Doctor Doom
Laissez-Faire Capitalism Has Failed
Nouriel Roubini,
02.19.09,
12:01 AM
ESThttp://www.forbes.com/2009/02/18/depression-financial-crisis-capitalism-opinions-columnists_recession_stimulus.html
The financial
crisis lays bare the weakness of the Anglo-Saxon model.
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).
The latest data on third-quarter 2008 gross
domestic product growth (at an annual rate) around the world are even worse
than the first estimate for the U.S. (-3.8%). The figures were -6.0% for the
euro zone, -8% for Germany, -12% for Japan, -16% for Singaporeand -20% for
Korea. The global economy is now literally in
free fall as the contraction of consumption, capital spending, residential
investment,
production, employment, exports and imports is accelerating rather than
decelerating.
To avoid this L-shaped near-depression, a
strong, aggressive, coherent and credible combination of monetary easing
(traditional and unorthodox), fiscal stimulus, proper cleanup of the financial
system and reduction of the debt burden of insolvent private agents (households
and nonfinancial companies) is necessary in the U.S.and other economies.
Unfortunately, the euro zone is well behind
the U.S.in its policy efforts for several reasons.
The first is that the European Central Bank is behind the curve in cutting
policy rates and creating nontraditional
facilities to deal with the liquidity and credit crunch. The second is that the
fiscal stimulus is too modest, because those who can afford it (Germany) are
lukewarm about it, and those who need
it the most (Spain, Portugal, Greece, Italy) can least afford it, as they
already have
large budget deficits. The last reason is that there is a lack of cross-border
burden sharing of the fiscal costs of bailing out financial institutions.
With its aggressive monetary easing and
large fiscal stimulus putting it ahead, the U.S.has done more. 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).
Moreover, in many countries, the banks may
be too big to fail but also too big to save, as the fiscal/financial resources
of the sovereign may not be large enough to rescue such large insolvencies in
the financial system.
Traditionally, only emerging markets
suffered--and still suffer--from such a problem. But now such sovereign risk,
as measured by the sovereign spread, is also rising in many European economies
whose banks may be larger than the ability of the sovereign to rescue them:
Iceland, Greece, Spain, Italy, Belgium, Switzerlandand, some suggest, even the
U.K.
The
process of socializing the private losses from this crisis has already moved
many of the liabilities of the private sector onto the books of the sovereign.
Among these liabilities are banks, other financial institutions and, soon
possibly, households and some important nonfinancial corporate companies.
At some point a sovereign bank may crack, in
which case the ability of governments to credibly commit to act as a backstop
for the financial system, including deposit guarantees, could come unglued.
Thus the L-shaped, near-depression scenario
is still quite possible (I assign it a 30% probability), unless appropriate and
aggressive policy action is undertaken by the U.S.and other economies.
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 (nyse: C - news - people ) 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.
** Nouriel Roubini, a
professor at the Stern Business School at New York University and chairman of
Roubini Global Economics,
is a weekly columnist for Forbes.com.
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