We know booms and busts are aspects of capitalism, and have been so historically. Many of them have been driven by a technological innovation--whether it was the railroad or the Internet--and they may create bubbles, fraud and eventual losses. But they are also driven by real innovation. This latest crisis we see today differs from such historical examples in two important elements. First, with housing there was no technological revolution of any sort. We still build homes basically the same way we did 50 years ago. The innovation in this instance was financial. We went from a system where banks held mortgages on their books to one in which banks originate mortgages, and then securitize and distribute them. The idea was to reduce systemic risk by getting the risk of holding mortgages out of the banks and into the capital markets, and out of the United States and into the global economy. Of course, as we see now with subprime, that has brought a massive contagion in financial markets that is now affecting the real economy.
Comparing with some recent financial crises, I think it's worse than 1987, when we just had a stock-market crash. It's worse than the savings and loan crisis of the late 1980s, because the contagion then was generally limited to the savings and loan thrifts and commercial real-estate sectors. It is much worse than the Long Term Capital Management crisis of 1998. That was a liquidity problem. Today we have insolvency problems. It is much worse than the tech bust of 2000 and 2001, when most of the problems were confined to the tech sector and we had a mild recession. You have to go back to the Great Depression for something comparable. We are, of course, far short of a Great Depression now, but in terms of systemic risk and the risks of a financial meltdown, you almost have to go back that far to find a good analogy.
Roubini is a professor of economics and international business at New York University's Stern School of Business.
What's happening now is not at all special, but follows the well-trodden paths of past financial folly. As my work with Carmen Reinhart of the University of Maryland shows, the most important determinant for the depth of a financial crisis is the size of the initial hit to the system. Unfortunately, we don't know that yet. If it's just the money lost on subprime—losses of perhaps $300 billion to $400 billion—it will be a medium-size crisis, not an epic one. It would be comparable to the S&L crisis in the late 1980s. But if the slowdown deepens and losses spread to credit cards, high-yield corporates and other mortgages, it could be much worse.
It is early days still. The U.S. economy is probably experiencing mildly negative growth right now. If we have no bad news like a slowdown in China or geopolitical problems in the Middle East, we'll just have a mild recession in the United States and recovery setting in by the year-end. The rest of the world will feel some pain, but the global economy itself will not go into recession. Does that mean not to worry? I am afraid not. The problem is, the U.S. economy is very vulnerable—think of someone with a bad cold who has not slept much for a week. The resiliency of the U.S. economy is down, and a year is a long time for nothing else to happen. Unfortunately, given the underlying problems of a deflation in the housing bubble and an apparent slowdown in productivity growth, there is not a lot policymakers can do. The U.S. fiscal package, besides tying the hands of the next president by making the budget problem worse, is not likely to help.
It's pretty simple--you either believe in globalization through increased border-trade linkages, or you believe in decoupling. But it's intellectually dishonest to believe in both. There's no region of the world that is more externally driven than developing Asia, which is where I live now. Exports represent 42 to 43 percent of pan-regional GDP, a record high. Private consumption represents 48 percent, a record low. So how is this region going to decouple? Advocates of decoupling would point to all the young consumers in China and India. But consider that the U.S. consumer last year spent $9.5 trillion. Chinese consumers spent about $1 trillion, and Indians about $650 billion. The power of the American consumer is still six times that of this new "Chindian" consumer. It's mathematically impossible to see a major decrease in U.S. consumption being made up by the Chinese and Indians. And there will be a meaningful decrease in U.S. consumer spending.
I believe the United States is in recession. The consumption share of GDP in the U.S. is 72 percent (a record) versus 48 percent in developing Asia. The housing market has driven U.S. consumption, as well as the credit bubble. Both have now burst. Consumers will now have to save the old-fashioned way--out of income--and the consumption share of GDP will likely drop to the 25-year trend level of about 67 percent. That's a big shift, and we need it to correct our current account deficit. But it will mean a full-blown U.S. recession that will be longer and deeper than most think, and will have repercussions throughout the world. Japan could fall into recession. Europe will narrowly avoid it, and there will be meaningful shortfalls in growth in much of Asia.
Robert J. Shiller
It's no surprise that the subprime debacle is continuing to fuel last week's market turmoil. The world is currently emerging from the biggest real-estate bubble in more than 100 years. Perhaps the best historical analogy to today's situation is the bubble that developed and deflated throughout the 1920s and '30s. In the four years leading up to 1925, there was a 19 percent increase in real home prices, and then prices fell 13 percent from 1925 to 1932. In comparison, from 1997 to 2006 there was an 85 percent increase in real home prices, followed by a fall of less than 10 percent so far. The 1920s bubble was due in part to a euphoria driven by a technology boom, including the advent of radio and the mass production of the automobile. As people began to drive, there was a sense that the world would run out of land. Resort areas like Florida, now accessible by car, boomed. Then, as now, there was also an explosion of easy credit. In fact, mortgage defaults were a substantial part of the Great Depression. One crucial difference: the government back then did a lot more to cushion the fallout, instituting major public programs to bail out homeowners. By comparison, the Bush administration has done very little. To me, that's a problem. The idea that we should simply let average citizens take the pain seems unjust--there are a lot of innocent victims of the subprime debacle. I think we need more substantive public-policy responses to the crisis. In the future, there should also be safeguards against mass defaults. People need more protection.
Shiller is a professor of economics at Yale University and a cofounder of MacroMarkets LLC.
I've spent most of this decade writing about the strengths of the major developing countries, but this year I'm not so sure. Sure, the big picture is still bright for Brazil, Russia, India and China, the emerging-market powerhouses known as BRICs. Look a bit closer, though. The key word is "valuations." There's been just a persistent, fantastic increase in emerging-market assets, driving expectations of even more-incredible gains. But assets in China and India aren't cheap anymore. That means these countries are vulnerable to any kind of disappointing news.
But what about decoupling--the notion that thanks to booming demand from China, the emerging markets can get by and perhaps even flourish in the teeth of a downturn in the United States? Not quite yet. It's one thing to talk about China and the world decoupling when the United States was growing just below the trend, as in 2007. But that's almost impossible in a recession. The United States is 30 percent of the global economy, and China is only 7 percent. For now, I'm betting on recoupling. The world cannot ignore a U.S. recession. What's more, the latest data make it pretty clear that China is losing some momentum. China and the United States represent 55 to 60 percent of global growth. You don't need to do much math to know that the emerging markets are not the place to be this year. On a selective basis, perhaps. But for a while, at least, I'd say maybe it's time to give BRICs a bit of a rest.
O'Neill, a senior economist at Goldman Sachs, specializes in emerging markets.
'A Return to Growth'
First the seizing up of money and credit markets, now the mini-crash in stock prices. The twin shocks will hurt economies around the world. But Europe is relatively well placed to deal with the fallout and rebound afterward. The credit upheaval makes it more difficult to borrow. Fortunately, many European companies are well capitalized and do not depend on easy credit for much of their growth. Most households in the 15 euro countries rely less on loans to finance purchases than consumers in the United States and the United Kingdom.
The same goes for the stock-market gyrations. Major European markets have fallen by roughly 14 percent this year. In unsettled markets, companies may find it more difficult to raise capital, and may shy away from building plants or hiring workers, but this is not yet happening in Europe. Last week, with markets plunging, business confidence improved slightly in Germany and held steady in France. Lower stock prices can also discourage consumer spending, but this effect is smaller in Europe than in the United States. For every dollar lost on the markets, Americans reduce their consumption by 2 cents, Germans and French only by 1 cent.
Bottom line: euro-zone growth will probably fall far below its 2 percent trend rate in early 2008. Stagnation is a serious risk. But the setback should be temporary. Most European domestic fundamentals are sound. The chance that the external shocks will fade later this year also supports our view that the euro zone can return to substantial growth in late 2008.
'Tug of War'
Mohamed A. El-Erian
Bond and equity markets swung widely last week as concerns about a U.S.-led global downturn gave way to excitement that policymakers were finally responding. What are global investors to make of all this volatility? First, it speaks to the tug of war between worrisome economic and financial trends and corrective policy moves. Second, it highlights differences in the reaction speed of market participants and policymakers, both of which are navigating an extremely fluid situation. Finally, and most important for the longer term, it illustrates the extent to which market and policy infrastructures have failed to keep up with the range of activities enabled by global economic transformations and financial innovations.
The world is now engaged in a massive process of catch-up. Through the combination of a fiscal response and an emergency interest-rate cut, the United States has signaled an understanding of the severity of the situation facing its economy. At the same time, we are starting to see evidence of more-decisive actions on the part of new CEOs at major Wall Street firms that declared large losses in the past few weeks (such as Citigroup and Merrill Lynch). On both counts, there should be little doubt as to the willingness to react. But this does not necessarily signal the end of the phase of high volatility. There remains a legitimate question as to the impact. Accordingly, investors would be well advised to keep their seat belts tightly fastened.
El-Erian is co-CEO and co-CIO of PIMCO. He was previously president and CEO of Harvard Management Co.
When sorrows come for markets, they come--to borrow a line from Hamlet--not in "single spies but in battalions." The news flow out of the U.S. economy had been deteriorating for many months, but global investors were hoping emerging markets led by China would save the day. But they will not be the havens of growth they had been in years past. Policymakers in these markets are more concerned about containing inflation than the U.S. slowdown--and for good reason: it is rising in four out of five developing countries and has accelerated, on average, by nearly 2 percentage points over the past six months. In many countries, inflation is now beyond the tolerance limit, often defined as a headline rate of 5 percent. The latest data out of China for December show consumer price index inflation running at 6.5 percent--close to a 10-year high. Rising food prices have accounted for 80 percent of the increase. The price leaps in China have triggered growing discontent. So for the first time in 15 years, Chinese policymakers are resorting to price controls. The good news is that inflationary pressure remains modest outside the food sector, and there is little reason to believe it will spread. Productivity growth remains high and wages are rising slower than the rise in output. But bull markets thrive on high growth and benign inflation--the two conditions that defined the global economic environment over the past five years. With the United States teetering on the brink of a recession, the world needs emerging markets--the growth leaders of this decade--to pick up the slack, just as the United States did in the late '90s following the Asian economic crisis. Back then, the U.S. Federal Reserve was able to cut interest rates and cushion the blow from emerging markets. But with China and other developing economies more preoccupied with fighting inflation than offering any stimulus, the bull market in emerging-market equities will remain suspended until the food inflation scare passes away.
Sharma is head of global emerging markets at Morgan Stanley Investment Management.
'Averting the Abyss'
The world is in an old-style financial panic out of the late 19th or early 20th century. Investors today, just as then, are human beings subject to extremes of greed and fear. Accountants and auditors are human also, and they are being pilloried for past sins of negligence and misconduct. I strongly suspect they are overreacting by compelling huge markdowns of the subprime paper held by their bank clients. Everyone is scared to death of being sued in a litigious world. These write-downs are crushing earnings, reducing book values and causing steep falls in the share prices of financial institutions.
This has happened before in banking crises. Sometimes the result was write-ups later of the value of the paper. It happened most recently in Asia in the late 1990s. This time, though, the scope of the crisis is far larger, and both the write-downs and the write-ups may be even greater. A lot depends on whether the financial contagion spreads and the United States and world economy slip into a prolonged period of stagnation and deflation like Japan. If so, the current conservative valuations will prove to be correct. On the other hand, the "authorities" in the United States (the Fed and the government) are now providing liquidity and spending stimulus. Unfortunately the European Central Bank still doesn't get it even though the European banking system is in just as much trouble as America's. The other factor in averting the abyss will be whether this year the United States and then the world economy falls into recession. The consensus believes it will, and in fact many loud voices say it already has. A U.S. recession could drag the world into recession and would set off a new round of contagion in leveraged debt. However, the data from the United States and the world at this moment do not support the recession conclusion. Meanwhile, stocks in the United States, Europe and Japan are cheap on all the valuation measures we use. Emerging-market equities are volatile but, considering their much faster growth prospects, they are intriguing. When the abyss is on the front page, as it is now, I am inclined to bet against the doomsayers.
Is the American credit crisis like the Japanese banking crisis of the 1990s? No. The key difference is between a liquidity crisis and a capital crisis. I don't see the systemic risk of a capital shortage like we had in Japan. That's the most important point. There are also similarities—for instance, the fact that the problem wasn't the bursting of the bubble, but mismanagement by the banks. Central banks can deal with a liquidity shortage, as we saw with the Federal Reserve's action last week. The Fed might have acted a little earlier, but by and large its reaction has been correct. The question is, will this create a capital shortage? I don't think so. Consider Citigroup. Last week its newest capital issue drew $25 billion in investor demand. The volume of recapitalization in the banking sector is massive. But it indicates there is still capital, and that we're not moving from a liquidity shortage to a capital shortage. The bigger danger is a second problem, the effect on household consumption and the macroeconomic slowdown we'll see in the second half of the year. This macro effect is more serious than the banking crisis. I don't believe in decoupling, and the slowdown in the United States will hit Asia hard.
The biggest risk factor is mismanagement and overreaction. Investors are reacting too negatively to the banking issue. The disclosure system is much better than it was in Japan, where banks hid their bad loans for 10 years and CEOs weren't fired. But it could still be better. There is a real risk of protectionism, as we're seeing in the reaction to sovereign wealth funds. With so much uncertainty, people will act on the worst assumptions. Everything is based on people's expectations. Finally, let's not blame the United States for everything. Japan and China have their own domestic economic problems that feed into this.
'We Need Greater Transparency'
On industry regulation: I think we are going to need more regulation in certain areas of the finance industry. For several years, you've had a Republican Congress and a Republican executive branch that have given freer reign to market forces, and have been less interested in the role of government in these issues. I think now we're going to see more insistence on better disclosure of risk, and more pressure on [banks] to maintain some kind of relationship with those to whom they lend.
On sovereign wealth funds: There's no question that we're better off in the United States because sovereign wealth funds have infused new capital into our financial institutions. One of the main threats to the economy at the moment would be a turn toward protectionism. That said, in the United States, we don't allow our government to invest the Social Security trust fund in companies because of the potential for politicization of investment. It seems appropriate to ask other governments making commercial investments to give commitments that those investments are being made on a commercial rather than a political basis. We haven't had problems yet, but the more the markets are politicized, the less well they perform. It's not an issue of transparency—it is up to the individual governments to decide how often they report on the progress of the funds to their citizens. But we should seek commitments that investments are being made on a commercial basis.
On a recession: There's a good chance that we are in a recession, and I think it's possible, though not probable, that it will be prolonged, and that it will have implications for the rest of the world. The effect could be quite serious for Europe, Japan and Latin America. There will also be some fallout in developing Asia.
On the correct response: The United States is at the root of the current market problems, and it should be at the center of the solution. I would like to see U.S. officials engaged in efforts to strengthen and enhance fiscal confidence and stability in the short and medium term. For starters, we could use more accurate pricing of assets. You've got bonds that are priced one way in one American bank, and another way in another American bank, and a third way in a European bank, and a fourth way in a hedge fund. We need greater transparency. There should also be further steps to avoid excess mortgage foreclosures in the United States. Mainly, that would include more provisions for writing down the value of mortgages—not just the interest, but the total value. This would help the innocent victims.
On central banks: In general, the independence of central banks is a very good thing. But it can be counterproductive if it inhibits international cooperation or domestic collaboration. Central banks probably should become more cooperative institutions in the years ahead. In terms of where we go from here—now that we've got strong fiscal and monetary measures in place, we should turn our attention back to the financial sphere. We need more pressure for greater capital requirements in financial institutions. And we need more thorough and accurate marking of financial assets to markets.
'The Prospect of Stagflation'
Sri Mulyani Indrawati
On lessons from history: The lesson from the Asian financial crisis is that when [corrective] decisions are made fast and the [policy] prescriptions are potent, a severe or prolonged crisis can be prevented. What happened in South Korea shows that economies can pick up again very fast. Their severe adjustments lasted just one year. Yet the Indonesian economy remained sluggish for five to seven years because [corrective policies were] too long in the making and too weak. The United States is the world's biggest economy, and one that's more complex than Thailand, South Korea or Indonesia. But the lessons are the same. We do hope that decisive action will not be delayed so the damage to the global economy is minimized. Whether we are talking about one financial institution or the U.S. economy as a whole, policymakers need to get things moving quickly again.
On the theory that Asia's economies have decoupled from the American consumer:From a trade point of view, I don't think decoupling is really there yet. If we look at capital flows, the regions are not decoupling at all but becoming more linked to each other. When we issued [government] bonds in early January, buyers from the U.S. were quite dominant. I don't think there has been any diversification in the way the United States finances its deficit with funds from Asia, or any increased ability by Asia to invest our reserves [elsewhere] that would constitute decoupling. I think the financial links are very close and very strong.
On fears about the economy: In this case, it is certainly the prospect of stagflation in the United States. A recession combined with high inflation would create a very difficult policy challenge, especially when the U.S. budget is not in very good shape. A mild recession can be corrected but if this is stagflation, the room to maneuver will be very limited.
'Now We Have a Mess on Our Hands'
On investor sentiment: The Fed is clearly becoming aware of the serious potential of an economic meltdown. The size of the cut is larger than anyone expected because the Fed usually moves in [increments of] .25 or .50 percentage points. But the danger of a cut this size is that it may panic the investors. Credit markets are still uncomfortably frozen and the housing slump continues to worsen. [But] the fact is that no one knows anything. Even experienced Wall Street hands have no idea whether we're near the bottom. We can expect even more violent swings in the stock market. The reason for all the uncertainty is that the big banks and lenders simply have no idea how many bad loans they're holding. I wouldn't be surprised if the Fed cut another quarter point this week, or within the next month or so. It is clearly worried. [And while lowering rates may cause] inflation, it is far less threatening now than a recession or perhaps—and I cringe at using the word—a depression. Several managing directors on the Street, whose opinions I trust, have said to me that the chances for a depression are 20 percent. That matches my sense. Even absent a depression, it seems likely that the coming recession will be deeper than the last several.
On Finding a Solution: The scale of the problems is so much larger than any stimulus package or Fed rate cut can readily deal with. The stimulus package now being considered on the Hill is in the range of $140 billion to $150 billion. But at the rate housing prices are dropping, consumer purchases are likely to be hit by $360 billion to $400 billion. Similarly the Fed rate cuts, under normal circumstances, would free up money, but lenders are afraid of lending because they don't know how much risk of default they face, even at lower interest rates. It's a little like offering a lobster dinner to someone who is so constipated he can't take in another mouthful.
On oversight: The housing bubble and the Wild West credit markets of the last few years came about not because the Fed kept interest rates too low, but because the Treasury, the comptroller of the currency, and the Fed, in its regulatory capacity, failed miserably to use their authority to oversee credit markets and assure that they were not unduly exploiting those low interest rates with irresponsible lending practices. Now we have a mess on our hands. Bernanke has the only pooper-scooper in town, but it is too small for the job.
'Now the Illusions Are All Gone'
On the market's steep decline: Japan's stock prices moved in line with other developed economies until July of last year. Since then the subprime has become one of the major issues. The irony is that Japanese banks didn't suffer from exposure, but Japanese share prices fell more sharply than average stock markets. There are a couple of reasons. First, global investors sold shares on all the stock markets, including Japan, the United States and Europe. In Tokyo, if my memory is correct, two thirds of the turnover is by the foreign investors. Second, the July election was a very big turning point, when Shinzo Abe became a lame duck and was later succeeded by Yasuo Fukuda. Since then there has been no strong message on reform.
On leadership: Japan has had no [perspective], not only from politicians but from firms, senior management and foreigners. Overseas stockholders who proposed a different management style in firms were unfortunately rejected. Japan disappointed the rest of the world in terms of governance.
On the market's prospects: Japan's stock prices have been overvalued, with a P/E ratio higher than the United States and other developed countries. That was justified until the 1980s, but then Japan's economic growth got much worse. We saw a normalizing of stock prices, until Junichiro Koizumi became prime minister [in 2001]. People started to get back to the old theme—"Well, Japan's potential growth rate might have changed." But now the illusions are all gone. We are in a correction phase, but the P/E ratio is still almost equivalent to America's and Europe's, and if people believe Japan's growth rate will remain far below the United States' and Europe's, then Japan's stock price needs to come down. That is the basic market sentiment. I think the rationale is very strong.
My personal view is optimistic. There have been market adjustments before. Our incoming order numbers are strong, and we haven't seen any signs of a slowdown. German industry has worked very hard in recent years to gain technology leadership, hold down costs and raise productivity. We've worked on diversifying our export markets away from being dependent on just one major region. German companies are more robust and better prepared than ever. We have a lot more room to breathe today than just a few years ago. Like many German companies that concentrate on the premium segment, our business is by nature not as volatile as the mass-market end of production. Our export markets are much more diversified today, and that holds not just for Audi but for all of German industry. We're no longer dependent on one or two major markets. For us, growth in the emerging markets is going to compensate for slower regions elsewhere. If there is a U.S. recession, American companies will be in a more difficult position, since they're more dependent than we are on the domestic market.