go bust? How will the U.S. government and other governments deal with the ma.s.sive amounts of debt a.s.sumed on account of the crisis? Will the government resort to high 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 market economies? Will the pendulum swing toward greater government intervention in economic and financial affairs, and what will be the consequences of such a s.h.i.+ft? While many commentators have a.s.sumed that the future belongs 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 emerging economies might survive and thrive-or struggle and collapse.

More generally, the final chapters of the book wrestle with several open questions: How will globalization affect the probability of future crises? How will we resolve the global imbalances that helped create the recent crisis? How, in other words, will we reform global capitalism? Here too the lessons of the past may have some bearing. 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 when we wonder 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 capitalism that has delivered serial crises instead of delivering the goods on a consistent and stable basis. Indeed, while market-oriented reforms have taken many emerging market economies out of endemic poverty and under-development, the frequency and virulence of economic and financial crises have increased in both emerging markets and industrial economies. To that end, we offer a road map, not merely of how we got into this mess, but how we can get out-and stay out.

Chapter 1.

The White Swan.

When did the boom begin? Perhaps it began with the sudden mania for flipping real estate, when first-time speculators bought 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 economy founded on new technology and new industries drew ordinary people to wager their life savings on Wall Street.

Politicians and policy makers, far from standing in the way of these get-rich-quick schemes, encouraged them. No less an authority than the president of the United States proclaimed that government should not bother business, while the Federal Reserve did little to stem the speculative tide. Financial innovation and experimentation were hailed for their tremendous contributions to economic growth, and new kinds of financial firms emerged to market little-understood securities to inexperienced investors and to make extensive lines of credit available to millions of borrowers.

At some point the boom became a bubble. Everyone from high-flying banks to ordinary consumers leveraged themselves to the hilt, betting on the dubious yet curiously compelling belief that prices could only go up. Most economists blessed this state of affairs, counseling that the market was always right; it was best not to interfere. The handful of dissidents who warned of a coming crash found themselves mocked if not ignored.

Then came the crash, and as it echoed up and down in the canyons of Wall Street, venerable inst.i.tutions tottered, besieged by fearful creditors. During lulls in the storm, some declared that the worst had pa.s.sed, but then conditions worsened. Financial firms slid toward the abyss, and though a few investment banks-most notably Goldman Sachs-managed to escape the conflagration, other storied firms collapsed overnight. Lines of credit evaporated, and the financial system's elaborate machinery of borrowing and lending seized up, leaving otherwise creditworthy companies scrambling to refinance their debts.