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On Looking into the Abyss

by David Smick

Crisis Economics: A Crash Course in the Future of Finance, by Nouriel Roubini and Stephen Mihm (Penguin, 368 pp., $27.95)

It has been a good financial crisis for Nouriel Roubini. The once-obscure New York University economist and former Clinton White House official is now a media superstar, and roams the world advising his consulting firm’s ballooning client base.

The seeds for this transformation were planted in 2006. Roubini warned of a coming disastrous U.S. mortgage crisis. He predicted accurately that a global network of trillions of dollars of U.S. mortgage-backed securities would unravel. This would send the world financial system to the edge. Roubini is now referred to as “Doctor Doom.” This label diminishes his achievements: Four years ago, it took enormous courage to take such a public stand. Most in the economics profession thought his dire pessimism absurd.

Roubini recently appeared on the Charlie Rose program. The Harvard-trained economist, born in Istanbul of Iranian Jewish parents, certainly makes an impression: Sitting stiffly upright, he answered Rose’s questions rapidly and with precision. It was difficult, frankly, not to see him as Count Dracula eyeing his next victim. In this case, the Count had his eyes on the necks of the hapless finance ministers of Europe, who were about to bail out holders of Greek and Portuguese sovereign debt. Roubini’s criticisms were, once again, devastatingly on the mark.

His new book, Crisis Economics, written with Stephen Mihm, is an important primer on how we got into today’s mess combined with a compilation of possible policy solutions. It is, in one regard, highly annoying. In the book’s world, President Obama doesn’t exist: It is difficult to find even a mention of him or his administration. Decades from now, economic historians will likely present George W. Bush and Barack Obama as very similar figures: Both produced unprecedented bailouts and mind-boggling levels of fiscal stimulus, including new entitlements without sources of funding. Both were perhaps too cozy with the Wall Street banks. Yet, in this accounting of the crisis, Obama and his team have largely vanished.

Roubini and Mihm begin with a commonsense observation: “Crises — unsustainable booms followed by calamitous busts — have always been with us, and with us they will always remain. . . . [They are] hard-wired into the capitalist genome.” They then describe the perfect storm of causes that came together to create the worst economic crisis since the 1930s. The book lays down principles by which such crises can be predicted and even avoided. The writers pound away on the “lender of last resort” issue, asking whether the actions by Washington to stem the crisis will “only encourage excessive risk-taking in the future.”

Roubini and Mihm compare financial crises to nuclear power, which can be similarly “enormously destructive if all the energy is released at once.” Given the inevitability of crises, say the authors, what we need is a kind of “controlled creative destruction,” relying not only on the ideas of Keynes but also on those of Schumpeter; but “the recent crisis has produced precious little of the kind of creative destruction that Schumpeter saw as essential for capitalism’s long-term help.”

The authors are particularly courageous in attacking Washington’s “too big to fail” financial firms, and suggest that the big banks, including Goldman Sachs, should have been broken up. They regularly blame Alan Greenspan on both regulatory and monetary fronts. Again, being careful not to offend their Democratic friends, they describe the deregulation of the U.S. financial system as beginning in the 1980s, culminating in the effort by Republican senator Phil Gramm to repeal the Glass-Steagall Act’s separation of commercial banking from riskier investment banking. Of course, former Clinton Treasury secretary Robert Rubin’s fingerprints were all over the Glass-Steagall changes; and as for financial deregulation, it began in the late 1970s under the Democratic administration of Jimmy Carter.

On the housing crisis, Roubini and Mihm offer up a straw man: They knock down supposed “overblown claims that Fannie Mae and Freddie Mac single-handedly caused the subprime crisis.” No serious observer has ever claimed Fannie and Freddie were the lone culprits for the crisis. What the writers should have noted instead is the surprising rate at which bank toxic waste is being off-loaded today to Fannie and Freddie, and how this shift threatens the viability of the U.S. financial system.

Despite these partisan lapses, the authors offer first-rate, commonsense observations on the regulatory front, beginning with the wisdom that “regulations are only as good as the regulators who enforce them.” They acknowledge that it is “astonishingly difficult to keep pace with financial innovation.” Drawing on Plato’s Republic, they offer the fascinating idea that Washington should work to raise the status of the regulatory agencies, appealing to those in the workforce who are “convinced of their own goodness” and might “scorn private gain and instead look out for the welfare of the republic.” In such a system, “the illusion of virtue would be its own reward.”

The book is most effective when critiquing Washington’s rescue operations in the financial crisis. The achieved economic stability may have come at a tremendous cost: “Thanks to all the bailouts, guarantees, stimulus plans, and other costs of managing the crisis, the public debt of the United States will effectively double as a share of the nation’s gross national product.” Deficits over ten years are expected to exceed $9 trillion.

The writers characterize as “highly misleading” comparisons of America’s fiscal situation today with the situation that existed after World War II, when the size of the public debt reached an astonishing 125 percent of the nation’s GDP: “The United States of today is not the country of 1946, and it’s naïve to believe it will be able to escape the shadow of the crisis by deficit spending alone. . . . We cannot rescue everyone who made bad decisions in advance of the crisis.”

Roubini and Mihm assume that Washington politicians will eventually confront the debt through spending cuts and/or tax increases. Don’t count on it. The political class globally is already flirting with an alternative route: having the central banks buy the public debt. Over the past year, for example, the Bank of England has purchased 85 percent of the British government’s new public debt. The European Central Bank recently began loading its balance sheet with the murky debt of Greece and Portugal. The Federal Reserve is using proxies to do the same. The 20 largest U.S. banks, while not lending, are borrowing massively from the Fed to purchase huge amounts of U.S. Treasury and government-agency debt. The industrialized world’s central bankers learned this approach — an approach that is ensuring downward pressure on bond yields, at least for now — from the Bank of Japan, which, ever since the early 1990s, has been loading up on Japanese-government ten-year bonds.

The problem is, no one really knows the long-term consequences of having the industrialized world’s central banks directly or indirectly purchase toxic public debt. Inflationary expectations could eventually soar, or disinflation could continue as private capital needs are crowded out to pay for expanding government spending. But at least one thing is certain: The world has entered a twilight zone in its handling of today’s mountains of sovereign debt. These are dangerous times, as  the cheapening of central-bank balance sheets may be turning into a de facto form of currency intervention. In other words, we may be seeing a race to the bottom in a subtle form of exchange-rate competition.

Roubini and Mihm are right on the mark in their argument for a global game plan to prevent another crisis. The place to start is by addressing the problem of huge global savings imbalances. For the last 15 years, these imbalances were built up by export-dependent developing economies that, in recycling their reserves into fixed-income investments back in the industrialized world, contributed to a dangerous state of affairs. Financial risk became severely underpriced. The rest is history.

True, as Roubini and Mihm point out, U.S. policy officials should have seen the effect this phenomenon was having on soaring asset prices, led by housing. But while targeting asset prices in a democracy at a time of nonexistent inflation sounds easy in the academy, it is tougher to accomplish in real life. Obama economic adviser Larry Summers once commented on Fed chairman Alan Greenspan’s famous 1996 remark that the U.S. stock market reflected “irrational exuberance.” The level of the Dow then was only roughly 6,400. “That turned out to be a bubble that wasn’t. Later the housing crisis turned out to be a bubble that was,” said Summers.

And here’s the scary part: Because of the lack of any international consensus, today the world’s export-dependent economies, led by China and Germany, are not about to change policies as they wait for American consumers to rebound, only to go further in hock buying things they can’t afford.

Contrary to his image as a mere salesman of doom, Nouriel Roubini has participated in an important exercise. The book is a useful policy encyclopedia, laying out a variety of effective, desperately needed reform initiatives. Yet given the still-frightening nature of the world financial system, my guess is that Doctor Doom will be in business for some time to come.

– Mr. Smick, author of The World Is Curved: Hidden Dangers to the Global Economy, is editor of The International Economy magazine and chairman and CEO of the macroeconomic consulting firm Johnson Smick International.

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