Nouriel Roubini and Willem Buiter Both See Downside Economic Risk

By coincidence of timing, two economists, Nouriel Roubini and Willem Buiter, who have sharply contrasting temperaments, writing styles, and analytical approaches, came out with posts that both argued that US growth prospects look weaker than mainstream forecasts suggest.

Readers who follow economics blogs doubtless know full well that NYU economics professor Roubini is a very vocal (one might say strident) bear. Regardless of whether he has a perceptual bias, Roubini has been spot-on for quite some time, and if anything, underestimated how seriously conditions would deteriorate.

By contrast, Willem Buiter, now a professor at the London School of Economics and more academically oriented in his line of thought than Roubini, also believes that mainstream forecasts are too rosy. However, Buiter and Roubini disagree on the particulars of their reasoning. Roubini argues that the wealth effect will dampen consumer spending considerably. Buiter, who is more theoretical, disagrees (and although I normally take Buiter seriously, he would benefit from either being more empirical or spending more time with behavioral finance types). Nevertheless, Buiter agrees that consumers are overextended, credit terms are tightening, and that alone is sufficient to put a damper on the economy.

Warning: these are long posts; I’ve whittled both down a bit, but they are very much worth reading.

First from Roubini:

Any recession call for the U.S. is clearly dependent on US consumption faltering…. Let us consider first the factors that will lead to such a consumption slowdown and then the evidence that such a slowdown is already starting in earnest.

First, there is the wealth effect of falling home values. Estimates of such a wealth effect range in between 5% and 7% of the change in wealth (see my survey – with Menegatti – of this literature). Recent work by Mark Zandi (Moody’s Economy.com) suggests figures closer to 7%. The total wealth effect of housing on consumption also depends on how much home values will fall. Current estimates range between a consensus of at least 10% price fall, some suggesting a 15% fall and some – like myself and others – arguing that home prices will fall 20% or more. So the fall in housing wealth could be in the $2 trillion to $4 trillion range. At $2 trillion and with a 5% effect one gets a fall of real consumption of $100 billion; with $4 trillion and with a 7% effect you get a fall in consumption of $280 billion. Even the lower figure implies a very significant and sharp reduction in consumption, let alone the larger one.

Second, there is the effect of home equity withdrawal (HEW) on consumption. There is some debate in the literature on whether the effect of HEW is a proxy for the wealth effect or an additional and separate effect. Again the literature has a variety of estimates ranging from 50% of HEW being consumed according to Greenspan-Kennedy to 25% of it being consumed according to other studies. The appropriate measure of HEW is also important: gross or net, overall or active. HEW peaked at $700 billion annualized in 2005 and has dropped to about $150 billion by Q2 of 2007. So, the fall in consumption – assuming unrealistically no further fall in HEW from now on – would be $275 billion based on the Greenspan-Kennedy estimates or about $140 billion according to the more conservative estimates. Evidence suggests that this effect of HEW on consumption occurs with lags; that is why we have not yet seen its full effects on consumption as late as Q3. Rather, we will see its effects in the next few quarters. Another interpretation – according to Zandi – is that HEW (measured in a different way) has started to fall only in the recent quarters; so again the effect of falling HEW on consumption will be observed mostly in 2008.

Third, there is the effect of the ongoing and worsening credit crunch on the ability and willingness of consumers to borrow…. The slowdown in consumer borrowing will be due both to demand and supply factors: the supply of credit will be reduced; but even in the presence of some new supply of credit, many households will decide to reduce their demand of credit to rebuild their savings rate. And indeed the savings rate of households has started to pick-up if very slowly.

Fourth, with about $1 trillion of ARMs resetting in the next 18 months and 450K households facing resetting ARMs every quarter from now until the end of 2008 we will see effects on consumption of this surge in mortgage servicing costs. The direct average aggregate effect on disposable income may seem small: with the average ARM resetting at 300bps above the initial rate you get a fall in disposable income of about $30 billion. But the aggregate average effects hide important compositional effects: for the households whose ARMs are resetting the fall in disposable income will be much larger than for the average household who does not have an ARM. Also, many households – who will not be able to refinance their resetting ARMs at a reasonable rate – will be forced into distressed sales that will lead to further excess supply of homes and further declines in home prices and in their home wealth. So the compositional effects are more important and larger than the aggregate effects.

Fifth, with oil (and energy) prices rising higher and higher (oil is now close to $100 a barrel) the reduction in household disposable income will be significant. The sharp reduction in consumption growth in Q2 (to 1.4% SAAR) was certainly due in part to the sharp increase in oil price during that period. A similar shock to disposable income is now underway. And with no evidence that oil and energy prices will fall in the months ahead (as global supply is tight and global demand is still strong) this reduction in disposable income will be persistent.

Sixth, consumer confidence is now sharply down based on both the Michigan and Conference Board measure….While it has become fashionable among some observers to dismiss the effects of consumer confidence on consumption, evidence suggests that in periods of economic slowdown and strain such effects of confidence on consumption are actually significant….

Seventh, income generation and job creation have significantly slowed down in the last year. Growth of employment has now decelerated from 2% to about 1%….. Based on the latest figures real disposable income growth is slowing down and close to a mediocre 1% (y-o-y) in real terms; so income generation is clearly weakening. And the slowdown in job growth will accelerate in the next few months as the economic slowdown, the housing carnage, the losses in the financial sector, the weakness of manufacturing, the job losses in the retail sector all persist and accelerate.

Eighth, the net worth of the household sector is now falling for a variety of reasons. Note that the Fed figures on household wealth are distorted by the Fed use of the OFHEO index for home prices. This measure – compared to the more precise indicators coming from the S&P/Case-Shiller – overestimates the earlier increase in home prices and underestimates its recent fall. Three factors are leading to falling net worth for households. First, the fall in home prices and in home values. Second, the sharp increase in the last few years in consumer debt: the ratio of households’ debt to income is now above 130% and sharply up from a ratio closer to 70% in the 1990s and 100% in the early part of this decade. The debt to income ratio is at an historical high; and with interest rates, credit spreads and average resetting mortgages rates going higher debt servicing ratios are now going higher. Third, there is now the beginning of a correction of the stock markets that will further reduce households’ wealth. The wealth effect on consumption of financial wealth is smaller than that of housing wealth (about 5% as opposed to 7%); and since the distribution of equity wealth is more unequal than that of housing wealth the effect of a falling stock market on consumption are smaller than those of falling housing equity. But in the next few months the fall in equity prices is likely to accelerate….

The factors above are the main channels through which a slowdown in consumption will occur in Q4 and over the next few quarters. While even the consensus agrees that Q4 growth will be particularly weak such consensus believes that consumption growth will recover in 2008. But the basis for such consumption recovery forecast is not clear: the bearish factors described abroad will increase their momentum in the next few quarters; so there is little basis for believing that consumption growth will recover.

And there is now clear evidence that the slowdown in consumption growth has started in earnest. Let us look at such evidence.

First, note that while private consumption grew at 3% SAAR (or a 1% actual for the quarter) most of the growth in consumption occurred in July and August. Real consumption spending grew 0.3% in July, 0.6% in August and 0.1% in September adding up to 1% for the quarter and 3% annualized. So, in September the slowdown in real consumption was already clear at a mediocre and close to stall rate of 0.1%.

Second, evidence suggests that October was weaker than September as far as retail sales go. Weekly data on same store chain store sales – from both Redbook Johnson Research and from the UBS/ICSC surveys – show a sharp slowdown of retail sales in October on a y-o-y basis and an actual fall in October relative to September in nominal terms that implies an even larger fall in real terms. Indeed, sales at chain stores increased 1.6 percent from the same month last year, the worst October since 1995, according to UBS.ICSC. Based on a Bloomberg survey overall retail sales (data due on November 14th) are expected to have increased only 0.2% in nominal terms in October after increasing 0.6% in September….

Third, all the factors above and especially the housing factors, rising gasoline prices and falling confidence are now leading to the weakest retail holiday since the recession of 2001….Major retailers are now revising down month after month their forecasts for sales during the holiday season.

Fourth, …. fall in earnings of the “consumer discretionary” sector in Q3 relative to the same period in 2005 is now 21%, even larger than the negative 17% for the financial sector….

Fifth, there is clear evidence that durable consumption – the part of consumption that is most sensitive to expectations about the business cycle – is weakening…. Vehicle sales per capita have now fallen for all of 2007 and much more sharply this year in the states where the housing recession is more severe (i.e. California, Nevada, Arizona, Florida, DC, Maryland, Virginia).

Finally, you don’t need consumption to actually fall (negative growth rate) to get a recession. With residential investment still in free fall, commercial real estate still doing fine until recently but now showing signs of strain, capex spending by the corporate sectors still being sluggish, it is enough for consumption to slowdown to 1% SAAR or less to trigger an economy wide recession. Thus, the evidence that real private consumption has not fallen since 1991 is irrelevant for two reasons: first, we can get an economy-wide recession if consumption slows down for a few quarters to 1% or below; second the headwinds hitting the US consumer are more severe than ever experienced since 1990. Thus, a sharp slowdown in consumption growth will be the last straw that will trigger an economy wide recession. Expect Q4 growth to be 1% or below and this growth further to accelerate into negative territory by H1 of 2008.

Now from Buiter:

First, the good news. The US housing slump is unlikely to drag the US economy down very much…. According to the Case-Shiller data, since the end of 2006, the average US house price may have fallen by 5 percent or so, knocking about one trillion dollars of the value of the US housing stock. The brain behind these data, Bob Shiller of Yale University, believes a further decline, over a period of years, of 15 percent is in the cards.

The reason for the good news is that there is no first-order wealth effect from a change in house prices on private consumption; a decline in house prices is a redistribution from home owners to consumers of housing services….

The good news is qualified because housing wealth is collateralisable wealth and can therefore help to relax liquidity and cash-flow constraints faced by households. The scope for financing consumption through mortgage equity withdrawal is reduced when house prices fall and this may cause a temporary fall in consumption. To allow for this collateral effect, {Federal Reserve governor Fredrick] Miskhin raises the marginal propensity to consume from 3.8 percent to 7.6 percent. Emulating this, I will raise my estimate of the combined wealth and collateral effect of housing price changes from zero to 3.8 percent. The impact on annual consumption of the 5 percent decline in house prices would then be $38 billion. With a $ 12 trillion annual GDP, this is a decline in demand of just over 0.31 percent of GDP – not quite the stuff recessions are made off. Even if, over the next three years, house prices were to continue to decline at a 5 percent rate, this would give us a further cumulative decline in demand of just over 0.9 percent GDP….

The sub-prime crisis, like any financial crisis, is first and foremost a distributional question

The sub-prime crisis, the write-downs by commercial banks and investment banks of CDO and other ABS exposures, the ABCP meltdown and related financial kerfuffles are first and foremost a redistribution of financial wealth from creditors to debtors. All these derivative claims are ‘inside’ financial claims – for every creditor there is a matching debtor. These write downs and write-offs do not in and of themselves destroy any net wealth….

I have to put my two cents worth in here. This is the sort of theoretical nonsense that makes me nuts. A writeoff, or foreclosure has no economic impact beyond the wealth transfer from the chump lender to the borrower? Tell that to the stockmarket, which is unhinged over continuing credit losses, or people who lost their homes. There is collateral damage beyond the immediate transfer

Furthermore, the losses suffered by the banks will lower their regulatory capital. So will the need to take back on balance sheet a whole range of illiquid assets that had been parked in a variety of off-balance sheet vehicles like sivs and conduits. Ratios. How large could these numbers be? Banks have currently written down sub-prime backed assets to the tune of about $40bn, and assorted pundits estimate this number will rise to $60 billion soon. Ben Bernanke, during his testimony before the Joint Committee of the House and Senate on Thursday, November 9, gave a guestimate of $150 bn for the total losses suffered eventually by the financial system because of the subprime debacle; earlier this summer he had mentioned a figure of $100 bn. Even $150 bn seems low. New subprime issues in 2004, 2005 and 2006 were $363, $465 and $449 bn respectively. By 2004, any attempt at quality control in subprime origination had already gone out of the window, so I would expect that most of these loans will default before long, unless there is a major bail-out by the Congress. How much of the almost $1.3 trillion of subprime lending during these three years is covered by the value of the properties held as collateral is unknown, as there is no prior experience of lending to such a large subprime population. A loss of $150 bn would be just be under 12 percent; that seems low, and one could easily conceive of it being as high as 20 or 25 percent. In addition, losses will be made on subprime loans made before 2004 and after 2006, and on higher-rate loans, including Alt-A and prime loans. A $250bn to $300bn eventual loss on all mortgage-related exposure would seem to be in the ball park.

At the end of October 2007, the net worth of commercial banks in the US (as reported by the Fed) stood at just under $ 1.1 trillion (against assets of $10.7 trillion). Tier 1 capital stood approximately at $964 bn. While quite a significant share of the mortgage-related losses will be born by financial institutions other than commercial banks, such as investment banks, commercial banks’ capital will take a significant hit. In addition, US commercial banks have, through unused liquidity commitments, obligations of up to $350bn to sponsored conduits that used to fund themselves with ABCP; they also are exposed to the risk of having to take back and hold up to $140bn of loans taken out for failed leveraged buy-out type deals, and are warehousing, at a loss. an indeterminate but significant amount of loans and other assets that were intended for securitisation, or packaging into other complex structures. The combination of losses and unintended asset accumulation may depress the banks’ capital ratios to the point that dividends and share repurchases are threatened and even rights issues may have to be contemplated. All that does not do much for their willingness to engage in new lending, including to the real economy.

Possibly more serious than the objective magnitude of the losses that banks will ultimately have to face is the uncertainty, indeed ignorance, about where the losses are likely to hit….

If the progressive reduction we are seeing in the willingness and ability of banks to lend, extends to lending to the non-financial sector (households and non-financial corporations), there could be further effects on the real economy. I believe households in the US are vulnerable to this, because they are highly indebted by historical standards and have been running financial deficits for many years. Non-financial corporates, however, are in rather good financial shape…

Subprime mortgages were not the only area of credit where lending and borrowing discipline collapsed. Similar reckless behaviour could be observed in unsecured consumer lending, including credit card lending, and with car loans. Both credit card receivables and car loans have been securitised on a large scale, and indeed both assets have been combined with mortgage loans in CDOs and other complex structures.

The major source of demand strength is the US economy is the external sector. This is not surprising, as the rest of the world is growing faster than the US and the real effective (that is, trade-weighted) exchange rate of the dollar has dropped like a stone. Exports are a much more important source of demand in the

US (12.0 percent of GDP in 2007Q3) than they were in 1975, for about 8.5 percent of GDP or in 1965, when they were 5.2 percent of GDP. From its peak in 2002Q1 the broad effective real exchange rate of the US dollar had depreciated by 25 percent by 2007Q3. The precipitous decline of the nominal and real exchange rate of the dollar since September can easily have added another 5 percent to the cumulative real depreciation rate. In real terms, the dollar today is as weak as it has been at any time since 1970.

It is therefore not surprising that the growth rate of real exports has been pretty spectacular recently (9.6 percent in 2007 Q3 on a year earlier). There is no doubt that, if the dollar stays weak (let alone weakens further) and if global growth slows down only modestly, the growth of export demand can easily more than compensate for the decline in residential investment.

Since the last quarter of 2003, the US terms of trade (relative price of exports to imports) has declined by eight percent, that is about two per cent per year. The US trade balance deficit averaged about 5.4 percent of GDP. As a result of the terms of trade deterioration since 2003 Q4, the US has suffered an annual real income loss equal to two percent of 5.4 percent of GDP, that is 0.11 percent of GDP, which is tiny.

An index of the real oil price (West Texas Intermediate divided by CPI) peaks at 48.8 in the first half of 1980, following the second oil price shock. The latest official data, for September 2007, have the index at just over 38.4, after a trough of 6.9 at the end of 1998. Since September, the oil price has risen by a further 25 percent while the increase in the CPI has been negligible. The real price of oil today therefore again stands at around 48 – its all time peak. This oil price shock will have a marked negative effect on potential output, and will increase future inflationary pressures through the output gap channel. This adverse potential output effect of an increase in the relative price of oil is over and above any general price level effect from an increase in the dollar price of oil. If potential output weakens more than aggregate demand, the ugly word ‘stagflation’ will have to be dusted off. Inflationary pressures in the US have for a long time been higher than acknowledged by the Fed. Headline CPI inflation for the 12-month period ending September 2007 was 2.8 percent, while core inflation, the will-0’-the-wisp that used to be viewed by the Fed as a good predictor of headline inflation in the medium term, was 2.1 percent. There is no doubt that the collapse of the dollar and the explosive increase in the dollar price of oil will give further momentum to US inflation, just at the time that the growth rates of both actual and potential output are declining.

For the Fed, these are interesting times indeed.

A final feature of the contribution of the rest of the world to the economic prospects for the US is that growth in the rest of the world, including the key emerging markets of China, Russia, Brazil and to a lesser extent India, is much more fragile than is generally appreciated. The mis-pricing of credit risk extended to the emerging markets. While sovereign risk in China and Russia is virtually absent, credit risk and other risk attached to private financial instruments is high. Neither China nor Russia benefits from the rule of law. There is no minority shareholder protection, creditor or bondholder protection, nor do we find any of the other institutions and fora for the resolution of property rights disputes taken for granted in the advanced countries. Administrative or regulatory expropriation has been a common phenomenon in Russia, Kazakhstan, Venezuela, Argentina and may also become a recurring phenomenon in resource-rich African countries and in other South-American countries. In my view these non-sovereign, private risks are significantly underestimated and underpriced.

There is also more sovereign risk than is priced in by the markets affecting emerging markets that do not have huge foreign exchange reserves and whose external surpluses are either vulnerable or absent altogether. Argentina and the Philippines are examples, and even a reasonably well-managed country like Turkey is more vulnerable to internal and external shocks than its ratings suggest.

The risk to global growth outside the US is therefore higher than generally recognised, and skewed to the downside.

Conclusion

The destruction of value and wealth thus far in the US as a result of the housing sector crisis is manageable. Its effects are mitigated and could well be more than offset by the strength of the export sector. However, the sub-prime crisis is but the tip of the credit risk mis-pricing iceberg. Unsecured consumer loans and car loans, and the large stock of ABS backed by credit card receivables, are waiting to join the credit risk-repricing party.

The single best thing that could happen would be for the true magnitude of the losses suffered by banks and other exposed parties to be revealed and put in the P&L. Until what happens, fear of getting stuck with the hot potato makes banks unnaturally unwilling to extend credit against the kind of collateral that they would not have thought about twice accepting at the beginning of the year.

Continued global economic growth and dollar weakness are a necessary condition for the US to avoid a serious slowdown, or even a recession. While both may continue to materialise, the risks to global growth are higher than generally recognised and rising.