Monday, December 17, 2007

Is Nouriel Roubini Losing his Religion?

Nouriel Roubini is one of the few economists to early on make the call that our current financial quagmire was a solvency crisis rather than one of just illiquidity. As a result, Nouriel concluded back in August that "liquidity injections and lender of last resort bail out of insolvent borrowers--however necessary and unavoidable during a liquidity panic--will not work; they will only postpone and exacerbate the eventual and unavoidable insolvencies." I found his reasoning then and now to be compelling.

Recently, however, it appears that Nouriel has begun to lose his religion. He wrote a post to his blog a few days titled "Why monetary policy easing is warranted even in the current insolvency crisis." In this piece, Nouriel makes that argument that there should be global easing of monetary policy so as to

"... reduce the length of such a recession and dampen its depth. Monetary policy may be impotent in affecting the likelihood of a economic downturn... but it is not impotent in affecting how deep and long such a recession will be."

Nouriel goes on to say he believes monetary policy can dampen the severity of the recession without (1) postponing the needed real economic adjustments, (2) creating new asset bubbles elsewhere, or (3) generating excessive inflationary pressures. So Nouriel now is articulating the following: let the recession happen, but do not let it get out of hand. In other words, let's avoid the Great Depression scenario of the 1930s where bad policies let a normal recession--that may have been necessary to purge the excesses of the 1920s--turn ugly.

The Great Depression is one scenario. Let me propose another one that I believe fits our current situation better: Japan in the 1990s. Here, there was an asset bubble that popped and similarly led to rot in the banking system--large amount of non-performing loans--that was not quickly removed. The rot, in turn, contributed to a stagnant economy for almost a decade. The non-performing loans and government support programs in Japan sound eerily familiar to the situations in the U.S. today. If the Japan scenario is the right one, then Nouriel's proposal simply postpones and potentially creates more problems down the road.

Paul Krugman
, who has not lost his religion on this topic, says the following
"
How will it all end? Markets won’t start functioning normally until investors are reasonably sure that they know where the bodies — I mean, the bad debts — are buried. And that probably won’t happen until house prices have finished falling and financial institutions have come clean about all their losses. All of this will probably take years. Meanwhile, anyone who expects the Fed or anyone else to come up with a plan that makes this financial crisis just go away will be sorely disappointed
."

I hope Nouriel's concerns over a Great Depression type scenario are wrong, but the alternative Japan scenario is not much better. Hang in there world.

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