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The Crisis and How to Deal with It

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Dominique Nabokov
Robin Wells at the symposium

Now, the great concern I have is that although we understand these things fairly well, there are thirty-eight Republican senators who say that the answer for the crisis is another round of Bush-style tax cuts that will reduce revenues by $3 trillion over the next decade.

This crisis has been so large and the political process has been so sluggish that the difficulties have been greater than expected. And yes, there are some green shoots. Things are getting worse more slowly, but we have not managed to head off a crisis that could turn out to be self-reinforcing, and leave us in this trap for many, many years.

Nouriel Roubini: It’s pretty clear by now that this is the worst financial crisis, economic crisis and recession since the Great Depression. A number of us were worrying about it a while ago. At this point it’s becoming conventional wisdom.

The good news is probably that six months ago there was a risk of a near depression, but we have seen very aggressive actions by US policymakers, and around the world. I think the policymakers finally looked into the abyss: they saw that the economy was contracting at a rate of 6 percent–plus in the US and around the world, and decided to use almost all of the weapons in their arsenals. Because of that I think that the risk of a near depression has been somewhat reduced. I don’t think that there is zero probability, but most likely we are not going to end up in a near depression.

However, the consensus is now becoming optimistic again and says that we are going to go from minus 6 percent growth to positive growth in the second half of this year, meaning that the recession is going to be over by June. By the fourth quarter of 2009, the consensus estimates that growth is going to be positive, by 2 percent, and next year more than 2 percent. Now, compared to that new consensus among macro forecasters, who got it wrong in the past, my views are much more bearish.

I would agree that the rate of economic contraction is slowing down. But we’re still contracting at a pretty fast rate. I see the economy contracting all the way through the end of the year, going from minus 6 to minus 2, not plus 2. And next year the growth of the economy is going to be very slow, 0.5 percent as opposed to the 2 percent–plus predicted by the consensus. Also, the unemployment rate this year is going to be above 10 percent, and is likely to be close to 11 percent next year. Thus, next year is still going to feel like a recession, even if we’re technically out of the recession.

The outlook for Europe and Japan, both this year and next year, is even worse. Most of the advanced economies are going to do worse than the United States for a number of reasons, including structural factors in Japan and weak policy response in the case of the Euro zone.

The problems of the financial system are severe. Many banks are still insolvent. If you don’t want to end up like Japan with zombie banks, it’s better, as Bill Bradley suggested, to do what Sweden did: take over the insolvent banks, clean them up, separate good and bad assets, and sell them back in short order to the private sector.

Now, on the question of policy responses, there is no inconsistency between monetary easing and fiscal easing. Both of them should be stimulating demand, and the monetary easing should be leading also to restoration of credit. Of course, in a situation in which the economy is suffering not just from a lack of liquidity but also problems of solvency and a lack of credit, traditional monetary policy doesn’t work as well. You also have to take unconventional monetary actions, and you have to fix the banks. And we need a fiscal stimulus because every component of our economy is sharply falling: consumption, residential investment, nonresidential construction, capital spending, inventories, exports. The only thing that can go up and sustain the economy for the time being is the fiscal spending of the government.

However, fiscal policy cannot resolve problems of credit, and it is not without cost. Over the next few years it’s going to add about $9 trillion to the US public debt. Niall Ferguson said it’s the end of the age of leverage. It’s not really. There is not deleveraging. We have all the liabilities of the household sector, of the banks and financial institutions, of the corporate sectors; and now we’ve decided to socialize these bad debts and to put them on the balance sheet of the government. That’s why the public debt is rising. Instead, when you have an excessive debt problem, you have to convert such debt into equity. That’s what you do with corporate restructuring—it converts unsecured debt into equity. That’s what you should do with the banks: induce the unsecured creditors to convert their claims into equity. You could do the same thing with the housing market. But we’re not doing the debt-into-equity conversion. What we’re doing is piling public debt on top of private debt to socialize the losses; and at some point the back of some governments’ balance sheet is going to break, and if that happens, it’s going to be a disaster. So we need fiscal stimulus in the short run, but we have to worry about the long-run fiscal sustainability, too.

George Soros: There are two features that I think deserve to be pointed out. One is that the financial system as we know it actually collapsed. After the bankruptcy of Lehman Brothers on September 15, the financial system really ceased to function. It had to be put on artificial life support. At the same time, the financial shock had a tremendous effect on the real economy, and the real economy went into a free fall, and that was global.

The other feature is that the financial system collapsed of its own weight. That contradicted the prevailing view about financial markets, namely that they tend toward equilibrium, and that equilibrium is disturbed by extraneous forces, outside shocks. Those disturbances were supposed to occur in a random fashion. Markets were seen basically as self-correcting. That paradigm has proven to be false. So we are dealing not only with the collapse of a financial system, but also with the collapse of a worldview.

That’s the situation that President Obama inherited. He’s faced with two objectives. One, he must arrest the collapse and, if possible, reverse it. Second, he has to reconstruct the financial system because it cannot be restored to what it was. This is a new situation. When people see this crisis as being the same as previous financial crises, they’re making a mistake.

The interesting thing is that what needs to be done in the short term is almost exactly the opposite of what needs to be done in the long term. Obviously the problem was excessive leverage. But when you have a collapse of credit there’s only one source of credit that is still credible, and that’s the state: the Federal Reserve and the Treasury. Then you have actually to inject a lot more leverage and money into the economy; you have to print money as fast as you can, expand the balance sheet of the Federal Reserve, increase the national debt. And that is, in fact, what has been done, which is the right thing to do. But then once this policy is successful, you have to rein in the money supply as fast as you can.

I would say that policy has generally lagged behind events. We were behind the curve. Now that the free fall is moderating, and the collapse has more or less occurred, I think there is hope that policy will, in fact, catch up with events. The outcome of the stress test of the banks will be important, because that’s basically where the policy has been lagging behind—in recapitalizing the banks. And that’s where most of the confusion comes from.

Robin Wells: I want to go back to what Paul said about the global savings glut. The global savings glut is what drove interest rates down to historically low levels. Housing is very sensitive to the interest rate, and therefore a housing bubble was practically foreordained by an extended period of low interest rates. But you’ll also notice that the bubble in housing hasn’t occurred just in the United States, it’s also occurred in Spain, Eastern Europe, and the UK; it’s been in Ireland, it’s been in Iceland. In order to prevent us from reexperiencing this catastrophe in another, say, ten years, we need to look at the origins of the global savings glut. Yes, there are some differences in how the bubbles were actually manifested in the different countries, and those manifestations are important; but let’s look for a moment at the global savings glut in its entirety.

I think this story starts really in the Eighties. During the Reagan years, we experienced chronic fiscal deficits, and we began to abdicate our responsibility to raise tax revenue that could sustainably finance government. In order to do that, we had to borrow, and who did we borrow from? We borrowed from countries that were running persistent trade surpluses. And as we continued to run these deficits with these countries, there grew to be a symbiotic relationship, as Niall Ferguson says, this Chimerica.

But it was on several different fronts. There were the net exporters, such as China, Japan, and Germany, and the net importers of capital, the largest, of course, being the United States. This import of capital allowed us to consistently live beyond our means, first by running fiscal deficits, not raising enough tax revenue to finance the government, and then also through, ultimately, the leverage that we used in housing, and in commercial real estate, and in leverage buyouts. And this continued; it grew because there was no point anywhere along the line at which anyone would say “halt.”

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