Final risk. The increasing asset prices we’ve seen since March for everything: global equities; in US, equities; EM [emerging market] asset classes; commodity; credit; everything around the world is driven by one factor.

Doom Transcripts: Index & Guide

The penultimate risk was merely the prospect of World War III breaking out.  Fortunately Nouriel was running overtime so Alex had to cut him short just before he got to the scary bit ;)

UPDATE (11/6): Here’s Nouriel’s Nov 4th expansion on the idea

Housing Doom is pleased to present a fourth selection from our under-construction transcript of the American Enterprise Institute’s October 22, 2009 event "The Deflating Bubble, Part VI: The Lessons of the Bubble and Crisis".1

The event site has a number of resources, including an audio and video of the proceedings. There is as yet no official transcript.

Dr. Doom was batting cleanup …

Nouriel Roubini: [0:37:03] OK. Tom spoke about housing and mortgages. What Chris spoke about — the banks. So I’ll try to speak about the economy and what’s going to happen to the economy looking ahead.

We’ve had the most severe recession and financial crisis since the Great Depression. Given the monetary and fiscal stimulus and the backstopping of the financial system now we’re close to the bottom, at least on a temporary basis.

And now the debate is, of course, on what’s going to happen — the shape of the recovery. Given what has happened in the markets I would say the markets are pricing now a V-shaped recovery with rapid return to potential growth, and that’s even what the macro forecasters’ consensus is.

There is a second view, which is the one I share, is that this recovery is going to be at best an anaemic, subpar, below trend, with growth well below trend for the next couple of years, much as in the US, but also in advanced economies. So more like a U-shaped recovery. That’s also the view of the IMF and the one of those folks at PIMCO who are talking about A New Normal.

But there is also a third view. The view that actually we might have kind of like a double-dip, a W-shaped kind of recession. And when I speak about that idea with people like George Soros he says there’s going to be a double-dip, there’s going to be an inverted square root, meaning it will go up, we go down, and then we go back to an L essentially, because we’re going to run out of policy bullets if there’s a second dip.

So what’s going to be the outlook? V, U, W? I assign about 60 percent probability the U, about 25 or so to a W, and less than 20 to a V, I think that the chances of a rapid recovery of growth, are very, very slim.

Why? First observation is about the labor market. And unemployment rate is almost 10 percent. If you include in the unemployed discouraged workers and partial employed its already 17 percent. It’s true we’re not losing 700,000 jobs a month like in January, it’s only 260[,000]. But during the last recession, it was only 150[,000]. And the last recession was mild, with only 8 months. And we had job losses continuing after the recession was over in November 2001 all the way through August 2003 — job loss, and then jobless recovery.

This time around it’s going to be just the same, only worse. The ratio between applicants and vacancies is 6/1, the ratio of continuing to initial claims is as high as ever, the average duration of unemployment is as high as ever.

And the point is that the losses of labor income are not deriving only from the job losses; because, as you know, labor income is the product of … jobs TIMES hours TIMES average hourly wages.

And now as a way of sharing the pain, many firms are telling their workers, "let’s cut hours; let’s accept furloughs; and also let’s accept a lower average wages." The full time equivalent of the loss of hours in the United States is another 3 million full time jobs lost on top of the [0:40:00] 7.2 million that were lost formally. So the effects on labor income have been massive.

And with collapse in labor income, how are you going to have a recovery of consumption?

Second observation: This is not your typical kind of recession because inflation gets out of hand, the Fed puts a brake and then you go into a recession and then you take the brake away and you have a rapid recovery which is V-shaped. This, we agree, is it’s the kind of a recession driven by over-leverage and debt accumulation — a balance-sheet recession: debt accumulation of the housing sector, of the financial system, and also the factor of the corporate sector.

And while there is a lot of talk about deleveraging, when you look at the debt ratio of the private sector, they’re not rising any further, they have stabilized at a very high level and they’re barely falling. And instead, as a way of socializing the private losses, we have now had a massive releveraging of the public sector. We’ve huge budget deficits and debt accumulation.

Net US debt as a share of GDP is going to double from 40 to 80. Officially we’re estimating a cumulative $9 trillion deficit over the next decade.

Now, if you take this interpretation of the crisis as being a debt crisis, there are at least another 5 reasons, in my view, in addition the weakness of the labor market, why it’s going to be at best an anaemic recovery, and at worst, a double-dip.

First one: The US consumer — and it’s not just the US consumer, it’s also the consumer in all the countries that have large current account deficits and housing bubbles: is UK, is Ireland, is Iceland, is Spain, is the Baltic states, is Dubai, is Australia, New Zealand — so this consumer is shopped out, saving less, debt burdened.

And even when GDP growth is going to become positive, consumption growth has to be smaller than GDP growth as a way of rebuilding savings and reducing the leverage ratio. But since consumption is 70 percent of GDP, then if consumption grows less than GDP then GDP growth has to be very weak, unless other components of aggregate demand are growing much faster. And I’ll argue they’re not going to grow much faster.

So that’s the first and crucial point — the US consumer has never been squeezed so much, both in terms of his P&L [profit and loss] and balance sheet. Savings rates have gone now from zero to 4. IMF estimates have it go to 8 percent so it will be a significant further slowdown in consumption.

Second point: In the typical V-shaped recovery investment, capex [captial expenditure] spending grows much faster than GDP. That’s why you have a V-shaped recovery. But this time around I don’t think there’s going to be any robust growth in capex spending, leaving aside even housing that is in the doldrums. And the reason is very simple. Capacity utilization in the United States today is 70 percent. Capacity utilization in the Eurozone is 70 percent. Is the lowest we’ve had in decades in any recession. Capacity has to be at least 80 / 85 percent before you see any pickup in investment.

The point is, if a third of capacity is not utilized, why would anybody want to do more capex spending? There’s a glut of capacity and you’re not using a third of it. So why would you want to do capex? There is not going to be any significant recovery of capex spending.

Third point: The damage to the financial system and to credit growth. It’s not just the damage, of course, to the traditional banks. You know the big ones have been backstopped, but we have 100 of them that have been closed by the FDIC, and those that are on the critical list is another 479 so far. Most likely is going to increase.

So is not just the small banks, the medium sized banks, that are in trouble, but more crucially, most of the Shadow Banking System, the non-bank financial institutions, has been either destroyed or severely damaged. 350 non-bank mortgage lenders gone. SIVs and conduits gone. Securitization, as Tom was saying, died 2 years ago and there’s none of it in the private sector. Hedge funds had to deleverage. Private Equity funds are having problems with LBOs which should never have occurred. AIG; Fannie & Freddie; Citi; Bear Stearns; Lehman; finance companies — massive amount of distress in the Shadow Banking System.

The point being, today credit growth in the financial system is negative. And as Chris was pointing out, there is not even credit growth through the corporate system. But even if and when credit growth is going to become positive, credit growth is not going to be as robust as the go-go years, in which were the high growth of the economy because of a credit bubble and a credit boom.

And if you don’t erect any credit growth, how are you going to finance capex spending? How are you going to finance residential investment? How are you going to finance construction of new homes? How are you going to finance consumption of durable goods?

So we’ve low credit growth, we’re going to have a slower growth of the economy.

Fourth point about the fiscal stimulus: The fiscal stimulus in the US and other countries by the middle of next year becomes a fiscal drag. And if there is not any means for recovery of private demand, and I argue why there is not going to be a recovery of private demand, then you’ll have a problem with growth again slowing down sharply.

And if instead [0:45:00] we decide to increase that fiscal stimulus — again we have another fiscal package or a series of other ones and we keep on monetizing them — eventually that’s going to crowd out the recovery. Monetization of large fiscal deficit through a number of channels going to be crowding out the recovery.

Finally point about the U [-shaped recovery] from a global point of view. For the last decade the US and a bunch of deficit countries were the consumer of first and last resort; spending more than their income, running current account deficits. And on the other side you had China, Germany, Japan, emerging Asia, Latin America were producer of first and last resort; spending less than their income, running current account surpluses.

Now the over-spending countries have to retrench private domestic spending, because they have to save more and they have to deleverage, and that’s just happened, not just the US but in all those overspending countries.

But if they overspent, now they’ll spend less, and their trade deficits are shrinking, and therefore the surpluses of the surplus countries are also shrinking. Then unless the over-saving countries compensate for the reduction in spending of the over-spender by reducing their own savings rate and increasing their own domestic private spending, then globally, where you have a glut of capacity — and that glut of capacity is becoming bigger, because now China is doing another round of capital intensive[ph] over-capacity investment.

So you have a glut of capacity globally, and the recovery of global aggregate demand is going to be slower than otherwise. And therefore you’re going to have essentially an anaemic recovery of the global economy.

That’s the best scenario. That is a U. I see many reasons why we could have a double-dip. Why could we have a double dip?

First of all, the risk of a significant policy mistake of one sort or another. And the way I see the exit strategy problem is: damned if you do, damned if you don’t. What do I mean by that?

We know that fiscal deficits of this sort of $1 trillion per year are unsustainable. And monetization of them eventually[ph] is going to be a disaster.

Suppose you take this deficit seriously, and you decide to raise taxes or cut spending sooner rather than later and to mop up the liquidity sooner rather than later. Then you’re making a mistake. Because demand in the private sector has not recovered, taking away the policy stimulus is going to push you back into stag-deflation. Is the same mistake Japan made between ‘98 and 2000, when they introduced a consumption tax and then moved away from ZIRP too soon. Same mistake FDR made in ‘37 when he raised taxes and took the monetary stimulus. In both cases you had a double-dip recession or depression.

So if we take away the stimulus too soon, stag-deflation.

But let’s suppose we don’t take it away, because in the US, at least, the policymaker realize they don’t want to do that. If you talk in private or public to Bernanke, Geithner or Summers would say, "We shouldn’t exit too soon." Then you have a runaway fiscal deficits. These deficits imply that next year with unemployment at 10 percent, and it stays above $1 trillion. Then you might have a universal healthcare plan that might not be fully funded. Then you’re going to add a series of mini fiscal stimuluses. You will extend the unemployment benefit for those who’ve expired. You’re going to have to help him bail out State and local governments. You might extend Cash for Clunkers, you might extend the First-Time Homebuyer’s Tax Credit. You might have a tax credit for hiring workers. You might even have another round of shovel-ready labor-intensive infrastructure projects. You add it all up, is another $200/$300 billion.

And then at some point by the middle of next year the bond market vigilantes, who’ve been asleep at the wheel so far, they’re going to wake up and say, "Wait a moment. Politically you cannot raise taxes, and you cannot control spending. And therefore the path of least resistance becomes to keep on running the printing presses." And if you do that, you don’t need to tell a Zimbawist story of hyperinflation, it’s enough that expected inflation starting in 2012 goes up by, say, 200 basis points, and then 10-year treasuries go from 3 1/2 to 5 1/2, mortgage rates go to 7 1/2, other private rates go to 10 percent or above, and then you crowd out the recovery again.

So damned if you do, and damned if you don’t.

And the policy path that gets you to do the exit and do it right is a very narrow-edged, razor-edged and difficult. And the risk, especially in an election year, of making a policy mistake on one side or the other is significant.

Additional point about a double-dip. Oil prices now have gone from $30/bbl to $80/bbl and above at a time when demand is back to 2005 level, and the inventory is at an excess supply like never before. Why? It’s not fundamentals. Is a game. The wall of liquidity and the bubble chasing these assets. Last year, oil at $145/bbl kept the global economy in a global recession. It was not just Lehman and the fallout from it. When oil it came at $145/bbl was a negative in terms of trade, a real disposable income shock in the US, the Eurozone, Japan, China, India and every other oil importing country in the world.

Today we are already at $80/bbl. We’ve just a weak recovery of the global economy. [0:50:00] Now that the ETF and the option traders and the speculators are starting to crank up the stuff, oil’s soon enough going to be at $90/bbl, and then $100/bbl. And if it’s admitted, oil at $100/bbl early next year, it’s going to have the same effect on the global economy as oil at $145/bbl last year.

Why? When oil was at $145/bbl, most of the global economy was still growing. Today instead we have a global economy that’s collapsed. The worst recession in 60 years is barely on its knees trying to rise. And if oil goes to $100/bbl it’s going to be like a hammer hitting you in the head from the back, and push you back into another recession. And oil is going up not because of fundamentals but because of speculation and it’s becoming dangerous.

Third point. There are also geostrategic risks. I would not rule out that there is going to be a military confrontation between Israel and/or the United States and Iran on the question of nuclear proliferation. If that were to happen, of course, you’ll have just a threat even of a blockage of oil leading to oil prices doubling overnight, and another global stag-deflation. And that’s something that you have to worry about.

Final risk. The increasing asset prices we’ve seen since March for everything: global equities; in US, equities; EM [emerging market] asset classes; commodity; credit; everything around the world is driven by one factor.

You have one easy monetary policy around the world, almost everywhere — zero interest rates in most countries. But more importantly, is driven by the fact that in the United States, not only are you at zero interest rates, and expected to stay at zero, but the Fed, essentially, by buying $1.8 trillion of treasuries, MBSs, Agency Debt, is a major seller of volatility and is keeping the volatility of asset prices very low, both on the short end and the long end.

And therefore the bet that everybody’s doing is borrowing dollar at zero interest rates and buy any other asset in the world.

Now you’re not borrowing at zero interest rates, you’re borrowing at negative rates to the tune of 20 / 30 percent annualized. Why? Because with the dollar falling, you have a capital gain on essentially going short in dollars and long in other global assets.

So you’re borrowing at minus 30 percent, and everybody, the people think they’re geniuses because everybody’s up, any asset manager — is just anyone can do it. Borrow in dollars, buy any asset in the world. Could be in China, could be in India, could be in Brazil, could be in Russia; could be commodities, could be equities, could be credit, could be anything under the sun. It’s all going up, and not only is it going up, but they’re all perfectly correlated.

So you are in a situation that in terms of Value At Risk is the scariest one, because you have now correlation among all assets that are going back to 1.

And volatility is now down close to zero. So it looks like you are safe. But everybody’s doing the same bet, you have the Mother of All Carry Trades. You have the Mother of All Asset Bubbles. And the dollar cannot keep on falling down to zero. At some point the music is going to stop. Something’s going to reverse, and when the reversal occurs, like it happened to the yen in 2006, could have the dollar swinging back 30 percent overnight? Because you’ll have unraveling of the carry trades, and everybody was long in that stuff and leveraged. Is going to collapse the asset that they bought.

So we’ll have another crash that’s going to be bigger than the one we had last year.

So we’ve created the biggest asset and credit bubble of all through this US monetary policy. They can’t raise the dollar. On the other side, either they have to intervene now, to prevent their currency from appreciating (that’s unstabilizing intervention that feeds their bubble) or like Brazil they’re imposing capital controls, or to have to ease further to prevent their currency from appreciating, and it creates more of a monetary easing around the world.

So we’re creating the biggest bubble ever, and it’s going to come crashing. Because when the music is going to stop, it’s going to get ugly.

So, in conclusion, if we’re lucky we’re going to get the U, most likely it’s going to be a W, and when things going to occur, is going to be scary. Is going to be scary for the following reason …

Alex Pollock: On that note, we’re going to have to wrap up. But do we take as your main lesson that we’ve addressed one bubble by creating another one?

Nouriel Roubini: A bigger one. Yes. [0:54:06]

Notes and References

[1]: "The Deflating Bubble, Part VI: The Lessons of the Bubble and Crisis", AEI event homepage, October 22, 2009.