Nouriel Roubini: This week, I will discuss why the recovery will be sub-par and below trends for a few years once it does occur, and why there is even the risk of a double-dip W-shaped recession.The crucial issue facing us is not whether the global economy will bottom out in the third or fourth quarter of this year, or in the first quarter of next year. It's whether the global growth recovery, once the bottom is reached, will be robust or weak over the medium term--say 2010-11. As I argued last week, one cannot rule out a sharp snapback of GDP for a couple of quarters, as the inventory cycle and the massive policy boost lead to a short-term growth revival. My analysis, however, suggests that there are many yellow weeds that may lead to a weak global growth recovery over 2010-11.
The current consensus among "green shoot" optimists sees U.S. economic growth going back in 2010 to a rate that is close to the 2.75% potential growth rate, and returning to potential by 2011. Many optimists go even further, arguing that the snapback of demand and production after the depressed levels of the current recession will lead growth to be well above trend (3.5% to 4%) for a couple of years, as most previous U.S. recessions have been followed by a period of above-trend growth once the recovery gets going. Yet a detailed analysis suggests that growth will remain well below potential for at least two years--if not longer--as the severe vulnerabilities and excesses of the last decade will take years to resolve. Let us examine 10 factors that will cause below-potential economic growth over the medium term even after this recession is over. First, an incorrect interpretation of the causes of this crisis has led to a policy response that doesn't resolve the fundamental causes. The right way to think of this crisis is of its being caused by: excessive over-borrowing and overspending by households; excessive and risky borrowing and lending by financial institutions; and excessive leverage of the corporate sector in a global economy where housing, asset and credit bubbles got out of hand and eventually went bust. So this is a crisis of debt, credit and solvency, not just illiquidity. The alternative interpretation is that this is a crisis of confidence--an animal-spirit-driven, self-fulfilling recession--that has led to a collapse of liquidity (as counterparties don't trust one another) and of aggregate demand (as concerned households and firms cut consumption and investment in ways that can turn a regular business-cycle recession into a near-depression).
Note that even those who believe that this is a crisis of over-leverage and overspending agree that aggressive monetary and fiscal easing is necessary to prevent a severe recession triggered by such excesses from turning into a near-depression. But while such easing is necessary to prevent the global economy from falling off a cliff into the depression abyss, the ability of these over-leveraged economies to resume lending, borrowing, spending, investment and growth depends on the resolution of the excesses that caused the crisis in the first place.
Yet true de-leveraging by households, corporate firms and financial institutions has not even started, as private losses and debts are being socialized and put on the balance sheet of governments. The lack of true de-leveraging--or appropriate debt restructuring--will lead to a corrosive debt deflation and limit the ability of households to spend, of firms to invest, and of banks and other financial institutions to lend. In other words, if this is a crisis of credit and solvency rather than just illiquidity and confidence, much more is needed than easy money and massive fiscal stimulus to resume high economic growth. Worse, the socialization of private losses creates--down the line--another dangerous debt and solvency problem, this time for the sovereign, with risks of a more severe financial crisis once a refinancing crisis occurs and/or the ability of the sovereign to borrow more is curtailed.
The right way to resolve a problem of excessive debt relative to equity capital is to reduce such debt and convert it into equity. Corporate debt and the financial sector's unsecured liabilities should be converted into equity. Even household debt can be converted into equity by reducing the principal value of mortgages and providing an equity upside to the mortgage creditor in the form of a warrant.
Second, in current-account deficit countries (i.e., where the country spent more than its income), consumers need to cut spending and save more: shopped-out, savings-less and debt-burdened consumers have been hit by a wealth shock (falling home prices and stock markets), rising debt-servicing ratios and falling incomes and employment. These deficit countries include not only the U.S., but also the U.K., Ireland, Iceland, Spain, many emerging European economies, Australia and New Zealand.
In these economies, the retrenchment of consumption and buildup in savings to reduce debt, restore net worth and resume robust spending will take several years. In the U.S., consumption averaged 65% of GDP (and household savings averaged 11% of disposable income) for a long time before the latest decade-long housing bubble and consumption binge.
At the peak of the bubble, consumption had risen from 65% to 72% of GDP, and the savings rate plunged to zero and even negative for a few quarters. Currently, consumption has fallen from 72% to 70% of GDP and saving has increased from near zero to about 5% of disposable income. Even if one were--heroically--to assume that consumption will not revert to the long-term average, a fall from 70% to, say, 67% is likely and necessary, while the savings rate goes toward double digits.
But how can households reduce debt ratios that have increased from 65% of disposable income in the early 1990s to 100% in 2000 and 135% today? And the debt ratio risks rising even further as price deflation leads to debt deflation (a rise in the real value of nominal debts). One solution might be to save a lot to reduce debt and rebuild net worth, but the "paradox of thrift" scuttles this. If households sharply cut spending and save more, the recession becomes a near-depression and the ensuing fall in income further increases the debt-to-income ratio. The only remaining solution is debt default and debt reduction.
Third, the financial system (specifically, traditional commercial banks) is severely damaged, and the credit crunch will thus not ease very fast. Most of the shadow banking system is either gone or in severe difficulty. The equivalent of a bank run has hit most of the highly leveraged institutions of this system: 300 non-bank mortgage lenders are bust; the system of conduits and structured investment vehicles is gone; two major broker-dealers are gone, one merged with another bank and the last two converted into bank holding companies; money-market funds cannot even cover their costs, as interest rates are zero and now under the umbrella of a government guarantee; half of all hedge funds may close shop in the next couple of years; even private equity will experience a serious refinancing crisis once "covenant lite" clauses and payment-in-kind toggles run their course; finance companies and insurance companies are also in trouble and need government support and recapitalization. Securitization is a shadow of its recent peaks and the attempt to revive it--TALF--has been a mixed bag.
After $12 trillion of liquidity support, guarantees, insurance and recapitalization, most of the U.S. financial system is under effective government control. And the financial sector damage is not limited to the U.S.: Most major U.K. banks--with the exceptions of HSBC and Barclays -are under effective government control. The IMF estimates massive losses on loans and securities of other European banks, given their exposure to both domestic borrowers and emerging Europe, a region on the verge of a broader financial crisis. According to the IMF, even Japanese and other Asian banks are not immune to significant losses on loans and securities.
Over time, financial institutions in the U.S. and around the world will clean up their balance sheet. But systemic banking crises are not resolved in a few months: They usually last several years and are associated with a persistent credit crunch. Given that a lot of economic activity is financed with debt/credit, this crunch will inflict persistent damage and restrict the ability of households and corporate firms to borrow, consume, spend and invest.
Fourth, a large part of the corporate sector is also under severe financial stress, and its ability to increase production, employment and capital spending will be restricted by poor profitability driven by slow revenue growth, deflationary pressures and rising corporate defaults. While most U.S. corporations are less leveraged than they were in 2000-01, the corporate sector has a large fat tail--similar to that of the household sector--that is severely indebted.
Firms that in the past would have been able to roll over their loans, bonds and debts coming to maturity now face a liquidity crisis that may lead them into costly debt restructuring. Some firms that would have gone into Chapter 11 debt restructuring will end up in socially costly liquidation (Chapter 7) because of the lack of financing. This process of corporate debt restructuring or outright liquidation may take years.
But the main constraint to a recovery in the corporate sector will be a weak recovery of corporate profitability. If the global economy grows at sub-par rates in 2010-11, corporate revenues will grow slower than otherwise; and if deflationary pressures remain across the world--given the glut of supply relative to aggregate demand--pricing power of firms will be limited and profit margins will be further squeezed. The ability to control costs and restore earnings by slashing employment will reach a limit, and excessive employment contraction has negative macro effects: Fewer jobs means less income, less consumption, less corporate revenue and lower profits and earnings.
p/s photos: Hanako Takigawa
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