An economic Cassandra whose predictions are coming true

Stephen Mihm, International Herald Tribune, www.iht.com  08/20/08

           ..."[T]he true cost of the housing crisis will not be a mere $300 billion...but something between a trillion and a trillion and a half dollars...We have a subprime financial system," he said, "not a subprime mortgage market."

           "This might be the beginning of the end of the American empire."

On Sept. 7, 2006, Nouriel Roubini, an economics professor at New York University, stood before an audience of economists at the International Monetary Fund and announced that a crisis was brewing. In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession.

He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt. These developments, he said, could cripple or destroy hedge funds, investment banks and other major financial institutions like Fannie Mae and Freddie Mac.

As Roubini stepped down from the lectern after his talk, the moderator of the event said, "I think perhaps we will need a stiff drink after that." People laughed - and not without reason. At the time, unemployment and inflation remained low, and the economy, while weak, was still growing, despite rising oil prices and a softening housing market.

But Roubini was soon vindicated. In the year that followed, subprime lenders began entering bankruptcy, hedge funds began going under and the stock market plunged. There was declining employment, a deteriorating dollar, ever-increasing evidence of a huge housing bust and a growing air of panic in financial markets as the credit crisis deepened. By late summer, the Federal Reserve was rushing to the rescue, making the first of many unorthodox interventions in the economy, including cutting the lending rate by half a percentage point and buying up tens of billions of dollars in mortgage-backed securities.

Over the past year, whenever optimists have declared the worst of the U.S. economic crisis over, Roubini has countered with steadfast pessimism. In February, when the conventional wisdom held that the venerable investment firms of Wall Street would weather the crisis, Roubini warned that one or more of them would go "belly up" - and six weeks later, Bear Stearns collapsed.

After the Fed's further extraordinary actions in the spring - including making lines of credit available to selected investment banks and brokerage houses - many economists made note of the ensuing economic rally and proclaimed the credit crisis over and a recession averted. Roubini stuck to his script of "nightmare" events: waves of corporate bankruptcies, collapses in markets like commercial real estate and municipal bonds and, most alarming, the possible bankruptcy of a large regional or national bank that would lead to a panic by depositors. Not all of these developments have come to pass, but last month's demise of the California bank IndyMac - one of the largest such failures in U.S. history - drew only more attention to Roubini's seeming prescience.

As a result, Roubini, a respected but formerly obscure academic, has become a major figure in the public debate about the economy: the seer who saw it coming. He has been summoned to speak before Congress, the Council on Foreign Relations and the World Economic Forum at Davos, Switzerland. He is now a sought-after adviser, spending much of his time shuttling between meetings with central bank governors and finance ministers in Europe and Asia.

The mainstream economic establishment appears to be moving closer, however fitfully, to his way of seeing things. "I have in the last few months become more pessimistic than the consensus," Lawrence Summers, a former Treasury secretary, told me this year. "Certainly, Nouriel's writings have been a contributor to that."

On a cold and dreary day last winter, I met Roubini over lunch in New York City. "I'm not a pessimist by nature," he insisted. I found the assertion hard to credit. With a dour manner and an aura of gloom about him, Roubini gives the impression of being permanently pained, as if the burden of what he knows is almost too much for him to bear.

Roubini, who is 50, has been an outsider his entire life. He was born in Istanbul, the child of Iranian Jews, and his family moved to Tehran when he was 2, then to Tel Aviv and finally to Italy. He moved to the United States to pursue his doctorate in international economics at Harvard.

After completing his doctoral degree in 1988, Roubini joined the economics department at Yale, where he first met and began sharing ideas with Robert Shiller, the economist now known for his prescient warnings about the 1990s technology bubble.

The 1990s were an eventful time for an international economist like Roubini. Throughout the decade, one emerging economy after another was struck by crisis, beginning with Mexico's in 1994. Panics swept Asia, including Thailand, Indonesia and South Korea, in 1997 and 1998. The economies of Brazil and Russia imploded in 1998. Argentina's followed in 2000. Roubini began studying these countries and soon identified what he saw as their common weaknesses.

On the eve of the crises that befell them, he noticed, most had huge current-account deficits (meaning, basically, that they spent far more than they made), and they typically financed these deficits by borrowing from abroad in ways that exposed them to the national equivalent of bank runs. Most of these countries also had poorly regulated banking systems plagued by excessive borrowing and reckless lending. Corporate governance was often weak, with cronyism in abundance.

Roubini's work was distinguished not only by his conclusions but also by his approach. By making extensive use of transnational comparisons and historical analogies, he was employing a subjective, nontechnical framework, the sort embraced by popular economists like Paul Krugman, columnist for The New York Times, and the Nobel laureate Joseph Stiglitz to reach a nonacademic audience.

Roubini takes pains to note that he remains a rigorous scholarly economist, but his approach is not the contemporary scholarly ideal in which an economist builds a model in order to constrain his subjective impressions and abide by a discrete set of data. The book that Roubini ultimately wrote (with the economist Brad Setser) on the emerging-market crises, "Bailouts or Bail-Ins?," contains not a single equation in its 400-plus pages.

After analyzing the markets that collapsed in the 1990s, Roubini set out to determine which country's economy would be the next to succumb to the same pressures. His surprising answer: the United States. Roubini was unnerved by what he saw in the U.S. economy, in particular its 2004 current-account deficit of $600 billion.

He began writing extensively about the dangers of that deficit and then branched out, researching the various effects of the credit boom - including the biggest housing bubble in the nation's history - that began after the Federal Reserve cut rates to close to zero in 2003. Roubini became convinced that the housing bubble was going to pop.

By late 2004 he had started to write about a "nightmare hard landing scenario for the United States." He predicted that foreign investors would stop financing the fiscal and current-account deficit and abandon the dollar, wreaking havoc on the economy.

What economic developments does Roubini see on the horizon? When Jim Nussle, the White House budget director, announced last month that the United States had "avoided a recession," Roubini was incredulous. For months, he has been predicting that the United States will suffer through an 18-month recession that will eventually rank as the "worst since the Great Depression." Though he is confident that the economy will enter a technical recovery toward the end of next year, he said job losses, corporate bankruptcies and other drags on growth would continue to take a toll for years.

Roubini has counseled various policy makers, including Federal Reserve governors and senior Treasury Department officials, to mount an aggressive response to the crisis. He applauded when the Fed cut interest rates to 2 percent from 5.25 percent beginning last summer. He also supported the Fed's willingness to engineer a takeover of Bear Stearns.

Roubini argues that the Fed's actions averted catastrophe, though he says he believes that future bailouts should focus on mortgage owners, not investors. Accordingly, he sees the choice facing the United States as stark but simple: either the government backs up a trillion-plus dollars' worth of high-risk mortgages (in exchange for the lenders' agreement to reduce monthly mortgage payments), or the banks and other institutions holding those mortgages - or the complex securities derived from them - go under.

"You either nationalize the banks or you nationalize the mortgages," he said. "Otherwise, they're all toast."

For months, Roubini has been arguing that the true cost of the housing crisis will not be a mere $300 billion - the amount allowed for by the housing legislation sponsored by Representative Barney Frank, Democrat of Massachusetts, and Senator Christopher Dodd, Democrat of Connecticut - but something between a trillion and a trillion and a half dollars. But most important, in Roubini's opinion, is to realize that the problem is deeper than the housing crisis.

"Reckless people have deluded themselves that this was a subprime crisis," he told me. "But we have problems with credit-card debt, student-loan debt, auto loans, commercial real estate loans, home-equity loans, corporate debt and loans that financed leveraged buyouts." All of these forms of debt, he argues, suffer from some or all of the same traits that first surfaced in the housing market: shoddy underwriting, securitization, negligence on the part of the credit-rating agencies and lax government oversight. "We have a subprime financial system," he said, "not a subprime mortgage market."

Roubini argues that most of the losses from this bad debt have yet to be written off, and the toll from bad commercial real estate loans alone may help send hundreds of local banks into the arms of the Federal Deposit Insurance Corp. "A good third of the regional banks won't make it," he predicted.

In turn, these bailouts will add hundreds of billions of dollars to an already gargantuan federal debt, and someone, somewhere, is going to have to finance that debt, along with all the other debt accumulated by consumers and corporations. "Our biggest financiers are China, Russia and the Gulf states," Roubini noted. "These are rivals, not allies." The United States, Roubini went on, will most likely muddle through the crisis but will emerge from it a different nation, with a different place in the world.

"Once you run current-account deficits, you depend on the kindness of strangers," he said, pausing to let out a resigned sigh. "This might be the beginning of the end of the American empire."

Stephen Mihm is an assistant professor of economic history at the University of Georgia.