Table of Contents Title Page Copyright Page Introduction Chapter - The White Swan Chapter - Crisis Economists Chapter - Plate Tectonics Chapter - Things Fall Apart Chapter - Global Pandemics Chapter - The Last Resort Chapter - Spend More, Tax Less? Chapter - First Steps Chapter - Radical Remedies Chapter 10 - Fault Lines Conclusion Outlook Acknowledgments NOTES SELECT BIBLIOGRAPHY INDEX ALSO BY NOURIEL ROUBINI New International Financial Architecture (with Marc Uzan) Bailouts or Bail-Ins? Responding to Financial Crisis in Emerging Economies (with Brad Setser) Political Cycles and the Macroeconomy (with Alberto Alesina and Gerald D Cohen) ALSO BY STEPHEN MIHM A Nation of Counterfeiters: Capitalists, Con Men, and the Making of the United States Artificial Parts, Practical Lives: Modern Histories of Prosthetics (editor, with Katherine Ott and David Serlin) THE PENGUIN PRESS Published by the Penguin Group Penguin Group (USA) Inc., 375 Hudson Street, New York, New York 10014, U.S.A Penguin Group (Canada), 90 Eglinton Avenue East, Suite 700, Toronto, Ontario, Canada M4P 2Y3 (a division of Pearson Penguin Canada Inc.) Penguin Books Ltd, 80 Strand, London WC2R 0RL, England Penguin Ireland, 25 St Stephen’s Green, Dublin 2, Ireland (a division of Penguin Books Ltd) Penguin Books Australia Ltd, 250 Camberwell Road, Camberwell, Victoria 3124, Australia (a division of Pearson Australia Group Pty Ltd) • Penguin Books India Pvt Ltd, 11 Community Centre, Panchsheel Park, New Delhi-110 017, India Penguin Group (NZ), 67 Apollo Drive, Rosedale, North Shore 0632, New Zealand (a division of Pearson New Zealand Ltd) Penguin Books (South Africa) (Pty) Ltd, 24 Sturdee Avenue, Rosebank, Johannesburg 2196, South Africa Penguin Books Ltd, Registered Offices: 80 Strand, London WC2R 0RL, England First published in 2010 by The Penguin Press, a member of Penguin Group (USA) Inc Copyright © Nouriel Roubini and Stephen Mihm, 2010 All rights reserved Library of Congress Cataloging-in-Publication Data Roubini, Nouriel Crisis economics : a crash course in the future of finance / Nouriel Roubini and Stephen Mihm p cm Includes bibliographical references and index eISBN : 978-1-101-42742-2 Financial crises Business cycles Economics I Mihm, Stephen, 1968- II Title HB3722.R68 2010 338.5’42—dc22 2009053925 Without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording, or otherwise), without the prior written permission of both the copyright owner and the above publisher of this book The scanning, uploading, and distribution of this book via the Internet or via any other means without the permission of the publisher is illegal and punishable by law Please purchase only authorized electronic editions and not participate in or encourage electronic piracy of copyrightable materials Your support of the author’s rights is appreciated While the author has made every effort to provide accurate telephone numbers and Internet addresses at the time of publication, neither the publisher nor the author assumes any responsibility for errors or for changes that occur after publication Further, the publisher does not have any control over and does not assume any responsibility for author or third-party Web sites or their content http://us.penguingroup.com Nouriel Roubini: To H.H., K.S., L.S., M.M., and M.W Stephen Mihm: To my family Introduction In January 2009, in the final days of the Bush administration, Vice President Dick Cheney sat down for an interview with the Associated Press He was asked why the administration had failed to foresee the biggest financial crisis since the Great Depression Cheney’s response was revealing “Nobody anywhere was smart enough to figure [it] out,” he declared “I don’t think anybody saw it coming.” Cheney was hardly alone in his assessment Look back at the statements that the wise men of the financial community and the political establishment made in the wake of the crisis Invariably, they offered some version of the same rhetorical question: Who could have known? The financial crisis was, as Cheney suggested in this same interview, akin to the attacks of September 11: catastrophic, but next to impossible to foresee That is not true To take but the most famous prediction made in advance of this crisis, one of the authors of the book—Nouriel Roubini—issued a very clear warning at a mainstream venue in the halcyon days of 2006 On September 7, Roubini, a professor of economics at New York University, addressed a skeptical audience at the International Monetary Fund in Washington, D.C He forcefully sounded a warning that struck many in the audience as absurd The nation’s economy, he predicted, would soon suffer a once-in-a-lifetime housing bust, a brutal oil shock, sharply declining consumer confidence, and inevitably a deep recession Those disasters were bad enough, but Roubini offered up an even more terrifying scenario As homeowners defaulted on their mortgages, the entire global financial system would shudder to a halt as trillions of dollars’ worth of mortgage-backed securities started to unravel This yet-to-materialize housing bust, he concluded, could “lead to a systemic problem for the financial system,” triggering a crisis that could cripple or even take down hedge funds and investment banks, as well as government-sponsored financial behemoths like Fannie Mae and Freddie Mac His concerns were greeted with serious skepticism by the audience Over the next year and a half, as Roubini’s predictions started coming true, he elaborated on his pessimistic vision In early 2008 most economists maintained that the United States was merely suffering from a liquidity crunch, but Roubini forecast that a much more severe credit crisis would hit households, corporations, and most dramatically, financial firms In fact, well before the collapse of Bear Stearns, Roubini predicted that two major broker dealers (that is, investment banks) would go bust and that the other major firms would cease to be independent entities Wall Street as we know it, he warned, would soon vanish, triggering upheaval on a scale not seen since the 1930s Within months Bear was a distant memory and Lehman Brothers had collapsed Bank of America absorbed Merrill Lynch, and Morgan Stanley and Goldman Sachs were eventually forced to submit to greater regulatory oversight, becoming bank holding companies Roubini was also far ahead of the curve in spotting the global dimensions of the disaster As market watchers stated confidently that the rest of the world would escape the crisis in the United States, he correctly warned that the disease would soon spread overseas, turning a national economic illness into a global financial pandemic He also predicted that this hypothetical systemic crisis would spark the worst global recession in decades, hammering the economies of China, India, and other nations thought to be impervious to troubles in the United States And while other economists were focused on the danger of inflation, Roubini accurately predicted early on that the entire global economy would teeter on the edge of a potentially crippling deflationary spiral, of a sort not seen since the Great Depression Roubini’s prescience was as singular as it was remarkable: no other economist in the world foresaw the recent crisis with nearly the same level of clarity and specificity That said, he was not alone in sounding the alarm; a host of other well-placed observers predicted various elements of the financial crisis, and their insights helped Roubini connect the dots and lay out a vision that incorporated their prescient insights Roubini’s former colleague at Yale University, Robert Shiller, was far ahead of almost everyone in warning of the dangers of a stock market bubble in advance of the tech bust; more recently, he was one of the first economists to sound the alarm about the housing bubble Shiller was but one of the economists and market watchers whose views influenced Roubini In 2005 University of Chicago finance professor Raghuram Rajan told a crowd of high-profile economists and policy makers in Jackson Hole, Wyoming, that the ways bankers and traders were being compensated would encourage them to take on too much risk and leverage, making the global financial system vulnerable to a severe crisis Other well-respected figures raised a similar warning: Wall Street legend James Grant warned in 2005 that the Federal Reserve had helped create one of “the greatest of all credit bubbles” in the history of finance; William White, chief economist at the Bank for International Settlements, warned about the systemic risks of asset and credit bubbles; financial analyst Nassim Nicholas Taleb cautioned that financial markets were woefully unprepared to handle “fat tail” events that fell outside the usual distribution of risk; economists Maurice Obstfeld and Kenneth Rogoff warned about the unsustainability of current account deficits in the United States; and Stephen Roach of Morgan Stanley and David Rosenberg of Merrill Lynch long ago raised concerns about consumers in the United States living far beyond their means The list goes on But for all their respectability, these and other economists and commentators were ignored, a fact that speaks volumes about the state of economics and finance over recent decades Most people who inhabited those worlds ignored those warnings because they clung to a simple, quaint belief: that markets are self-regulating entities that are stable, solid, and dependable By this reasoning, the entire edifice of twenty-first-century capitalism—aided, of course, by newfangled financial innovation—would regulate itself, keeping close to a steady, self-adjusting state of equilibrium It all seems naïve in retrospect, but for decades it was the conventional wisdom, the basis of momentous policy decisions and the rationale for grand-scale investment strategies In this paradigm, not surprisingly, economic crises had little or no significant place Indeed, if crises appeared at all, they were freak events: highly improbable, extremely unusual, largely unpredictable, and fleeting in their consequences To the extent that crises became the object of serious academic study, they were generally considered to afflict less developed, “troubled” countries, not economic powerhouses like the United States This book returns crises to the front and center of economic inquiry: it is, in short, about crisis economics It shows that far from being the exception, crises are the norm, not only in emerging but in advanced industrial economies Crises—unsustainable booms followed by calamitous busts—have always been with us, and with us they will always remain Though they arguably predate the rise of London London Interbank Offered Rate (LIBOR) Long-Term Capital Management (LTCM) Luskin, David McCulley, Paul Mackay, Charles Madoff, Bernard Maiden Lane corporations Malaysia managers Manias, Panics, and Crashes (Kindleberger) manufacturing margin calls margin requirements markets efficiencies of failure of self-regulation of Markit Group mark-to-market accounting rules Marshall, Alfred Martin, William McChesney, Jr Marx, Karl mathematical models MBSs Mellon, Andrew Mellon Bank Menger, Carl Merit Financial Merrill Lynch Mexico bailout of swap lines and mezzanine tranche Middle East see also specific countries migrant workers Mill, John Stuart Minsky, Hyman taxonomy of borrowers of Minsky moment Mises, Ludwig von Mississippi Company monetarism monetary policy aftermath of Austrian School’s view of deflation and easy fiscal policy blurred with fiscal policy compared with to frustrate bubbles Great Depression and Great Moderation and of Greenspan Keynesian view of liquidity trap and tight money easy government guarantees for printing of remittances of migrant workers money market funds Money Market Investor Funding Facility (MMIFF) money markets money supply contraction of monoline insurers Moody’s Investor Service moral hazard bailouts and contingent capital and Fannie Mae and Freddie Mac and guarantees and money loaned to banks and principal-agent problem and shareholders and Morgan, J P Morgan Stanley mortgage lenders, nonbank collapse of mortgages default on for emerging Europe fixed-rate foreclosure on illiquidity of “originate and hold” model for rates for refinancing of reforms and securities backed by, see securities, mortgage-backed subprime Mozilo, Angelo municipal bonds National Bank Supervisor National Credit Union Administration (NCUA) nationalization Nationally Recognized Statistical Rating Organizations (NRSRO) neoclassical economics neoclassical synthesis Netherlands, see Holland New Century Financial New Deal New Orleans, La New York City New York Times New Zealand NINJA (No Income, No Job, [and no] Assets) loans Nixon, Richard M Northern Pacific Railroad Northern Rock Norway Obama, Barack (Obama administration) regulation and Obstfeld, Maurice Office of National Insurance Office of the Comptroller of the Currency Office of Thrift Supervision offshore financial centers oil price of shocks open market operations optimism Options Clearing Corporation “originate and distribute” model “originate and hold” model overnight repro financing over-the-counter (OTC) derivatives Pakistan pandemics crises compared with death of decoupling and disease vectors and emerging economies and financing of shared excesses and panics, financial of 1825 of 1837 of 1847 of 1857 of 1866 of 1873 of 1893 of 1907 paradox of thrift Paulson, Henry pension fund managers pension funds Peru peso, Argentinian peso, Mexican Philippines Philippon, Thomas Plato Poland politics crisis in Japan lobbying and Ponzi borrowers portfolio insurance Portugal pound, British poverty, the poor prices: decline in deflation and, see deflation feedback theory and future increases in of gold housing increase in monetarist view of oil real estate Primary Dealer Credit Facility (PCDF) Prince, Chuck principal-agent problem Principles of Political Economy (Mills) procyclicality production, industrial productivity proprietary trading strategies protectionism see also tariffs Prussia Public-Private Investment Program (PPIP; Pee-Pip) public works projects Putin, Vladimir quantitative easing railroads Great Britain and Rajan, Raghuram Rand, Ayn random walk theory Rashomon (film) rating agencies reforms and see also specific ratings real estate boom price of real estate bubbles in Japan recession China and deflation and in emerging Europe in Europe exogenous negative supply-side shock and fiscal policy and Great Moderation and in Japan in Latin America monetary policy and in U.S see also Great Recession Reconstruction Finance Corporation recovery in BRICs debt default and in Eurozone forms of globalization and gold and inflation vs deflation and in Japan threat of new bubble and in U.S see also reform of financial system reflation reform of financial system Basel accords and compensation and derivatives and future crises and global governance Great Depression and ratings and securitization and regulation Austrian School’s view of of bank holding companies enforcement and coordination of independence of international lax lobbying activities and Obama and reform and regulation of regulators (Quis custodiet ipsos custodes?) shadow banks and of too-big-to-fail firms see also self-regulation; specific regulatory agencies Regulation D Regulation T Regulation Z (Truth in Lending) regulatory arbitrage regulatory capture Reinhart, Carmen renminbi, Chinese Republic (Plato) repurchase agreements (repos) Reserve Primary Fund reverse auction r evolving-door appointments Ricardo, David risk: aversion to Basel accords and counterparty managing of systemic Risk, Uncertainty, and Profit (Knight) risk, uncertainty vs risk taking compensation and excessive in foreign countries moral hazard and proprietary trading strategies and securitization and underestimation of Roach, Stephen Rogoff, Kenneth Romania Roosevelt, Franklin Delano Roosevelt, Theodore Rosenberg, David Rothschild, Baron Karl Mayer von Roubini, Nouriel, predictions made in advance of crisis by Roubini Global Economics Royal Bank of Scotland Rúa, Fernando de la ruble, Russian Russia debt crisis in demand in future of Sachsen LB Samuelson, Paul Saudi Arabia savings in China current account and in emerging markets in Japan U.S savings and loan (S&L) crisis savings and loans Say, Jean-Baptiste Schumpeter, Joseph Schwartz, Anna Jacobson SDR (Special Drawing Rights) SEC, see Securities and Exchange Commission securities asset-backed (ABS) auction-rate commercial banks and default on esoteric mortgage-backed railroad rating of reforms and subprime Securities Act (1933) Securities and Exchange Commission (SEC) derivatives and employees of NRSRO category and securitization compensation and Fannie Mae and Freddie Mac and reform and standardization and self-regulation (soft-touch regulation) regulatory arbitrage and self-reliance Senate, U.S senior tranche September 11 attacks shadow banking system bank runs on coining of term defined forerunners of liquidity of regulation and shareholders of banks Shaw, George Bernard Shiller, Robert silver Singapore SIVs (structured investment vehicles) Smith, Adam Smoot-Hawley Tariff South Africa South Korea IMF loans to South Sea Bubble (1720) sovereign wealth funds Soviet Union Spain banks in Special Drawing Rights (SDR) special purpose vehicle (SPV) speculation see also bubbles speculative borrowers spending capital (capex) consumer current account and deficit Federal Reserve and government stimulus, see stimulus spending Stability and Growth Pact Stabilizing an Unstable Economy (Minsky) stag-deflation stagflation Standard & Poor’s (S&P) 500 Stand-By Arrangement (SBA) state government fiscal policy and regulation and Steinbrück, Peer stimulus spending in China in Japan Keynesian view of stock bubbles stock market, U.S crashes of reforms and stock markets foreign stocks of banks Internet of Mexico preferred shares of prices of railroad restricted shares of structured investment vehicles (SIVs) student loans Sturzenegger, Federico Suez Crisis (1956) Suharto Summers, Lawrence supervision lax supply side, reforms on surety bonds surpluses, current account Sutton, Willie Swap Financing (retitled The Das Swaps & Financial Derivatives Library) swap lines Sweden Swiss National Bank Switzerland Taft, William H Taleb, Nassim Nicholas Tangible Common Equity (TCE) tariffs TARP (Troubled Assets Relief Program) tax credits taxes cuts in increase in tax rebates TBTF, see too-big-to-fail (TBTF) firms tech boom tech bubble tech bust technological innovation TED spread Temin, Peter tender option bonds Term Asset-Backed Securities Loan Facility (TALF) Term Auction Facility (TAF) Term Securities Lending Facility (TSLF) Thailand Théorie de la spéculation (Bachelier) This Time Is Different (Reinhart and Rogoff) Tier capital Tier capital Time Times (London) Tokyo too-big-to-fail (TBTF) firms capital adequacy ratios and international approach to living wills and special bankruptcy regime and see also specific firms too-interconnected-to-fail firms trade barriers to deficits global globalization and surplus Trade Reporting and Compliance Engine (TRACE) traders compensation of as regulators trade wars transfer payments transparency lack of Travelers Treasury, U.S bills bonds Treatise on Money, A (Keynes) Triffin, Robert Triffin’s Dilemma Troubled Assets Relief Program (TARP) trust companies Trust Company of America tulip bubble Turkey UBS Ukraine IMF loans to uncertainty risk vs underemployment equilibrium unemployment in emerging economies fiscal policy and in Great Depression Keynes’s views on recovery and unemployment benefits United Kingdom Financial Services Authority in future of United States Bretton Woods system and cooperation issue and current account deficit of current account surplus of debt, foreigners’ purchase of decline of demand in as emerging market empire of foreign investment in Great Moderation and housing bubble in housing bust in Latin American debt crisis and in Mexican bailout pandemics and panics in railroads and recovery in Roubini’s predictions for savings and loan crisis in savings in, see savings, U.S spread of financial crisis from stagflation in trade deficit of uninsured deposits in Unocal Uruguay U.S Central Value at Risk model (VaR) Van Buren, Martin Vienna Vietnam Vietnam War Volcker, Paul Wachovia wages and income current account and decline in disposable of hedge fund managers from migrant workers rise in see also compensation Wall Street educated workers attracted to greed and Greenspan put and regulators compared with employees of vanishing of Walraséon Washington Mutual Washington Post Wealth of Nations (Smith) Weill, Sanford Wells Fargo WesCorp Western Europe see also specific countries White, William white swans World Bank World War II Yeltsin, Boris yen, Japanese Yom Kippur War yuan, Chinese z ero-interest-rate policy (ZIRP) Zhou Xiaochuan ... Library of Congress Cataloging -in- Publication Data Roubini, Nouriel Crisis economics : a crash course in the future of finance / Nouriel Roubini and Stephen Mihm p cm Includes bibliographical references... Cheney was hardly alone in his assessment Look back at the statements that the wise men of the financial community and the political establishment made in the wake of the crisis Invariably, they offered... not acting as a lender of last resort, making lines of credit available to faltering banks and financial institutions Had the Federal Reserve prevented the waves of bank failures in the early