Nouriel Roubini: "The Coming U.S. Hard Landing"

Some may have already seen Nouriel Roubini’s latest piece, “The Coming U.S. Hard Landing.” He goes through an exhaustive and exhausting litany of what ails the US economy (short answer: pretty much everything, although he did spare weak-kneed readers the role of global imbalances).

His article is worth reading, and the extracts that relate to the financial markets merit further discussion:

The probability of a US economic hard landing (either a likely outright recession and/or an almost certain “growth recession”) was already significant even before the severe turmoil and volatility in financial markets during this summer. But the recent financial turmoil – that has manifested itself as a severe liquidity and credit crunch – now makes the likelihood of such a hard landing even greater. There is now a vicious circle where a weakening US economy is making the financial markets’ crunch more severe and where the worsening financial markets and tightening of credit conditions will further weaken the economy via further falls of residential investment and further slowdowns of private consumption and of capital spending by the corporate sector…..

Indeed, the forthcoming easing of monetary policy by the Fed will not rescue the economy and financial markets from a hard landing as it will be too little too late. The Fed underestimated the severity of the housing recession, its spillovers to other sectors, and the contagion of the sub-prime carnage to other mortgage markets and to the overall financial markets. Fed easing will not work for several reasons: the Fed will cut rate too slowly as it is still worried about inflation and about the moral hazard of perceptions of rescuing reckless investors and lenders; we have a glut of housing, autos and consumer durables and the demand for these goods becomes relatively interest rate insensitive once you have a glut that requires years to work out; serious credit problems and insolvencies cannot be resolved by monetary policy alone; and the liquidity injections by the Fed are being stashed in excess reserves by the banks, not relent to the parts of the financial markets where the liquidity crunch is most severe and worsening. The Fed provided liquidity to banking institutions but it cannot provide direct liquidity to hedge funds, investment banks, other highly leveraged institutions and parts of the credit markets – such as asset backed commercial paper – where the crunch is severe. Thus, the liquidity crunch in most credit markets remains severe, even in the usually most liquid interbank markets.

Unfortunately, financial globalization together with securitization and mushrooming of complex credit instruments has lead to greater opacity and less transparency in the financial system. And this lack of transparency breeds unmeasurable uncertainty rather than priceable risk. Risk can be priced as you have a distribution of probabilities on various events. But unmeasurable uncertainty causes higher risk aversion under conditions of market distress. This generalized uncertainty is now coming from two sources: first, we do not know the size of the overall losses in credit markets: sub-prime alone could lead to losses of $100 billion or much higher depending on how much home prices will fall. And other losses from other illiquid financial instruments remain unmeasured in a world where institutions were marking to model rather than marking to market and where credit rating agencies were mis-rating complex credit instruments. Second, as securitization implies that financial risks have been spread out of banks and to the corners of the global financial system we do not know which firms are holding the toxic waste and thus which firms will go belly up next. It is like walking blind in a minefield where you have no idea of where the mines are. This uncertainty breeds large fear – after the massive greed of the previous credit and asset bubble has now burst – and lack of trust of financial counterparties, even otherwise respected ones: everyone want to hoard liquidity and hold the safest assets as even large financial institutions do not trust each other and are unwilling to lend to each other. This greater opacity of financial globalization and securitization implies that the re-pricing of risk that we have observed in the last few weeks is a permanent rather than a transitory phenomenon. And the sharp spike in the cost of credit will further weaken an already weakened economy. This is thus the first real crisis of the new world of financial globalization and securitization.

Roubini makes some excellent observations about the interplay between the markets and the real economy and central bankers’ limitations in combatting this crisis.

Not to quibble unduly, for Roubini has advanced the discussion of the problems facing the financial market by calling attention to the role of uncertainty and insolvency, but there’s an internal inconsistency in his argument.

Roubini says that a Fed cut will be “too little, too late” yet also tells us that an interest rate cut is futile because the Fed cannot provide liquidity to the sectors of the market that are seizing up, because they are dominated by non-bank actors. So if a cut is futile, how can it also be too late?

Perhaps Roubini means that an earlier cut might have provided a sop to autos and consumer durables. But how exactly would that have occurred? GDP growth in this expansion has gone disproportionately to corporate profits and not to labor (either in the form of more hiring or higher wages). So the net effect of an earlier cut on the real economy would be that it would stimulate continued spending by over-extended consumers, who (depending on which analysis you believe) are either not saving or dis-saving, that is, getting further into debt.

And we pointed out earlier that overextended consumers tapping home equity might be a bigger culprit in the subprime crisis than is commonly acknowledged.

We imagine that Roubini would have criticized an earlier rate cut as not only delaying the day of reckoning for financial excesses, but worsening the painful process of wringing out the excesses.

Another quibble is with ” the re-pricing of risk that we have observed in the last few weeks is a permanent rather than a transitory phenomenon.” Permanent is a bit too strong a word; lasting is more accurate. In the world of finance, there seems to be no such thing as institutional memory. Quants are repeating LTCM’s mistake of a mere 10 years ago of ignoring tail risk and radical changes in cross-market correlations in a crisis; LBO lenders made the same mistakes they did in the 1980s takeover boom. But the damage to the financial system this time may be so severe that the participants are chastened for longer than the usual half-to-full generation amnesia period.