Saturday, August 16, 2008

Roubini - the economist who warned of the coming economic crisis two years ago - and why has he been correct?

Who is Nouriel Roubini, and what is wrong with modern American economics?

The New York Times profiled Nouriel Roubini - Dr. Doom - like this:
On Sept. 7, 2006, Nouriel Roubini, an economics professor at New York University, stood before an audience of economists at the International Monetary Fund and announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession. He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt. These developments, he went on, could cripple or destroy hedge funds, investment banks and other major financial institutions like Fannie Mae and Freddie Mac.

The audience seemed skeptical, even dismissive. [Snip]

Roubini was known to be a perpetual pessimist, what economists call a “permabear.” When the economist Anirvan Banerji delivered his response to Roubini’s talk, he noted that Roubini’s predictions did not make use of mathematical models and dismissed his hunches as those of a career naysayer.

But Roubini was soon vindicated. In the year that followed, subprime lenders began entering bankruptcy, hedge funds began going under and the stock market plunged. There was declining employment, a deteriorating dollar, ever-increasing evidence of a huge housing bust and a growing air of panic in financial markets as the credit crisis deepened. [Snip]

Over the past year, whenever optimists have declared the worst of the economic crisis behind us, Roubini has countered with steadfast pessimism. In February, when the conventional wisdom held that the venerable investment firms of Wall Street would weather the crisis, Roubini warned that one or more of them would go “belly up” — and six weeks later, Bear Stearns collapsed. Following the Fed’s further extraordinary actions in the spring — including making lines of credit available to selected investment banks and brokerage houses — many economists made note of the ensuing economic rally and proclaimed the credit crisis over and a recession averted. Roubini, who dismissed the rally as nothing more than a “delusional complacency” encouraged by a “bunch of self-serving spinmasters,” stuck to his script of “nightmare” events: waves of corporate bankruptcies, collapses in markets like commercial real estate and municipal bonds and, most alarming, the possible bankruptcy of a large regional or national bank that would trigger a panic by depositors. Not all of these developments have come to pass (and perhaps never will), but the demise last month of the California bank IndyMac — one of the largest such failures in U.S. history — drew only more attention to Roubini’s seeming prescience.

Roubini’s work was distinguished not only by his conclusions but also by his approach. By making extensive use of transnational comparisons and historical analogies, he was employing a subjective, nontechnical framework, the sort embraced by popular economists like the Times Op-Ed columnist Paul Krugman and Joseph Stiglitz in order to reach a nonacademic audience. Roubini takes pains to note that he remains a rigorous scholarly economist — “When I weigh evidence,” he told me, “I’m drawing on 20 years of accumulated experience using models” — but his approach is not the contemporary scholarly ideal in which an economist builds a model in order to constrain his subjective impressions and abide by a discrete set of data. As Shiller told me, “Nouriel has a different way of seeing things than most economists: he gets into everything.”

After analyzing the markets that collapsed in the ’90s, Roubini set out to determine which country’s economy would be the next to succumb to the same pressures. His surprising answer: the United States’. “The United States,” Roubini remembers thinking, “looked like the biggest emerging market of all.” Of course, the United States wasn’t an emerging market; it was (and still is) the largest economy in the world. But Roubini was unnerved by what he saw in the U.S. economy, in particular its 2004 current-account deficit of $600 billion. He began writing extensively about the dangers of that deficit and then branched out, researching the various effects of the credit boom — including the biggest housing bubble in the nation’s history — that began after the Federal Reserve cut rates to close to zero in 2003. Roubini became convinced that the housing bubble was going to pop.

By late 2004 he had started to write about a “nightmare hard landing scenario for the United States.” He predicted that foreign investors would stop financing the fiscal and current-account deficit and abandon the dollar, wreaking havoc on the economy. He said that these problems, which he called the “twin financial train wrecks,” might manifest themselves in 2005 or, at the latest, 2006. the end of 2006, the train wrecks hadn’t occurred.[Snip]

Kenneth Rogoff, an economist at Harvard who has known Roubini for decades, told me that he sees great value in Roubini’s willingness to entertain possible situations that are far outside the consensus view of most economists. “If you’re sitting around at the European Central Bank,” he said, “and you’re asking what’s the worst thing that could happen, the first thing people will say is, ‘Let’s see what Nouriel says.’ ” But Rogoff cautioned against equating that skill with forecasting. Roubini, in other words, might be the kind of economist you want to consult about the possibility of the collapse of the municipal-bond market, but he is not necessarily the kind you ask to predict, say, the rise in global demand for paper clips.

His defenders contend that Roubini is not unduly pessimistic. Jeffrey Sachs, his former adviser, told me that “if the underlying conditions call for optimism, Nouriel would be optimistic.” And to be sure, Roubini is capable of being optimistic — or at least of steering clear of absolute worst-case prognostications. He agrees, for example, with the conventional economic wisdom that oil will drop below $100 a barrel in the coming months as global demand weakens. “I’m not comfortable saying that we’re going to end up in the Great Depression,” he told me. “I’m a reasonable person.”

What economic developments does Roubini see on the horizon? And what does he think we should do about them? The first step, he told me in a recent conversation, is to acknowledge the extent of the problem. “We are in a recession, and denying it is nonsense,” he said. When Jim Nussle, the White House budget director, announced last month that the nation had “avoided a recession,” Roubini was incredulous. For months, he has been predicting that the United States will suffer through an 18-month recession that will eventually rank as the “worst since the Great Depression.” Though he is confident that the economy will enter a technical recovery toward the end of next year, he says that job losses, corporate bankruptcies and other drags on growth will continue to take a toll for years.

Roubini has counseled various policy makers, including Federal Reserve governors and senior Treasury Department officials, to mount an aggressive response to the crisis. He applauded when the Federal Reserve cut interest rates to 2 percent from 5.25 percent beginning last summer. He also supported the Fed’s willingness to engineer a takeover of Bear Stearns. Roubini argues that the Fed’s actions averted catastrophe, though he says he believes that future bailouts should focus on mortgage owners, not investors. Accordingly, he sees the choice facing the United States as stark but simple: either the government backs up a trillion-plus dollars’ worth of high-risk mortgages (in exchange for the lenders’ agreement to reduce monthly mortgage payments), or the banks and other institutions holding those mortgages — or the complex securities derived from them — go under. “You either nationalize the banks or you nationalize the mortgages,” he said. “Otherwise, they’re all toast.”

For months Roubini has been arguing that the true cost of the housing crisis will not be a mere $300 billion — the amount allowed for by the housing legislation sponsored by Representative Barney Frank and Senator Christopher Dodd — but something between a trillion and a trillion and a half dollars. But most important, in Roubini’s opinion, is to realize that the problem is deeper than the housing crisis. “Reckless people have deluded themselves that this was a subprime crisis,” he told me. “But we have problems with credit-card debt, student-loan debt, auto loans, commercial real estate loans, home-equity loans, corporate debt and loans that financed leveraged buyouts.” All of these forms of debt, he argues, suffer from some or all of the same traits that first surfaced in the housing market: shoddy underwriting, securitization, negligence on the part of the credit-rating agencies and lax government oversight. “We have a subprime financial system,” he said, “not a subprime mortgage market.”

Roubini argues that most of the losses from this bad debt have yet to be written off, and the toll from bad commercial real estate loans alone may help send hundreds of local banks into the arms of the Federal Deposit Insurance Corporation. “A good third of the regional banks won’t make it,” he predicted. In turn, these bailouts will add hundreds of billions of dollars to an already gargantuan federal debt, and someone, somewhere, is going to have to finance that debt, along with all the other debt accumulated by consumers and corporations. “Our biggest financiers are China, Russia and the gulf states,” Roubini noted. “These are rivals, not allies.” [Snip]

“Once you run current-account deficits, you depend on the kindness of strangers,” he said, pausing to let out a resigned sigh. “This might be the beginning of the end of the American empire.”
I first learned of Roubini's writings through Atrios (a student of economics himself), and as I kept reading Atrios' description of the great "Shitpile", my own training in economics and strategic management reminded me - medium-sized and large companies do not invest in unproven markets. Keynes was right. Demand determines production. Investment follows demand, it does not precede it.

So no effort by the government to throw money to investors will improve the economy. For the government to give money or tax breaks to investors is nothimg more than politically motivated patronage from the government. It (by itself) is economically useless unless it opens totally new but highly productive markets as did giving railroad free land to build the Intercontinental railroad. Such throwing money towards any investment is a waste of government and taxpayer assets or money. It is patronage by politicians to ensure reelection. It is Republican so-called Free-Enterprise (reelect me) patronage. It has nothign to do with true market-oriented economics. It is a waste of taxpayer money designed to get the politician reelected.

Small companies gamble that they can see a market that no one else does, so they throw investment at unseen and unproven markets. Big companies do not waste investment money that way. They wait until small companies have proven a market, then, like IBM or Microsoft, they either buy the leader in the market or they throw money at competing with them so heavily - primarily with marketing techniques rather than developing new or better products - that they dominate the market with second rate products. See MSDOS vs. CPM, or Netscape vs. Internet Explorer.

But if demand determines the level of production in an economy, where is the money needed for demand? Demand is defined as the desire for a product or service together with the money to buy it. Mere desire for a product is not economic demand.

So any evaluation of the American economy has to start with the question of where consumers get the money needed to buy the product or service. The critical equation is:
Total Demand = Consumption Demand + Investment Demand + Government Demand.
And total demand is equal to Gross Domestic Product. I'm ignoring international demand for American goods because it is so much lower than American demand for foreign goods.

Consumption is roughly 70% of the economy. It dominates everything.

Investment only goes to markets that provide proven consumption demand, so throwing money to investors is a waste of funds. Investment demand amounts to roughly 20% more of the market, but is determined by consumption demand. Investors with funds will invest overseas where the return on investment is greater. That is guaranteed, since the most globalized market in the world in the market for investment funds. There are no significant effective barriers to sending investment funds to another national market.

Government demand depends on government taxes and government borrowing. American taxes are constrained in a "No New Taxes" environment as they were in the Herbert Hoover administration and in the FDR administration before WW II. That leaves the US government limited to borrowing overseas, something that the drop in the dollar is making more difficult for lenders like China and Saudi Arabia who have a lot of dollars to lend. Bush/Cheney have pushed the limit on this, and it is only a matter of time before China and Saudi Arabia make other arrangements for their use of dollars. China will start requiring payment for their exports in Euros and so will Saudi Arabia once they have protected their dollar-denominated investments from the resulting catastrophic drop in the value of the dollar. When that happens, the bankruptcy of the American economy will become obvious. Think Argentina times 100, or even Indonesia back in the late 90's.

As far as I can see right now, this result is inexorable. Only the timing is in doubt.

Russia went through this same thing in the 90's. In the early 90's the economic statistics showed that if Russia had sold it's raw materials on the international markets without processing, they would have been more valuable than Russia's exported industrial goods. This was unique in economic history. Never before had the net industrial effort of an industrial nation subtracted from the total value of raw materials extracted in the nation.

America does not need to consider that possibility. We have already exported our industrial production jobs and we already depend on the rest of the world to subsidize our imports. America is currently worse off than Russia was in the 90's. Only the kindness of China and Saudi Arabia keep us afloat.

This is economic history, not economic mathematical modeling. But economic modeling does not work to identify major changes in economic situations.

I think that is why Nouriel Roubini is getting it right and the rest of the Economists are getting it wrong. Modern economics is tied to the mathematical models, but those models cannot predict changes in the economy. Roubini is going back to economic history and looking at the core of economics. Models get the details right when nothing major changes, but it takes a historian to recognize when the core assumptions of the models in current use are being exceeded.

Considering the large number of ways the current economy is pushing past any historical precedents, it should be obvious that current models (based on current conditions) will fail.

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