The Guy Who Called It Right

Nouriel Roubini is one of the few economists who warned about the housing bubble and predicted the financial collapse before it occurred. His alarms — dismissed as extreme by Wall Street nabobs and most economists — turned out to be right. Now he details the scope — and the limits of the global financial rescue plan announced this week.

And he issues an urgent call for a $300 billion right-now stimulus plan — investing in green energy, retrofitting buildings to make them energy efficient, rebuilding infrastructure etc.

He sees a two year recession as inescapable, but argues that we must act now and boldly to avoid a decade long downturn.

Read the piece. This is the guy who called it right while most were still "dancing" to the music, in the immortal words of former Citibank president Charles Prince.

Religion (And Keynes) To The Rescue
Nouriel Roubini

I spent the weekend in Washington attending the International Monetary Fund annual meetings. After last week's crash in stock markets and financial markets — and it was, indeed, a crash, as during the week equity prices fell as much as the two-day crash of 1929 — policy makers finally realized the risk of a systemic financial meltdown. They peered into the abyss a few steps in front of them and finally got religion.

With this newfound fear of God, they started announcing radical policy actions: the G7 statement [1]; the European Union leaders agreement to bail out European banks; the British plan to rescue — and partially nationalize — its banks; the European countries' plans along the same lines; and the Treasury plan to ditch the initial TARP that was aimed only at buying toxic assets in favor of a plan to partially nationalize (aka recapitalize) U.S. banks and broker-dealers.

Here are the main policy actions that will be undertaken:

--Preventing systemically important banks and broker-dealers from going bust, i.e., the U.S. made a mistake letting Lehman fail; so Morgan Stanley and other systemically important financial institutions will be rescued.

--Recapitalization of banks and broker-dealers via public injections of capital in the form of preferred shares (i.e., partial nationalization of financial institutions as is already occurring in the U.K., Belgium, Netherlands, Germany, Iceland and, soon enough, the U.S.) matched by private equity injections.

--Temporary guarantee of bank liabilities: certainly all deposits; possibly interbank lines, along the lines of the British approach; likely other new debts incurred by the banking system.

--Unlimited provision of liquidity to the banking system, and to some parts of the shadow banking system, to restore interbank lending and lending to the real economy.

--Provision of credit to the corporate sector via purchases of commercial paper (certainly in the U.S., possibly in Europe).

--Purchase of toxic assets to restore liquidity in the U.S. mortgage-backed securities market.

--Implicit triage between distressed banks that will be solvent if given liquidity support and capital injection and non-systemically important and insolvent banks that will need to be closed down/merged/resolved/etc.

--Use of the IMF and other international financial institutions to provide lending to many emerging-market economies--and some advanced ones such as Iceland--that are now at risk for a severe financial crisis.

--Use of any other tools that are available and necessary to avoid a systemic meltdown (including implicitly more monetary policy easing as well as, possibly, a fiscal policy stimulus).

At this stage, central banks that are usually supposed to be lenders of last resort need to become the "lenders of first and only resort." Why? 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. Private lending will only recover over time.

While most of the economic and financial damage is already done, and the global economy will not be able to avoid a painful recession and a financial and banking crisis, the rapid and consistent implementation of these and other actions will prevent the U.S., European and global economies from entering an even more severe, L-shaped, decade-long stagnation like the one experienced by Japan after the bursting of its real estate and equity bubble.

So, are we close to the bottom of this financial crisis? Financial markets will remain volatile, with significant downside risks, over the next few weeks. This is because:

--Details of these government plans are still very fuzzy, and contain uncertain effects on various asset classes [2] (common shares, preferred shares, unsecured debt of financial institutions, etc.)

--Macro news will surprise on the downside as the economies sharply weaken and contract while fiscal policy stimulus is lagging.

--Earnings news for financial and nonfinancial firms will surprise on the downside.

--The damage done to confidence, and to leveraged investment, is already severe and the process of deleveraging the shadow financial system will continue.

--Major sources of future stress in the financial system remain. These include the risk of a credit default swap market blowout; the collapse of hundreds of hedge funds [3]; the rising troubles of many insurance companies; the risk that other systemically important financial institutions are insolvent and in need of expensive rescue programs; and the risk that some significant emerging-market economies, and some advanced ones too (Iceland), will experience a severe financial crisis.

More aggressive, consistent and rapid implementation of the policy plans will increase the likelihood that risky asset prices will bottom out sooner rather than later and then start recovering. A key policy tool — one that is currently missing in G7 and E.U. plans — is to use fiscal policy to boost aggregate demand.

Indeed, given the current collapse of private aggregate demand, it is urgent to provide a boost to aggregate demand to ensure that an unavoidable two-year recession does not become a decade-long stagnation. Since the private sector is not spending and the first fiscal stimulus plan (tax rebates for households, and tax incentives [4] to firms) bombed, it is necessary now to boost directly public consumption of goods and services via a massive spending program (a $300 billion fiscal stimulus).

The federal government should have a plan to immediately spend on infrastructures and new green technologies. Also, unemployment benefits [5] should be sharply increased, combined with targeted tax rebates only for lower income households at risk, and federal block grants should be given to state and local governments to boost their infrastructure spending (roads, sewer systems, etc.). If the private sector does not/cannot spend, then traditional Keynesian spending by the government is necessary.

It is true that we already have large and growing budget deficits, but $300 billion of public works is more effective and productive than spending $700 billion to buy toxic assets. If such a fiscal stimulus plan is not rapidly implemented, any improvement in the financial conditions of financial institutions provided by the rescue plans will be undermined — in a matter of six months — with an even sharper drop of aggregate demand that will make an already severe recession even more severe.

If Main Street goes bust in the next six months, a short-run rescue of Wall Street will certainly not stop Wall Street from going bust again.

A large fiscal stimulus plan, and a plan to reduce the debt overhang of distressed homeowners, will also ease the political economy of the financial bailout. As the debate in Congress showed, the American public is enraged by a system where gains and profits are privatized while losses are socialized — a welfare system, in other words, for the rich, the well-connected and Wall Street.

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Nouriel Roubini, a professor at the Stern Business School at NYU and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.