The World Is at Severe Risk of a Global Systemic Financial Meltdown and a Severe Global Depression

The US and advanced economies' financial system is now headed towards a near-term systemic financial meltdown as day after day stock markets are in free fall, money markets have shut down while their spreads are skyrocketing, and credit spreads are surging through the roof. There is now the beginning of a generalized run on the banking system of these economies; a collapse of the shadow banking system, i.e. those non-banks (broker dealers, non-bank mortgage lenders, SIV and conduits, hedge funds, money market funds, private equity firms) that, like banks, borrow short and liquid, are highly leveraged and lend and invest long and illiquid and are thus at risk of a run on their short-term liabilities; and now a roll-off of the short term liabilities of the corporate sectors that may lead to widespread bankruptcies of solvent but illiquid financial and non-financial firms.

On the real economic side all the advanced economies representing 55% of global GDP (US, Eurozone, UK, other smaller European countries, Canada, Japan, Australia, New Zealand, Japan) entered a recession even before the massive financial shocks that started in the late summer made the liquidity and credit crunch even more virulent and will thus cause an even more severe recession than the one that started in the spring. So we have a severe recession, a severe financial crisis and a severe banking crisis in advanced economies.

There was no decoupling among advanced economies and there is no decoupling but rather recoupling of the emerging market economies with the severe crisis of the advanced economies. By the third quarter of this year global economic growth will be in negative territory signaling a global recession. The recoupling of emerging markets was initially limited to stock markets that fell even more than those of advanced economies as foreign investors pulled out of these markets; but then it spread to credit markets and money markets and currency markets bringing to the surface the vulnerabilities of many financial systems and corporate sectors that had experienced credit booms and that had borrowed short and in foreign currencies. Countries with large current account deficit and/or large fiscal deficits and with large short term foreign currency liabilities and borrowings have been the most fragile. But even the better performing ones -- like the BRICs club of Brazil, Russia, India and China -- are now at risk of a hard landing. Trade and financial and currency and confidence channels are now leading to a massive slowdown of growth in emerging markets with many of them now at risk not only of a recession but also of a severe financial crisis.

The crisis was caused by the largest leveraged asset bubble and credit bubble in the history of humanity were excessive leveraging and bubbles were not limited to housing in the US but also to housing in many other countries and excessive borrowing by financial institutions and some segments of the corporate sector and of the public sector in many and different economies: an housing bubble, a mortgage bubble, an equity bubble, a bond bubble, a credit bubble, a commodity bubble, a private equity bubble, a hedge funds bubble are all now bursting at once in the biggest real sector and financial sector deleveraging since the Great Depression.

At this point the recession train has left the station; the financial and banking crisis train has left the station. The delusion that the US and advanced economies' contraction would be short and shallow -- a V-shaped six month recession -- has been replaced by the certainty that this will be a long and protracted U-shaped recession that may last at least two years in the US and close to two years in most of the rest of the world. And given the rising risk of a global systemic financial meltdown the probability that the outcome could become a decade long L-shaped recession -- like the one experienced by Japan after the bursting of its real estate and equity bubble -- cannot be ruled out.

And in a world where there is a glut and excess capacity of goods while aggregate demand is falling soon enough we will start to worry about deflation, debt deflation, liquidity traps and what monetary policy makers should do to fight deflation when policy rates get dangerously close to zero.

At this point the risk of an imminent stock market crash -- like the one-day collapse of 20% plus in US stock prices in 1987 -- cannot be ruled out as the financial system is breaking down, panic and lack of confidence in any counterparty is sharply rising and the investors have totally lost faith in the ability of policy authorities to control this meltdown.

This disconnect between more and more aggressive policy actions and easings and greater and greater strains in financial market is scary. When Bear Stearns' creditors were bailed out to the tune of $30 bn in March the rally in equity, money and credit markets lasted eight weeks; when in July the US Treasury announced legislation to bail out the mortgage giants Fannie and Freddie the rally lasted four weeks; when the actual $200 billion rescue of these firms was undertaken and their $6 trillion liabilities taken over by the US government the rally lasted one day and by the next day the panic has moved to Lehman's collapse; when AIG was bailed out to the tune of $85 billion the market did not even rally for a day and instead fell 5%. Next when the $700 billion US rescue package was passed by the US Senate and House markets fell another 7% in two days as there was no confidence in this flawed plan and the authorities. Next as authorities in the US and abroad took even more radical policy actions between October 6th and October 9th (payment of interest on reserves, doubling of the liquidity support of banks, extension of credit to the seized corporate sector, guarantees of bank deposits, plans to recapitalize banks, coordinated monetary policy easing, etc.) the stock markets and the credit markets and the money markets fell further and further and at an accelerated rates day after day all week including another 7% fall in U.S. equities today.

When in markets that are clearly way oversold even the most radical policy actions don't provide rallies or relief to market participants you know that you are one step away from a market crack and a systemic financial sector and corporate sector collapse. A vicious circle of deleveraging, asset collapses, margin calls, cascading falls in asset prices well below falling fundamentals and panic is now underway.

At this point severe damage is done and one cannot rule out a systemic collapse and a global depression. It will take a significant change in leadership of economic policy and very radical, coordinated policy actions among all advanced and emerging market economies to avoid this economic and financial disaster. Urgent and immediate necessary actions that need to be done globally (with some variants across countries depending on the severity of the problem and the overall resources available to the sovereigns) include:

• Another rapid round of policy rate cuts of the order of at least 150 basis points on average globally.
• A temporary blanket guarantee of all deposits while a triage between insolvent financial institutions that need to be shut down and distressed but solvent institutions that need to be partially nationalized with injections of public capital is made.
• A rapid reduction of the debt burden of insolvent households preceded by a temporary freeze on all foreclosures
• Massive and unlimited provision of liquidity to solvent financial institutions.
• Public provision of credit to the solvent parts of the corporate sector to avoid a short-term debt refinancing crisis for solvent but illiquid corporations and small businesses.
• A massive direct government fiscal stimulus packages that includes public works, infrastructure spending, unemployment benefits, tax rebates to lower income households and provision of grants to strapped and crunched state and local government.
• A rapid resolution of the banking problems via triage, public recapitalization of financial institutions and reduction of the debt burden of distressed households and borrowers.
• An agreement between lender and creditor countries running current account surpluses and borrowing and debtor countries running current account deficits to maintain an orderly financing of deficits and a recycling of the surpluses of creditors to avoid a disorderly adjustment of such imbalances.

At this point anything short of these radical and coordinated actions may lead to a market crash, a global systemic financial meltdown and to a global depression. At this stage central banks that are usually supposed to be the "lenders of last resort" need to become the "lenders of first and only resort" as, under conditions of panic and total loss of confidence, no one in the private sector is lending to anyone else since counterparty risk is extreme. And fiscal authorities that usually are spenders and insurers of last resort need to temporarily become the spenders and insurers of first resort. The fiscal costs of these actions will be large but the economic and fiscal costs of inaction would be of a much larger and severe magnitude. Thus, the time to act is now as all the policy officials of the world are meeting this weekend in Washington at the IMF and World Bank annual meetings.

Originally posted October 9 at RGE Monitor.

Comments

[doogiedude]

While I agree with most of Mr. Roubini"s recommendations, I would like to make a couple of points.

First, I notice this article does not include one key recommendation Mr. Roubini has made in other interviews: The removal of Secretary Paulson. As Mr. Roubini has stated, I think all confidence has been lost in Mr. Paulson and, for that matter, Chairman Bernanke. IMHO, these individuals should be removed to restore leadership confidence.

Secondly, I question the effectiveness of further rate cuts. I think the credit crisis is now much more of a demand side issue rather than supply side. It seems like government actions to date have been to make credit available to financial companies and hope they exercise this credit. It seems fairly obvious that consumers very reluctant to assume any additional debt and banks are very reluctant to lend in the current economic environment.

I think, in order to get markets flowing again, the government should essentially open a bank and thereby ensure at least some implementation of desired effects of Fed stimulus actions. This is the basic idea behind the Commercial Paper Funding Facility (CPFF) set up by the Fed last week.

I also think these measures are designed to "stabilize" the situation. Once stabilized, further measures will need to be taken further improve the situation and prevent recurrence.

[robotfog]

You forgot we could get someone to declare the leaves of trees as our new currency.

I hope someone with the proper vision and the influence to have it carried out is available.

[satyriasis]

We survived the first great depression and we'll survive this one. We just have to hope Obama wins or else it would be like Hoover getting re-elected. The future of America and the world depends on Obama.

[teddyni]

Thanks so much!

Great, but scary, article! Great proposals!

Here are two specific suggestions regarding the recapitalization of banks with both private and Fed funds:

Proposal 1

¢ Allow all US banks to create and issue a new class of stock: "Patriotic Pair"

¢ The stock would be non-voting and issued in pairs, one private, one Fed

¢ Private shares would be offered to private investors at, say, $20 /share

¢ Each share sold would have a matching share that would be purchased by the Fed for $20

¢ Each private share would carry an option to buy the corresponding Fed share for $22

¢ After five years the banks would buy back any unsold Fed shares for $22.50

¢ Promote this program with patriotic "Uncle Sam" posters, ads and public service announcements as something patriotic citizens can do for their beloved country.

Proposal 2

Is for credit card companies to immediately offer 2% cash discounts for all accounts paid in total within 10 days of the current statement

Regards,

[noesis]

Step one: Start issuing United States Notes, Silver Certificates and Gold Certificates. Restoring sound money is crucial to the long term health of the US economy. Why are we paying interest to the parasitic banksters that run the Federal Reserve?

[MajorKong]

I can always count on Nouriel Roubini to brighten my day. I wonder if it's too early to start drinking heavily.

[robotfog]

better do it while it's affordable.

[jsarets]

Obama should announce a plan to pay down the entire national public debt within 2 years by steadily issuing interest-free Treasury notes to retire Treasury bonds while also steadily increasing the fractional reserve requirement for banks. This plan would wipe out our public debt, dramatically reduce taxes, cause no inflation or deflation, and restore confidence in our financial institutions by transitioning to an interest-free currency fully backed by reserve deposits.

As necessary during this money crisis and continuously after the public debt is completely retired, the Treasury should also issue notes to retire private debt until all interest-bearing Federal Reserve notes are purged from circulation, an equal amount of interest-free U.S. Treasury notes deposited in their place, and full reserve banking instituted.

Under today's monetary system, credit controls money. Under the proposed system, money controls credit. If we need more credit, the Treasury simply issues more interest-free money for the banks to lend at full reserve. Banks can't manipulate the money supply with their lending practices. And because the currency is interest-free, we can stop the exponential growth and strike a better ecological and social balance.

[turfkiller]

Thomas Sowell is currently being pushed by the far right as the economist to do battle against Obama should he be elected.

Thomas Sowell looks to be the economist version of Supreme Court Justice Clarence Thomas.

[SteveMDFP]

I hope all the central banks take this article to heart.

But really, we've already entered a global, high-speed, explosive "deflationary death spiral." It's not a "risk," it's here.

http://stevemdfp.blogspot.com/

[jsarets]

This is a money crisis. Every dollar in circulation represents a debt of one dollar plus interest. The money supply needs to grow exponentially in order to keep up. The only way to make more money is to make more loans.

But nobody wants to make any loans on account of reality intruding on the fantasy of perpetual exponential growth. No more loans means that even the largest national banks can't create enough money to service their debt to the Federal Reserve.

We're so in debt that we can't afford enough new debt to pay off our existing debt. If the Fed were a real bank, they'd be headed for bankruptcy, but instead they will drive the dollar off a cliff.

I repeat: This is a money crisis. Within a few weeks to a few months, our money will become worthless, and we will forget all about Fannie and Freddie.

[francoise]

The pessimism of this analysis seems to be closer to reality than W's reassuring lies.

I'm not sure that politicians are able to unite and find an ideal plan to save the system.

Some wealthy nations, like the BRICs and the Middle East countries, have toxic derivatives and they might help the Western economies out of self-interest.

They might also buy many parts of our economies. This might become dangerous in the future when their and our geopolitical views differ.

If all governments could afford to guarantee bank deposits and inter-bank lendings, to invest and create jobs, etc... it would be easier. The problem is that our governments, the American and the French ones, are deeply indebted. Where will the money come from to pay for everything ?

[Idytme]

You missed a big one. Credit Default Swaps are only about 20% of the derivative market. They need to, in one day, declare all derivatives worth zero. I have read so many estimates of the derivative market, from 60 trillion all the way to 1000 trillion dollars. It is worth more than the global economy. And these are just bets. Like the flipping of a coin. A bet that nothing will go bad looks pretty good when the economy is going up, but when it is going down everyone is losing on these bets. Many of them borrowed money just to make the bet and paying all these bets back is going to wipe everyone out. Get rid of shadow banking, get rid of derivatives and the media needs to stop blaming a few people who could no longer pay for their house. We have been through housing slumps before and it did not bring down the world economy.

[drec1500Madrid]

I'm not holding my breath that anything even remotely like this will be enacted. We may get some more words like "Don't Panic" and "We're Working Hard on This" from the global leadership...if you can call it that.

And Hey! If this is in any way a precursor to how the world will deal with a really, really bad crisis, like say, the Giant Asteroid Heading Our Way scenario or if that pesky Global Warming Thing, we are doomed.

These people are programed to lie and cover their own butts...what makes anyone think they can actually come up with a clear, concise plan that focuses on the actual problem.

[cyclewerker]

OK, again I am going to ask this question, why are only people in debt to mortgages being rescued???
Say a person isn't an idiot, and didn't buy a dumb loan, or a house for that matter, because guess what, they couldn't afford one...why does that persons taxes get to save another persons house????

How about just "debt relief" by the government? Sure, freeze sketchy mortgages, that's fine, but damn it, I get effing insane at the thought that people are being rewarded for their stupidity...why is it that mine and my wife's student loans aren't being frozen, and relieved??? We aren't insolvent, but we aren't exactly living the high life...not to mention I will be paying them off even after my week old son goes to college...why only the house owner's debt being relieved? Why not just buy everyone's ridiculous credit cards at 20%interest??? IF you were dumb enough to buy a house you couldn't afford, or hire a lawyer to go over your mortgage contract, why on earth should I be paying for your house?????

[nezumi]

The main problem about student loans that there is no collateral such as a house. As a creditor you invest in the future of the student. Therefore, student loan debt is less readily forgiven. If it were, there would be no creditors. One of the problems is that you actually need(ed) a loan to be able to study.
This is what you should rally against.

[vahana]

In time, bailouts for student loans and other types of credit may come. The language of the $850 billion "rescue" bill enables the Treasury Secretary to purchase derivatives backed by mortages AND other loans/credit. Given Roubini's observation that so many different economic bubbles are popping now, it's going to be a rough ride for everyone, even those of us who feel we did everything right and who resent the fact that other people's greed and stupidity has brought economic hell upon us all. Keep the faith: Americans survived the Great Depression, and we can survive this, too, even though no one really knows what to name it yet.

BTW, congratulations on the birth of your son.

[MatoSka]

It is a mistake to think that YOU are bailing out people in foreclosure. The bailout is for investors and investors only. The problem at the heart of the bailout is that is does not address communities as the focal point of financial support . In point of fact, it continues trickle down economics. If it didn't you would have more say over the process.

[Philament]

I did not fully understand this post, but I get the main idea and greatly appreciate that people are trying to explain what's happening to the market and what can be done about it. My parents are jittery - Dad pulled his money out of his 401K last week and Mom is emailing me to tell me to buy canned goods and make sure I have plenty of cash handy in case my bank implodes. Of course they also lined the walls of their garage with canned goods and kerosene for their heater in anticipation of Y2K, so I'm used to their... ah... intensity. Unfortunately, a lot of people think like my parents - so we'll just have to ride it out until this too passes and hundreds of PhD students write their doctoral theses explaining what the hell happened in 2008 and how we can avoid a repeat. In the meantime, I just hope we get a wise and cool-headed President with the presence of mind to say things like, "the only thing we have to fear is fear itself".

[MatoSka]

Roosevelt's assurances aside, your parents are right in this case. Your dad was smart. And your mom understands that what goes up, must come down. You have not seen how bad things can really get and presume that there is an inherent logic in prosperity. Roosevelt's words did not prevent the Great Depression nor did his actions as President end it. You can believe what you want to, but that will not save your 401(k).

My parents lived through the Depression, so I know it can be done. That is not the same as assuming that we can have everything, anytime we want.