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America’s economy risks mother of all meltdowns

By Martin Wolf

Published: February 19 2008 18:21 | Last updated: February 19 2008 18:21

Ingram Pinn illustration

“I would tell audiences that we were facing not a bubble but a froth – lots of small, local bubbles that never grew to a scale that could threaten the health of the overall economy.” Alan Greenspan, The Age of Turbulence.
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That used to be Mr Greenspan’s view of the US housing bubble. He was wrong, alas. So how bad might this downturn get? To answer this question we should ask a true bear. My favourite one is Nouriel Roubini of New York University’s Stern School of Business, founder of RGE monitor.

Recently, Professor Roubini’s scenarios have been dire enough to make the flesh creep. But his thinking deserves to be taken seriously. He first predicted a US recession in July 2006*. At that time, his view was extremely controversial. It is so no longer. Now he states that there is “a rising probability of a ‘catastrophic’ financial and economic outcome”**. The characteristics of this scenario are, he argues: “A vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe.”

Prof Roubini is even fonder of lists than I am. Here are his 12 – yes, 12 – steps to financial disaster.

Step one is the worst housing recession in US history. House prices will, he says, fall by 20 to 30 per cent from their peak, which would wipe out between $4,000bn and $6,000bn in household wealth. Ten million households will end up with negative equity and so with a huge incentive to put the house keys in the post and depart for greener fields. Many more home-builders will be bankrupted.

Forecasts for GDP growth in 2008/US real house prices

Step two would be further losses, beyond the $250bn-$300bn now estimated, for subprime mortgages. About 60 per cent of all mortgage origination between 2005 and 2007 had “reckless or toxic features”, argues Prof Roubini. Goldman Sachs estimates mortgage losses at $400bn. But if home prices fell by more than 20 per cent, losses would be bigger. That would further impair the banks’ ability to offer credit.

Step three would be big losses on unsecured consumer debt: credit cards, auto loans, student loans and so forth. The “credit crunch” would then spread from mortgages to a wide range of consumer credit.

Step four would be the downgrading of the monoline insurers, which do not deserve the AAA rating on which their business depends. A further $150bn writedown of asset-backed securities would then ensue.

Step five would be the meltdown of the commercial property market, while step six would be bankruptcy of a large regional or national bank.

Step seven would be big losses on reckless leveraged buy-outs. Hundreds of billions of dollars of such loans are now stuck on the balance sheets of financial institutions.

Step eight would be a wave of corporate defaults. On average, US companies are in decent shape, but a “fat tail” of companies has low profitability and heavy debt. Such defaults would spread losses in “credit default swaps”, which insure such debt. The losses could be $250bn. Some insurers might go bankrupt.

Step nine would be a meltdown in the “shadow financial system”. Dealing with the distress of hedge funds, special investment vehicles and so forth will be made more difficult by the fact that they have no direct access to lending from central banks.

Step 10 would be a further collapse in stock prices. Failures of hedge funds, margin calls and shorting could lead to cascading falls in prices.

Step 11 would be a drying-up of liquidity in a range of financial markets, including interbank and money markets. Behind this would be a jump in concerns about solvency.

Step 12 would be “a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices”.

These, then, are 12 steps to meltdown. In all, argues Prof Roubini: “Total losses in the financial system will add up to more than $1,000bn and the economic recession will become deeper more protracted and severe.” This, he suggests, is the “nightmare scenario” keeping Ben Bernanke and colleagues at the US Federal Reserve awake. It explains why, having failed to appreciate the dangers for so long, the Fed has lowered rates by 200 basis points this year. This is insurance against a financial meltdown.

US household debt and debt service/US commercial paper

Is this kind of scenario at least plausible? It is. Furthermore, we can be confident that it would, if it came to pass, end all stories about “decoupling”. If it lasts six quarters, as Prof Roubini warns, offsetting policy action in the rest of the world would be too little, too late.

Can the Fed head this danger off? In a subsequent piece, Prof Roubini gives eight reasons why it cannot***. (He really loves lists!) These are, in brief: US monetary easing is constrained by risks to the dollar and inflation; aggressive easing deals only with illiquidity, not insolvency; the monoline insurers will lose their credit ratings, with dire consequences; overall losses will be too large for sovereign wealth funds to deal with; public intervention is too small to stabilise housing losses; the Fed cannot address the problems of the shadow financial system; regulators cannot find a good middle way between transparency over losses and regulatory forbearance, both of which are needed; and, finally, the transactions-oriented financial system is itself in deep crisis.

The risks are indeed high and the ability of the authorities to deal with them more limited than most people hope. This is not to suggest that there are no ways out. Unfortunately, they are poisonous ones. In the last resort, governments resolve financial crises. This is an iron law. Rescues can occur via overt government assumption of bad debt, inflation, or both. Japan chose the first, much to the distaste of its ministry of finance. But Japan is a creditor country whose savers have complete confidence in the solvency of their government. The US, however, is a debtor. It must keep the trust of foreigners. Should it fail to do so, the inflationary solution becomes probable. This is quite enough to explain why gold costs $920 an ounce.

The connection between the bursting of the housing bubble and the fragility of the financial system has created huge dangers, for the US and the rest of the world. The US public sector is now coming to the rescue, led by the Fed. In the end, they will succeed. But the journey is likely to be wretchedly uncomfortable.

*A Coming Recession in the US Economy? July 17 2006,; **The Rising Risk of a Systemic Financial Meltdown, February 5 2008; ***Can the Fed and Policy Makers Avoid a Systemic Financial Meltdown? Most Likely Not, February 8 2008

Charlie's avatar

The MONEY of this country by Constitutional Law is GOLD/SILVER coin. It still is the LAW since the Constitution has never changed on this matter. But, OUR people in the Government allowed the Federal Reserve System to come in. That fist paper money was backed by either Gold/silver but over the years the backing was taken from the paper We use today until now, there is nothing to back it. They tried to figure the Gross National Product as a means of backing but since nearly everything is made in China that can’t even carry the Debt this country is in so the Federal Reserve Notes that WE are forced to use as money is becomeing worthless much as the same thing that happened in Germany with the Mark. To even make it a bit more understanding, it was the same people from Germeny that setup this Banking system We have now. I expect an all out collapse of this system we have today.

soundedfury's avatar

@charlie – The Constitution does not specify that the currency of the United States be backed by anything. Article I, Section 8 gives Congress the power ”[t]o coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures,” which Congress established in 1792 with the Mint Act and modified over the years, by Congress, with such entities as the Federal Reserve.

mirza's avatar

I think Prof Roubini’s 12 steps to Disaster plan is an exaggerated version of the effects of a recession. I do believe that we are in a huge risk of heading towards a recession but I do not think that the outcome will be so bad. I mean the 2001 recession was far worse than the one we are headed for now and even the 2001 recession wasn’t that bad. Yes there will be job cuts and th housing market will suffer. But at the same time since everyone is expecting a recession the effects will be less severe since we are better prepared. Personally what I am hoping from this recession is that banks would stop giving out loans to bad credits and people will learn to control their spending. This economist obviously knows a lot more than me. But you have to realize most economist share different theories as to the outcome of the recession. There are some economists at the Harvard School of Business who argue that the economy will have a recession that will not last more a few months. And there are Federal Reserve Governors like Plosser who say that we might be headed for a terrible recession .If you are interested in finding more opinions from economists about the recession, check out this magazine called The Economist that has a good selection of opinions from economists with a diverse school of thought.

And here is why we are headed for a recession (according to me since I had to a presentation on it a few weeks ago):
– The economy grew 0.6 % vs 1.2 % rise expected—> Slowest growth since 2002
– Exports slowed down to 3.9 % increase during Q4 compared to the 17.3 % of Q3 of 2007
-Weakness was in auto production and housing  resulted in a drop 2.2 points off the GDP number
– Final sales in the US economy slipped last quarter to 1.9 % growth from 4.0% in the third quarter.
– The CPI rose 2.0 % last quarter, slower than the 2.8 % rate in prior quarter.
– Unemployment rate shot up to 4.9 percent (border line to full employment which is 5 %)
– The drop in S&P 500 Index over the past few months indicate sluggish spending throughout the economy.

mirza's avatar

@charlie: You are saying that we are headed towards a recession just because we don’t have a gold standard? Wait last time, I checked the fact that we were falling a gold standard was one of the causes of the Great Depression and wait didn’t we get out of the Depression by repealing the gold standard (under the new deal) and following a theory called Keynesian economics that urged people to spend more..

Also, the founding fathers did agree on the First Bank of the United States which was the first attempt at Central Banking—which is what the Fed does. So , charlie, if you don’t want a central bank, do you want a free banking era. We already had that and it led to nothing but financial disasters thorughout the 1880s to 1910. If you are interested in knowing about the history of the Federal Reserve, check out this site

@charlie: Here’s one more question. Why should we as a people be required to follow a set of rules that were written over 300 years ago. There’s a lot of thing that the Constitution does not mention but that doesn’t mean that it’s illegal for the government to do things. For example, just because the constitution does not mention anything about computers, should not make it illegal for the government to have computers.

Charlie's avatar

The Constitution is the LAW of this land and it doesn’t matter how old it is and yes, It does say that NO Thing shall be used as a tender in debt but Gold or silver coin. Government has one problem when it comes to it’s people. It will always seek to completely RULE it’s people rather then to Govern them, for them, by them. That is why there is the Constitution which is STILL in affect. NO economy will last long IF there isn’t something to base it on. If you create something out of thin air what do you have? Thin air! And understand. YOU are the Government. It isn’t the people in D.C. or on Capital hill. IT is We the People. It is too bad that people forget that Freedom isn’t free and the reason WE are the only free people on this Earth is because of the Constitution. If it wasn’t for it we would be nothing but slaves of the people within the Government which we nearly are because people tend to let them do whatever they want without any checks and balances. Let’s look at a LAW that is peoples ignorance and Governments. The smokeing ban. I can’t stand outside in front of a school and have a smoke yet a deisel truck can sit right there beside me running. What is going to hurt who? It’s like designating a pee area in a swimming pool. I have found that if the Government does anything, it is best to ask why. If you check, NO law is a law if it doesn’t adhere to the Constitution. Even now there is legal battles right in Washington D.C. over the Rights of the people to have a gun as a means of Defending one self. This question has been in the Governments courts since the 2nd Amendment was approved. So it comes down to this. Do you want Power of and for the people or do you all want the people within the Government have the power to rule you. For me, I’ll take care of myself.

soundedfury's avatar

I think Charlie must be a bot. Or he hasn’t read the Constitution.

lefteh's avatar

This is a really old thread and I’m bumping it, but I must point out that the founders made it clear in Article One, Section Ten that gold and silver should be the basis of the monetary system.

Zuma's avatar

Interesting. Here we are 8 months (31 Oct 08) later and the predicted scenario has come to pass, more or less as outlined.

And here is a brief history of monetary policy explaining, among other things why we do not have (and do not want) a gold standard today.

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