Do you think stocks have bottomed?
No, I don’t think so. Of course, in the last few weeks we have been in another bear market rally, but bear market rallies have occurred for the last 12 months. Markets rally after shocks, and then shocks come and they fall further.
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Nouriel Roubini: The $700 Billion Bailout Isn’t Enough
Luke Mullins
18 December 2008
I spoke with the bearish – but prescient – economist Nouriel Roubini on Wednesday about what’s in store for the economy, housing, and stock markets in 2009. Here’s what he had to say:
What is your outlook for the length and depth of the recession?
My view is that that recession is going to continue at least through the end of 2009. It started in December 2007, so it’s going to be 24 months long. It’s going to be the longest we’ve had in the last 60 years. I expect a cumulative fall in output from the peak of 4 to 5 percent. Just to give you a sense, in the last recession, the cumulative fall in output was only 0.4 percent – this one is 10 times deeper. The unemployment rate will peak at above 9 percent sometime in 2010. And we’re facing not just a U.S. recession but a global recession. There is a recession in all of the advanced economies, and now there is the beginning of a hard landing also in the emerging markets.
What are the main factors behind the recession?
Initially, it was the excesses in the U.S. housing market, but we have discovered that those excesses were not limited only to housing. The household sector was highly leveraged – subprime, prime, credit cards, auto loans, student loans. There was a releveraging of the financial system, with massive amounts of excessive leverage and risk taking. That led to the worst financial crisis since the Great Depression and, because of securitization, we spread it to the rest of the world. Also easy money from the Fed – they pushed down the federal funds rate and kept it too low for too long – and lax supervision of financial institutions played a role. So a number of different factors [triggered the crisis].
What’s your outlook for housing?
Well, between 1996 and 2006, real home prices doubled. So just to go back to the previous level – without undershooting – you need a fall in real terms of 50 percent in home prices. You can achieve 40 percent of that through nominal falling home prices and 10 percent of it through inflation. That means that home prices have to fall at least 40 percent [from the peak]. And they have fallen, as of today, from their peak of 2006 by 25 percent. I expect them to fall at least another 15 percent or maybe even 20 – so a cumulative fall in home prices in nominal terms of at least 40 percent, possibly 45. And the housing recession has not bottomed out. The data yesterday about housing starts and building permits suggested that it’s a total disaster in housing, and there is no bottom to it. This is the worst housing recession since the Great Depression.
Do you think stocks have bottomed?
No, I don’t think so. Of course, in the last few weeks we have been in another bear market rally, but bear market rallies have occurred for the last 12 months. Markets rally after shocks, and then shocks come and they fall further. But I see another downside to U.S. and global equities of at least 15 to 20 percent from current levels for three reasons. One is that the news about the economy – both in the U.S. and abroad – is going to be much worse than expected. The numbers have been just awful, and they are going to get worse. Two, there is still a lot of delusion about what earnings are going to be in 2009. And three, I think that there are going to be many more financial shocks, other large institutions going bust – highly leveraged institutions like hedge funds.
The financial shocks are not over, and the credit losses are going to mount because they are spreading from subprime to prime to credit cards to auto loans to student loans to leveraged loans to municipal bonds to industrial and commercial loans to corporate bonds. We have to take about $2 trillion of credit losses and so far nearly half of it has been recognized. So I see another wave of massive credit losses that is going to worsen the credit crunch.
Would you say then that the credit crisis is at its halfway point?
Well, we’re still in the middle of it. We are still in the deepest part of this credit crunch. Look at corporate credit spreads – they are unprecedented. We are nowhere near the bottom. The credit crunch is as painful now as it has been. And so far, everything the Fed has done in its massive quantitative easing has not made much of a difference as far as corporate credit spreads.
What is your opinion of the government’s response to the credit crisis so far?
My first observation would be that even if they do everything right, the recession is going to proceed through the end of next year. I don’t think that there is anything that the government can do at this point to reverse that. What they can do is to try to ensure that there is at least the beginning of an economic recovery toward the end of next year and into 2010. What needs to be done is actually many different things. The first thing is we need a huge fiscal stimulus because private demand, consumption, and spending are collapsing. So you need a huge stimulus – $500 billion to $700 billion of government spending in infrastructure, money to state and local governments, unemployment benefits. The usual range of things.
The second thing you need is to more aggressively recapitalize the financial institutions, not just banks but broker dealers, finance companies, and insurance companies. And there is only $350 billion of TARP [Treasury Asset Relief Program] money left. We are going to spend all of that, and we are going to need a TARP II because in order to cover all the losses you will need more than $1 trillion. Three, you need to reduce the debt burden of the households that are insolvent. Loan modifications are meaningless. You need debt reduction, similar to what we did during the Great Depression with the [Home Owners’ Loan Corp.] – the government buying up the mortgage, reducing its face value, and converting [the loans] from variable rates to long-term fixed rates. And all of these things have to be done in a cohesive, consistent way showing that you have a plan of action because otherwise you’re not signalling credibility to the market.
What advice do you have for President-elect Obama?
First of all, he has a great team. He doesn’t need my advice; he has excellent people like Tim Geithner and Larry Summers – they are people that know markets, know policy, know the financial sector and the economy. The advice is essentially a combination of aggressive fiscal policy, more aggressive recapitalization of financial institutions, and plans to reduce the debt burden of the household sector, and the Fed continuing to do aggressive quantitative easing.
Are we headed for a depression?
I don’t believe we are going to be in a depression – we could end up like Japan that had essentially economic stagnation for a decade with deflation. You know, the “L”-shaped recession. At this point the “U”-shaped recession could turn into an “L”-shaped recession if we don’t fix the financial system, and the credit crisis becomes worse and if we don’t get a massive fiscal stimulus. So, a lot depends on our policy reaction. If our policy reaction is appropriate, by 2010 there will be some recovery of growth. The only risk is that the recovery of growth could be so weak that it feels like a recession even though we are technically out of it. So there is a risk of something like a Japanese-style, multiyear economic stagnation. I would not rule it out, but it is not my benchmark scenario. I think there is a one-third probability it will end up that way, but a two-thirds probability that we will end up in a severe, two-year-long recession. And that would be by any standard the worst recession that the U.S. has experienced in the last 60 years.
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