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 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 6-Aug-07
Nouriel Roubini says: "Worry about systemic risk." Whoo hoo!

Web Log - August, 2007

Nouriel Roubini says: "Worry about systemic risk." Whoo hoo!

His arguments show what's wrong with mainstream macroeconomics.

I know I shouldn't keep picking on the same guy, after I wrote about his housing recession predictions, but he's so important, and his reasoning is so mainstream, and the mainstream reasoning is so vacuous.

Roubini provides pro and con lists of reasons whether we're having a period of "temporary economic turmoil," versus "a more severe and protracted period of financial market volatility and downturn that could end up into a systemic risk episode."

Since he's laid out the reasons pretty clearly, it's of interest to me to comment on them, as representives of current mainstream economic thinking.

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As I explained at length in my comprehensive analysis of macroeconomic theory that I wrote last year, "System Dynamics and the Failure of Macroeconomics Theory," economists have been wrong about everything, at least since the start of the bubble in 1995. They didn't explain or predict the bubble or its timing. They failed to predict low inflation or high unemployment in the early 2000s. They didn't predict or explain productivity increases. They didn't predict or explain the low interest rate "conundrum." They didn't predict or explain the housing bubble. They've been consistently wrong about almost everything.

Because Roubini lays out the mainstream macroeconomics arguments in such details, it gives me an opportunity to explain again why mainstream macroeconomics is a complete failure.

"Any time there is an episode of turmoil in US and global financial markets the question in the mind of investors is whether this is a period of temporary turmoil or the beginning of a more severe and protracted period of financial market volatility and downturn that could end up into a systemic risk episode.

In the last decade only the LTCM episode in 1998 at the peak of the Asian and emerging markets financial crisis and the bust of the tech bubble in 2000-2001 - that triggered the US recession of 2001 - had systemic implications. Since then we have experienced a variety of other episodes of financial turmoil that have ended up being only temporary shocks. In these episodes of temporary turmoil investors risk aversion sharply rose for a while, volatility indices and gouges of investors risk aversion (such as the Vix, the 10 year swap spread and credit spread) sharply increased; and the financial pressures spilled over from credit/debt markets to equity markets. But in each of the most recent episodes the turmoil was transitory (a few weeks or, at most, a couple of months); once the transitory sources of the financial disturbances disappeared, calm returned to markets and investors risk aversion returned to lower levels.

This gets right to the heart of the debate going on today among mainstream economists. Start with the assertion that the surging economic problems are caused by investors' increasing risk aversion, since investors are then unwilling to buy stocks or remain in the stock market, and so stock share prices fall.

The economists' debate then is about how to get investors' risk aversion back to "normal."

Roubini refers to risk aversion returning "to lower levels." He doesn't say "to normal levels," but the unstated assumption of every pundit, as far as I can tell, is that lower levels are "normal" and today's higher level is "abnormal."

In fact, from the point of view of Generational Dynamics, it's the higher levels of risk aversion that have been abnormal. The current generations of investors have been so fearless, that they've been willing to take any risk whatsoever, making investments that would be out of the question of generations of investors who personally survived the 1930s Great Depression.

So right off the bat, we see that Roubini and other mainstream economists base their reasoning on an incorrect assumption: That the levels of risk aversion in the recent past have been "normal," when in fact they've been abnormally low.

This means that the debate on how to lower risk aversion again to "normal" levels is fundamentally wrong. There may be a way to push it down to abnormally low levels again, but that can't be more than temporary. The level MUST rise to normal levels at some point, and then the bubbles MUST burst.

"One of such episode of temporary turmoil followed 9/11 in 2001 and the collapse of Enron in late 2001. Another episode of transitory turmoil occurred in early 2003 before the US invasion of Iraq when market started to worry about the risks and consequences of the war on the economy. A more recent episode was the one that – in the spring of 2005 – followed the downgrade of GM and Ford by credit rating agencies; that downgrade caused serious but temporary pressures in the credit derivatives markets and in equity markets. Another episode occurred in the spring of 2006 when a sudden “inflation scare” in the US (worries that inflation was rising and that, therefore, the Fed was not done yet with rising the Fed Funds rate) led to a sharp downturn in US and global equity markets and serious pressures on some emerging markets currencies, equity markets and bond markets. And the final episode – before the most recent turmoil this summer – was in late February 2007 when the combination of a mini-crash in the Chinese stock market, rising worries about the fallout of the subprime crisis and a US “growth scare” affected mostly equity markets in the US.

Since most previous episodes of financial turmoil since 2001 have been temporary, the optimistic and consensus view in the markets is that the current financial turmoil will be again transitory and that risky assets – starting with equities – will recover their upward price path once investors’ nervousness abates. That is certainly possible as previous episodes of turmoil since 2001 were mostly contained. But I will flesh out a number of reasons why the current episode of market turmoil may be more serious and protracted than previous ones and why we should worry now about systemic risk.

Roubini presents one side of the argument. He notes that in previous recent surges in investors' risk aversion, the risk aversion has come down as soon at the triggering event was over. Thus, the argument is that the same thing will happen soon, as soon as investors forget the Bear Stearns debacle.

However, he now proceeds to the opposite arguments: That today's environment has some fundamental differences from previous recent surges, and that "we should worry now about systemic risk."

"First, most of previous transitory episodes occurred at the time when US and other G7 monetary policy conditions were much looser than today. Starting in January 2001 the Fed aggressively cut the Fed Funds rate that fell from 6.5% to a bottom of 1% by 2004. Next, the normalization of US monetary policy brought back the Fed Funds rate to 5.25%; while at the same time monetary policy has been tightened in all G7 countries and several other emerging markets. And with inflationary pressures being still on the upper limits of many central banks’ comfort zone further tightening is expected (say in the Eurozone, UK, China and many other economies). Thus, in past episodes, easy monetary conditions helped; today instead policy is tighter and on the way to further tightening.

So, his first reason "why we should worry about systemic risk" is that interest rates have been tightening. What does that have to do with systemic risk? Tightening interest rates were once thought to affect unemployment (Keynesian), and more recently have been thought to affect inflation (Monetarist). But what do they have to do with systemic risk? Roubini is just guessing.

"Second, following the brief US recession between March and November 2001, economic growth – first in the US, then in other G7 economies and emerging markets – recovered rapidly and has remained high for a number of years. But starting with the fall of 2006 the US has experienced a serious economic growth deceleration that may turn out into a hard landing (either a growth recession or an outright recession). The rest of the world is growing robustly but the clouds over US economic growth are rising. In previous episodes – like the spring of 2006 or early 2007 – we had an inflation “scare” or a “growth” scare and markets reacted sharply downward. Now, if instead of having a growth “scare” the US were to experience an actual sharp growth hard landing (say a growth recession) the financial consequences would be serious as housing, capex spending and private consumption would sharply slow down.

Next, Roubini's second reason to worry is because the American economy has been slowing down. Once again, I have to ask why this means a "systemic risk.

A growth recession is defined as "An economy in which the output of goods and services slowly expands but unemployment remains high or grows."

This gets down to the question of exactly what "systemic risk" Roubini is talking about.

I know what I've been talking about -- since 2002 -- a stock market panic and crash, and a new 1930s style Great Depression.

Roubini seems to be covering all the bases: maybe it'll simply be a deceleration of growth (a "soft landing"), or maybe it'll be a sharp slowdown in housing, capital expenditure spending, and private consumption (a "hard landing"). He's covering all the bases. That way he won't be wrong.

"Third, between 2001 and 2006 the debt, credit and financial excesses of important sectors of the economy were contained; today they are not. At the time of the 2001 recession the balance sheets of the corporate sector were weak but those of the household were relatively sound. Today, instead, after six years of excessive borrowing and two years of negative savings the balance sheets of the household sector are weak and fragile. At the same time the process of releveraging of the financial and corporate system (hedge funds, private equity, prop desks, LBO and share buyback activity) has led to significant increase in the amount of debt and leverage in the private sector. As suggested by Ed Altman – the leading academic expert of corporate distress - corporate defaults have been kept at a much lower levels (0.6%) than justified by current corporate financial fundamentals (2.5%) only because of the slosh of liquidity that allowed potentially distressed corporations to refinance their debts or do out-of-court restructuring plans. In the last few years a credit boom – if not a bubble – stimulated asset prices in a typical Minsky-style credit-driven asset bubble. The easy monetary conditions after 2001 and the continued wall of liquidity coming from highly saving and forex-accumulating emerging markets fed a US and partly global asset bubble and a credit/debt bubble. Thus, the excessive leveraging of households, some parts of the corporate sector and many financial investors is a new source of financial fragility and systemic risk."

Roubini's third reason to worry is that the "debt, credit and financial excesses of important sectors of the economy" are not "contained."

This of course is a serious problem. This web site started saying so years ago, first talking about a stock market bubble in 2002, then housing and credit bubbles in 2004 and 2005.

The sentence "In the last few years a credit boom – if not a bubble – stimulated asset prices in a typical Minsky-style credit-driven asset bubble" refers to Roubini's previous posting, about economist Hyman Minsky and his view that "periods of economic and financial stability lead to a lowering of investors’ risk aversion and a process of releveraging," or excessive use of credit. This is the Minsky Credit Cycle Model.

According to Roubini, the Minsky Credit Cycle peaked with the Savings and Loan bust in the late 1980s and the dot-com bubble bust in 2000. He says that we're now at the peak of a new Minsky cycle.

Well no, he's not sure it's a bubble. Or maybe he is sure. To repeat what he says: "In the last few years a credit boom – if not a bubble – stimulated asset prices in a typical Minsky-style credit-driven asset bubble. ... fed a US and partly global asset bubble and a credit/debt bubble." Well, it looks like he's covered either way.

In his posting on the Minsky Cycle, he concludes with this: "Note also that, as Minsky - as well as more recently the BIS – have warned the deflation of such credit-driven asset bubbles is historically painful and associated with economic downturns and recessions."

What the heck is this? I've quoted Greenspan many times as saying exactly the same thing: "Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums." Only Greenspan said it two years ago.

"Fourth, the housing bubble has already popped in the US and is at risk of popping in other bubbly housing markets (UK, Spain, Ireland, Australia, New Zealand, and Iceland to name a few cases). The fallout of the US housing recession has been twofold. First, spillover to other sectors of the economy (auto recession, weakness in durable goods and housing related sectors, weak capex investment of the corporate sectors, slowdown of private consumption among overstretched US households). Second, spillover to other financial markets as: a) this is not just a subprime problem but increasing a near prime and prime mortgage problem; b) there is now a liquidity and credit seizure in a variety of credit markets (LBOs, CDOs, CLOs, etc)."

The fourth reason is the one that I and many other people have been talking about for months, and has riveted the attention of investors everywhere, ever since the Bear Stearns debacle. No argument here.

"Fifth, we are now reaching a point where the distress of many and different economic agents may lead to a systemic effect. Some have argued that the growth of credit derivatives has diffused financial risks among many different agents and in a variety of countries reducing systemic risk. That is why – it is argued - the risk of one huge LTCM blowing up and causing systemic risk are limited. But the experience with previous episodes of systemic risk (the S&L crisis where hundreds of smaller financial institutions went belly up causing a credit crunch and the 1990 recession; the tech bust of 2000-2001 where hundreds of smaller tech and internet companies went belly up and triggered the 2001 recession) suggest that the LTCM type of systemic crisis (one large institution getting in trouble and taking with it most of the financial system) is the exception rather than the rule: many and different agents and institutions getting in trouble can lead to systemic effects especially after a period of asset bubbles driven by a credit/debt bubble.

And today there is a variety of economic and financial agents that are under financial pressure if not outright distress. Specifically, hundreds of thousands of subprime and near prime households will default on their mortgage and their homes will end up in foreclosure; the ability of the financial and legal system to manage such a surge in bankruptcies is severely limited. Also, over fifty subprime lenders have now gone out of business and now some of the larger lenders – see AHM and Accredited Home Lenders Holdings Co. - are also in trouble and near bankrupt; the mortgage rot is spreading from subprime to near prime and Alt-A (see Countrywide, IndyMac, etc.). Now, there are news of massive losses among major US home builders and rumors that some may be near bankruptcies. There are already half a dozen mid-sized hedge funds – between US, Australia and Europe – that have gone belly up; and every day financial institutions across the world are reporting large subprime-related losses as a lot of the RMBS and CDO were bought by foreign investors. And in a world where most investors in these illiquid instruments (RMBS, CDOs, CLOs, etc.) are marking to model rather than marking to market the extent of the eventual losses is unknown and the number of financial institutions that will go belly up is also unknown and likely to surprise on the upside. Systemic risk episodes often occur with a death through 1000 cuts rather than one single major – a’ la LTCM – blow."

So Roubini's conclusion then is that we should indeed "worry about systemic risk."

I find that his summary is useful as representing the point of view of mainstream economists today.

This entire posting illustrates everything that's wrong with modern macroeconomics.

In order to illustrate the problem, I'd like to return to and expand upon an analogy that I've used before: a heat wave in New York City in November.

Here's the situation: It's New York City, and it's late November. There's been a heat wave, and now the weather has cooled off a bit, and there's a debate going on over whether winter is coming.

I'm going to mimic Roubini's arguments, pro and con. First, here are the arguments that winter is NOT coming:

"The weather has cooled off several times in the last few months. In the first week of September, the temperature fell rather sharply. In the second week of October there was another dip in the temperature. Nervous pedestrians began wearing heavy coats, but in both cases the pedestrians stopped wearing heavy coats as the temperature went up again. Today, pedestrians are starting wear heavy coats again as the temperature dips. But we believe that the pedestrian will regain his confidence, shed his heavy coat, and the temperature will rise once more, so there won't be any winter. That's what happened in September and October, and we can expect that to happen again today."

Notice the "cause and effect" confusion in this argument: Do the pedestrians' heavy coats cause the chill, or does the chill cause the heavy coats? The argument could go either way, and leaves the possibility open that either interpretation is correct.

I first wrote about this problem in September, 2004, in an article entitled "Federal Reserve congratulates itself on jawboning policy." I commented on a study by Ben Bernanke that supposedly showed that long-term interest rates have been kept low merely because the Fed SAID that they would remain low. By setting expectations, Bernanke's study claimed, the economy stayed stable, because the Fed SAID it would remain stable.

This claim was ludicrous in 2004, but now in 2007 surely even Bernanke can't believe it. But that's the same argument that by convincing people not to wear heavy coats, then the weather won't get cold.

In Roubini's argument, reflecting mainstream economic theory, the risk averseness of the investors has been increasing at the same time that market turmoil occurs. Which is cause, and which is effect? Economists really have no idea, but the hope is there that if we can only convince people to be risk-seeking again, then the market will start heating up again, and the bubble will grow again.

Now I'll mimic Roubini's arguments in the other direction:

"Things are different today than they were in September or October. First, there was a snowstorm in Minnesota last week, indicating a more widespread breakdown in the warm weather, and nothing like that happened in September or October. Furthermore, the jet stream appears to be changing course, more and more flowing from the north and less from the south. Finally, factories in China are producing more heavy coats and shipping them to the United States, including New York City, and that will bring temperatures down further. So we have good reason to worry that winter is coming."

You may think that I'm making a joke in comparing these weather arguments to Roubini's economics arguments, but I'm not. The two sets of arguments are equally invalid.

If you want to understand whether winter is coming, you have to go back farther than September or October -- you have to go back a full year or two to previous Novembers. Any attempted comparison at all between November's weather and September's weather is going to fail, because they're at different points in the seasonal cycle. The comparisons are totally irrelevant.

Similarly, if you want to understand today's economic climate, you have to go back much farther than 2003 or 2000 or the 1990s or the 1980s. Any macroeconomic model developed at those times cannot possibly be relevant to today's economy, because they're at different points in the long-term economic cycle. The comparisons are totally irrelevant.

To understand today's economic conditions, you have to compare it to the 1920s. But mainstream economists NEVER do that, because they believe that the they've totally solved the "Great Depression" problem, and that it will never happen again.

Over the years, I've given many arguments why we're headed for a major panic and stock market crash, and a new 1930s style Great Depression. But the following argument, that I've made many times, is really all by itself absolute proof: The Price/Earnings ratio since 1995 has been way above its average of around 14, and has to be around 5 for a decade to maintain its long-term average (the Law of Mean Reversion).

This argument is not exactly rocket science; it's pretty standard stuff. If Nouriel Roubini or any other mainstream economist even simply ADDRESSED these arguments, and at least TRIED to explain why this argument is wrong, the attempt might give me some pause.

But they never do. They simply ignore these arguments, and go obsessively into details on Minsky Cycles and other stuff from which you can't conclude anything.

That's one of the reasons why I've no doubt these last few years that Generational Dynamics is correct, and all of its predictions are correct: Almost no one ever bothers to address the arguments, even when the arguments are obvious.

And so, as I've said so many times before, Generational Dynamics predicts that we're headed for a new 1930s style Great Depression. It's impossible to make short term predictions, but for the reasons that I've given in numerous recent articles, the economy now appears to be deteriorating rapidly, and so the time may well be getting close. (6-Aug-07) Permanent Link
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