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Tuesday, December 25, 2007

Nouriel Roubini: Too Little, Too Late

Nouriel Roubini sees a hard landing ahead (though Jim Hamilton says "The bears must wait another quarter"):

The Global Economy’s Inevitable Hard Landing, by Nouriel Roubini, Project Syndicate: In recent weeks, the global liquidity and credit crunch that started last August has become more severe. ... To be sure, major central banks have injected dozens of billions of dollars of liquidity into the commercial banking sector, and the US Federal Reserve, the Bank of England, and the Bank of Canada have lowered their interest rates. But worsening financial conditions prove that this policy response has failed miserably.

So it is no surprise that central banks have become increasingly desperate... The recent announcement of coordinated liquidity injections by the Fed and four other major central banks is, to be blunt, too little too late.

These measures will fail ... because monetary policy cannot address the core problems underlying the crisis. The issue is not just illiquidity – financial institutions with short-term liabilities and longer-term illiquid assets. Many more economic agents face serious credit and solvency problems, including millions of households in the US, UK, and the Eurozone with excessive mortgages, hundreds of bankrupt sub-prime mortgage lenders, a growing number of distressed homebuilders, many highly leveraged and distressed financial institutions, and, increasingly, corporate-sector firms.

At the same time, monetary injections cannot resolve the generalized uncertainty of a financial system in which globalization and securitization have led to a lack of transparency that has undermined trust and confidence. When you mistrust your financial counterparties, you won’t want to lend to them, no matter how much money you have.

The US is now headed towards recession, regardless of what the Fed does. ... Other economies will also be pulled down as the US contagion spreads.

To mitigate the effects of a US recession and global economic slump, the Fed and other central banks should be cutting rates much more aggressively... The Fed’s 25-basis-point cut in December was puny relative to what is needed; similar cuts by the Bank of England and Bank of Canada do not even begin to address the increase in nominal and real borrowing rates that the sharp rise in Libor rates has induced. Central banks should have announced a coordinated 50 basis-point reduction to signal their seriousness about avoiding a global hard landing.

Likewise, the European Central Bank’s decision not to cut rates ... is mistaken..., the ECB is virtually ensuring a sharp euro-zone slowdown.

In any case, the actions recently announced by the Fed and other central banks are misdirected. Today’s financial markets are dominated by non-bank institutions – investment banks, money market funds, hedge funds, mortgage lenders that do not accept deposits, so-called “structured investment vehicles,” and even states and local government investment funds – that have no direct or indirect access to the liquidity support of central banks. All these non-bank institutions are now potentially at risk of a liquidity run.

Indeed, US legislation strictly forbids the Fed from lending to non-depository institutions, except in emergencies. But this implies a complex and cumbersome approval process and the provision of high-quality collateral. And never in its history has the Fed lent to non-depository institutions.

So the risk of something equivalent to a bank run for non-bank financial institutions, owing to their short-term liabilities and longer-term and illiquid assets, is rising – as recent runs on some banks (Northern Rock), money market funds, state investment funds, distressed hedge funds suggests. There is little chance that banks will re-lend to these non-banks the funds they borrowed from central banks, given these banks’ own severe liquidity problems and mistrust of non-bank counterparties.

Major policy, regulatory, and supervisory reforms will be required to clean up the current mess and create a sounder global financial system. Monetary policy alone cannot resolve the consequences of inaction by regulators and supervisors amid the credit excesses of the last few years. So a US hard landing and global slowdown is unavoidable. Much greater and more rapid reduction of official interest rates may at best affect how long and protracted the downturn will be.

    Posted by on Tuesday, December 25, 2007 at 03:42 PM in Economics, Housing, Monetary Policy, Regulation | Permalink  TrackBack (0)  Comments (27)

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