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

[noesis]

A realist...how refreshing.

[Overd0g]

A rapid reduction of the debt burden of insolvent households? And how might that be accomplished. I'm presuming that the non-deadbeats are being asked to pay off the home equity funded Hummers and European vacations of the deadbeats. Over my dead body.

[Yermammy]

That's too easy. That's YOU resenting people that used their home equity to buy toys. If this was simple, they never would have been able to get the loan. No, the predatory lending practices are what led to this. You'll never convince me otherwise. I remember a day, when if you didn't have a HUGE down payment, you couldn't get a bank to finance a house. It worked. But, the banks got greedy. Why loan money to just one person when they can loan THAT SAME MONEY TO TEN PEOPLE. But, Banks and Wall St. thought they're slick by complicating things. One thing they didn't factor in. We're all basically monkeys- with monkey needs and monkey wants. Keep it simple stupid. That works for everything in life, from mechanical machines to human interaction. So don't hate the players, hate the game. Banks used to be doing you a favor when they turned you down. Those days are long gone. Blame the Banks.

[judesedit]

I want to know how and why that is true when there are many billionaires in the world???? If the government loves borrowing money so much, why the hell don't they borrow it to give it to the people who will spend it on you name it. 300 million is peanuts compared to 700 billion. They can even collect tax on it. Leave the greedy ba5tard5 to themselves. This is all a bunch of bs, like the lies that led us to the war in Iraq, and plenty more. Wake up people. It's about fear and control.

[Indubio]

I'm afraid it isn't a bunch of BS.

[DavidLeffler]

How about taking a look to the aftermath of all of this? Let's turn the clock back about 75 years to see what's going to happen next. The 1929 Great Depression spawned several pieces of major legislation, among them the Securities Act of 1933 and the Securities Exchange Act of 1934, plus gave birth to the Securities and Exchange Commission. Expect more of the same, but this time on a worldwide basis coordinated amongst the developed nations.
http://staringatstrangers.typepad.com/staring_at_strangers/2008/10/the-financial-1.html

[Weathermaker]

Great job, HuffPo for posting this analysis from Dr. Roubini. Dr Roubini is one of the few economists I trust at this point. Try to convince Dr Roubini to allow you to post his February 2008 analysis "The Risk of a Systemic Financial Meltdown: 12 Steps to a Financial Disaster”. It is scary how accurate his predictions were.

[tsammani]

Perhaps we have all been as divorced from reality as Theodore Roethke's "The Victorians":

O the gondolets, the mandolins, the twanging of the lutes,
The girls all dressed in crinoline among the flowers and fruits --

The flowers all symbolical, the lily and the rose,

And how the sherry blossomed on the end of grandma's nose.

The maiden sighs and turns away, the maiden she relents,

Attracted by the glitter of a pile of five per cents.

They danced beneath the arbors, they strolled upon the grass,

O never aware, O never aware of what would come to pass.

[letsmakesense]

It's a blackhole. Take the money you have and change it into what you need i.e. storeable food, medicine, water filters, precious metals, guns, land and seeds before the blackhole of the 60 trillion cds meltdown takes the value of that money away.

[SteveMDFP]

Deflation is what's happening, and it's self-accelerating. Those dollars will buy MORE of everything in the very near future. It is dollars you'll be wishing you had.

This is why deflation is explosively self-accelerating. When everybody rationally wants and needs to cash out accounts of all types to hold dollars, the usual money creation process reverses. The money supply (of which currency is usually just a small fraction) contracts rapidly, approaching the point of just being the paper currency.

With so few dollars around for purchasing all available assets of all types, prices have to rise.

We've had inflation, and nothing but inflation, from 1933 to 2008. We're starting to see massive deflation now; nobody is familiar with this beast. Right now, the best investment is dollars in a very secure safe (well, Japanese Yen and Swiss Francs might be slightly better). Recognition of this eminently rational and profitable investment strategy is exactly why the process is explosively self-accelerating.

By election day, most ATMs won't be dispensing cash.

Expect to see more barter, cash substitutes, bread lines, and many cold families this winter.

[Novista]

Glad to see your important message reading a larger audience, sir!

[larry278]

We've passed the point of no return. The world is in a severe melt-down & a monumental depression. It's far too late for preventive measures. Place all efforts on recovering from & preventing future melt-downs & depressions. Things are real bad now & will get much worse. The world will be fortunate if it recovers in 10 years.
Use past tense verbs to correct the blog & delete the nonsense about preventing a depression. We are in a depression now. The sound which you are hearing isn't thunder; it's the sky falling down & the economy collapsing. We are not close to reaching the bottom. It will take at least a year to hit the bottom.
Oh, ye of little faith-you are right; it is going to get much worse.

[SteveMDFP]

Most money exists as informatio­n--recorde­d account balances. We live in the information age, in which transactions happen by the millions per second. The bottom of a deflationary spiral might happen with breathtaking speed. I suspect we'll be hitting a breathtaking bottom within weeks to a few months. Much economic activity will be at a standstill.

Then, the lubricant of lots more cash *might* get everyone and everything working again fairly promptly.

[larry278]

Try 3-5 years before we hit the so called bottom. Cash often is paper money or coins. Drop a handfull of coins into the mechanism of a grand father clock. Tell me what happens to the gears. Try it on another grand father clock with a handfull of C notes. If you wish to lubricate a clock, try whale oil or synthetic whale oil, not metal coins or paper money.

[Mickey7]

So, since the taxpayers bailed out Wall Street and the gov is looking at cash (taxpayer) infusions for the banks, would this be a good time to file bankruptcy to get out from under the 26.99% interest that Ca;pital One charges for it's helpful "healthcare financing" credit for those of us who have not been deemed insurable by the corrupt health insurers that we'll probably be bailing out next? I only ask since it seems that either way I'm going to be paying them, but I'd just as soon not be raped at high interest while being robbed. What a world we've created.

[chasingsol]

"We're doomed".

[Zenith1959]

I don't understand everything you said, but it sorta freaked me out anyway. Uh, thanks I guess.

[chasingsol]

"We're screwed"

[William1950]

nah... getting screwed feels good... sort of