by Eric Martin
Nouriel Roubini speaks, you listen:
It is now clear that this is the worst financial crisis since the Great Depression and the worst economic crisis in the last 60 years. While we are already in a severe and protracted U-shaped recession (the deluded hope of a short and shallow V-shaped contraction has evaporated), there is now a rising risk that this crisis will turn into an uglier, multiyear, L-shaped, Japanese-style stag-deflation (a deadly combination of stagnation, recession and deflation).
With its aggressive monetary easing and large fiscal stimulus putting it ahead, the U.S. has done more [than the EuroZone]. Except for two elements, both key to avoiding a near-depression, which are still missing: a cleanup of the banking system that may require a proper triage between solvent and insolvent banks and the nationalization of many banks, even some of the largest ones; and a more aggressive, across-the-board reduction of the unsustainable debt burden of millions of insolvent households (i.e., a principal reduction of the face value of the mortgages, not just mortgage payments relief). [...]
This severe economic and financial crisis is now also leading to a severe backlash against financial globalization, free trade and the free-market economic model.
To paraphrase Churchill, capitalist market economies open to trade and financial flows may be the worst economic regime--apart from the alternatives. However, while this crisis does not imply the end of market-economy capitalism, it has shown the failure of a particular model of capitalism. Namely, the laissez-faire, unregulated (or aggressively deregulated), Wild West model of free market capitalism with lack of prudential regulation, supervision of financial markets and proper provision of public goods by governments.
There is the failure of ideas--such as the "efficient market hypothesis," which deluded its believers about the absence of market failures such as asset bubbles; the "rational expectations" paradigm that clashes with the insights of behavioral economics and finance; and the "self-regulation of markets and institutions" that clashes with the classical agency problems in corporate governance--that are themselves exacerbated in financial companies by the greater degree of asymmetric information. For example, how can a chief executive or a board monitor the risk taking of thousands of separate profit and loss accounts? Then there are the distortions of compensation paid to bankers and traders.
This crisis also shows the failure of ideas such as the one that securitization will reduce systemic risk rather than actually increase it. That risk can be properly priced when the opacity and lack of transparency of financial firms and new instruments leads to unpriceable uncertainty rather than priceable risk.
It is clear that the Anglo-Saxon model of supervision and regulation of the financial system has failed. It relied on several factors: self-regulation that, in effect, meant no regulation; market discipline that does not exist when there is euphoria and irrational exuberance; and internal risk-management models that fail because, as a former chief executive of
Citigroup put it, when the music is playing, you've got to stand up and dance.
Furthermore, the self-regulation approach created rating agencies that had massive conflicts of interest and a supervisory system dependent on principles rather than rules. In effect, this light-touch regulation became regulation of the softest touch.
Thus, all the pillars of the 2004 Basel II banking accord have already failed even before being implemented. Since the pendulum had swung too much in the direction of self-regulation and the principles-based approach, we now need more binding rules on liquidity, capital, leverage, transparency, compensation and so on.
But the design of the new system should be robust enough to counter three types of problems with rules. A tendency toward "regulatory arbitrage" should be kept in mind, as bankers can find creative ways to bypass rules faster than regulators can improve them. Then there is "jurisdictional arbitrage," as financial activity may move to more lax jurisdictions. And, finally, "regulatory capture," as regulators and supervisors are often captured--via revolving doors and other mechanisms--by the financial industry. So the new rules will have to be incentive-compatible, i.e., robust enough to overcome these regulatory failures. [emphasis added]
But seriously, isn't it about time we started heeding the advice of the people that have been right about the major economic devlopments of the past decade or so rather than, say, the Larry Kudlows and Donald Luskinsof the econo-world? Unfortunately, there's a price to pay for being prescient when you prophesy bad news, or tough times, or - gasp - the irrefutable notion that bubbles eventually pop.
The reward for such insight is induction into the Order of the Shrill or the tarring of monikers like "Dr. Doom." But really, it's just about describing reality at a time when the prevailing groupthink is hopelessly pollyannish and resentful of any voice that seeks to tamp the irrational exuberance of the day.