How to prevent a depression

By Nouriel Roubini
September 19, 2011

By Nouriel Roubini
The opinions expressed are his own.

AMSTERDAM – The latest economic data suggests that recession is returning to most advanced economies, with financial markets now reaching levels of stress unseen since the collapse of Lehman Brothers in 2008. The risks of an economic and financial crisis even worse than the previous one – now involving not just the private sector, but also near-insolvent sovereigns – are significant. So, what can be done to minimize the fallout of another economic contraction and prevent a deeper depression and financial meltdown?

First, we must accept that austerity measures, necessary to avoid a fiscal train wreck, have recessionary effects on output. So, if countries in the eurozone’s periphery are forced to undertake fiscal austerity, countries able to provide short-term stimulus should do so and postpone their own austerity efforts. These countries include the United States, the United Kingdom, Germany, the core of the eurozone, and Japan. Infrastructure banks that finance needed public infrastructure should be created as well.

Second, while monetary policy has limited impact when the problems are excessive debt and insolvency rather than illiquidity, credit easing, rather than just quantitative easing, can be helpful. The European Central Bank should reverse its mistaken decision to hike interest rates. More monetary and credit easing is also required for the US Federal Reserve, the Bank of Japan, the Bank of England, and the Swiss National Bank. Inflation will soon be the last problem that central banks will fear, as renewed slack in goods, labor, real estate, and commodity markets feeds disinflationary pressures.

Third, to restore credit growth, eurozone banks and banking systems that are under-capitalized should be strengthened with public financing in a European Union-wide program. To avoid an additional credit crunch as banks deleverage, banks should be given some short-term forbearance on capital and liquidity requirements. Also, since the US and EU financial systems remain unlikely to provide credit to small and medium-size enterprises, direct government provision of credit to solvent but illiquid SMEs is essential.

Fourth, large-scale liquidity provision for solvent governments is necessary to avoid a spike in spreads and loss of market access that would turn illiquidity into insolvency. Even with policy changes, it takes time for governments to restore their credibility. Until then, markets will keep pressure on sovereign spreads, making a self-fulfilling crisis likely.

Today, Spain and Italy are at risk of losing market access. Official resources need to be tripled – through a larger European Financial Stability Facility (EFSF), Eurobonds, or massive ECB action – to avoid a disastrous run on these sovereigns.

Fifth, debt burdens that cannot be eased by growth, savings, or inflation must be rendered sustainable through orderly debt restructuring, debt reduction, and conversion of debt into equity. This needs to be carried out for insolvent governments, households, and financial institutions alike.

Sixth, even if Greece and other peripheral eurozone countries are given significant debt relief, economic growth will not resume until competitiveness is restored. And, without a rapid return to growth, more defaults – and social turmoil – cannot be avoided.

There are three options for restoring competitiveness within the eurozone, all requiring a real depreciation – and none of which is viable:

·         A sharp weakening of the euro towards parity with the US dollar, which is unlikely, as the US is weak, too.

·         A rapid reduction in unit labor costs, via acceleration of structural reform and productivity growth relative to wage growth, is also unlikely, as that process took 15 years to restore competitiveness to Germany.

·         A five-year cumulative 30% deflation in prices and wages – in Greece, for example – which would mean five years of deepening and socially unacceptable depression; even if feasible, this amount of deflation would exacerbate insolvency, given a 30% increase in the real value of debt.

Because these options cannot work, the sole alternative is an exit from the eurozone by Greece and some other current members. Only a return to a national currency – and a sharp depreciation of that currency – can restore competitiveness and growth.

Leaving the common currency would, of course, threaten collateral damage for the exiting country and raise the risk of contagion for other weak eurozone members. The balance-sheet effects on euro debts caused by the depreciation of the new national currency would thus have to be handled through an orderly and negotiated conversion of euro liabilities into the new national currencies. Appropriate use of official resources, including for recapitalization of eurozone banks, would be needed to limit collateral damage and contagion.

Seventh, the reasons for advanced economies’ high unemployment and anemic growth are structural, including the rise of competitive emerging markets. The appropriate response to such massive changes is not protectionism. Instead, the advanced economies need a medium-term plan to restore competitiveness and jobs via massive new investments in high-quality education, job training and human-capital improvements, infrastructure, and alternative/renewable energy. Only such a program can provide workers in advanced economies with the tools needed to compete globally.

Eighth, emerging-market economies have more policy tools left than advanced economies do, and they should ease monetary and fiscal policy. The International Monetary Fund and the World Bank can serve as lender of last resort to emerging markets at risk of losing market access, conditional on appropriate policy reforms. And countries, like China, that rely excessively on net exports for growth should accelerate reforms, including more rapid currency appreciation, in order to boost domestic demand and consumption.

The risks ahead are not just of a mild double-dip recession, but of a severe contraction that could turn into Great Depression II, especially if the eurozone crisis becomes disorderly and leads to a global financial meltdown. Wrong-headed policies during the first Great Depression led to trade and currency wars, disorderly debt defaults, deflation, rising income and wealth inequality, poverty, desperation, and social and political instability that eventually led to the rise of authoritarian regimes and World War II. The best way to avoid the risk of repeating such a sequence is bold and aggressive global policy action now.

This piece originally appeared on Project Syndicate.

Photo: A man walks past a display board of a currency exchange office in Bucharest August 19, 2011. European shares extended the previous session’s sharp sell-off on Friday on deepening worries over slowing global economic growth and the region’s banks facing short-term funding stress because of the euro zone’s sovereign debt crisis. REUTERS/Bogdan Cristel


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Professor Roubini proposes restoring competitiveness through pumping liquidity into Western economies, which, besides general bank and sovereign treasury bailout, should include “massive new investments in high-quality education, job training and human-capital improvements, infrastructure, and alternative/renewable energy”. In one recent interview, Professor Roubini said that Karl Marx was right that the capitalist economy had an uncontrollable potential of self-destruction. Karl Marx’s name is usually connected to failed socialist experiments of controllable economies and ineffective government investments. However, modern Western economists still don’t understand the main Marx’s thesis about manufacturing forces as a basis of any economy. It’s naive to think that Marxist China will sustain conditions for service and innovation growth in “advanced” economies. It’s manufacturing that creates demand in services, spurs technical innovation and demand in engineers. Without restoring manufacturing, any “investments” in education and infrastructure would just produce new bureaucrats and Ponzi-scheme “innovations”.

Posted by PavelLevin | Report as abusive

This is laughable. The US can AFFORD short-term economic stimulus? Is he serious or is he going to provide a second article in which he says, just kidding, here’s my real argument?

The stimulus IS the problem. We’re facing the hangover of years and years of monitary and fiscal stimulus and now the solution is more?!

Where do these people learn economics? Kindergarden? Fairy tales? I bet Roubini will say that Santa Claus needs to drop “stimulus” on the world to boost the economy.

If a government provides “stimulus,” it must first TAKE those rescources from the private economy. Even if you make the argument that the government would make better use of such funds (laughable), this would have so be great in order to pay for the cost of collecting such funds in the first place, let alone doling them out.

If this process worked, the Soviets would have won the cold war.

Just another Keynesian clueless hack who has no-idea whats going on.

We need monitary and fiscal re-hab. Sure it will hurt for a couple years, but after we’ll have REAL growth.

If we take this idiotic advice, sure we’ll be chugging along for a couple years, but then we face a world wide currency collapse.

Yeesh, how people buy this crap… I have no idea.

Posted by aboyo | Report as abusive

In my opinion, we are ALREADY IN a DEPRESSION!!!

Posted by csmarker | Report as abusive

I’m yet to hear a convincing argument about why Protectionism isn’t good for a fully developed currency appreciated country like the US. Just about every single “new business” / tech startup seeks employees from a low currency geography.

If a private enterprise wanted to create a super high speed rail system powered by non-oil based fuel, even if that technology doesn’t exist elsewhere in the world, there is a strong likelihood that this enterprise will outsource a good portion of the labor to a different country — because a Hedge Fund manager sitting in NY who might have funded this company will force the CEO for profitability. Please Explain.

Posted by Penman | Report as abusive

@Penman – there are a number of reasons why protectionism would not be a good idea at the moment for the USA, but ultimately global mutual protectionism is the correct way forward – but this is basically what mechanisms like the bancor or SDR-based global trade currency really advocate: prevention of imbalances through centrally administered “protectionism” fairly administered to all.

For why a nationalist rush to protectionism would be a disaster right now, for the USA, you simply have to look first at what the USA actually produces: almost nothing. The USA has been de-industrialising for decades and in order to “protect” itself, it would have to begin actually making things again. This would take time, and primarily: debt.

The private sector in the USA is broke. The only way out for the private sector is to hope for increased state funding (the anarchist extremists in the USA will prevent this), or for those very anarchist extremists to focus their attention on the banks – have them nationalised/bankrupted and private debt written off.

Other reasons include the ensuing trade war. If the USA, through protectionist measures, was to invoke mass unemployment in the x-billion population of China-ASEAN, you could happily expect World War 3 and nothing short of it.

Posted by FrankSz | Report as abusive

$645 TRILLION of deregulated derivatives traded between 2000 – June 2008. $645 TRILLION!!!! This is the BLACK hole the world economy is trying to climb out of. The workers and ordinary people around the world are being punished for this elaborate PONZI scheme. Lehman was just the fall guy. The repeal of the Glass Steagall act in 1999 allowed investment bankers to become depository bankers/ mortgage lenders. Then deregulation of derivatives in 2000, mastermined by Phil Gramm (R) TX with the GLB act and CFM act resulted in no SEC oversight and 40 – 1 odds. Investment bankers are risk takers by the nature of their business. Derivative money was laundered into mortgages with high risk subprime loans. Since they were selling off MBS’s to Fannie, Freddie, it didn’t matter what the risks’ were. Besides AIG guaranteed repayment of the money with credit default swaps. Big banks around the world traded derivatives using government treasuries i.e. tax payers money.(normally, only governments have access to this amount of capital). When AIG defaulted on $14 Billion credit default swaps in 2008, the PONZI scheme started to unravel. One comment mentioned we have known for last 10-15 years baby boomers around the world are going to start retirng. So maybe this is the political solution to the baby boomers. (Who drove the economies for most of the last 40 years.) Remember, 90 Senators voted to repeal the Glass Steagall act. Only 8 Senators voted NO and 2 abstained. One of those 8 should be President!!!!!

Posted by vietnam2 | Report as abusive

What the United States and the Euro-Zone countries need to do is a simple marketing campaign as follows:

“If your happy and you know it spend your cash. If your happy and you know it spend your cash. If your happy and you know it and you really wanna show it. If your happy and your know it spend your cash.”

Simple solution to a complex problem. People need to start spending again.

Posted by tehnitis55 | Report as abusive

We all have to pitch in to help America. I am in the automotive industry in the mid-west. From 2007 till now I’ve seen so many dealerships close to never re-open. 30 percent of dealerships in america have closed. I decided to do something about it. I launched a Website called in January 2011 and have posted over 300 jobs for free for Automotive dealers. We all have to do our part to put America back together. We can’t sit back and do nothing or HOPE that CHANGE will happen on its own. We can’t blame Obama, Congress, or the jerks who fire people for no reason everyday. One-by-one, we all have to make it happen. Period.

Posted by | Report as abusive

The principle of “Fractional Reserve Banking” and the perverse amount of infleunce that commercial banks have been allowed to exert in all our lives has been our undoing. There are voices of sanity beginning to be heard, e.g. the Positive Money initiative in the UK. Check out Let’s hope it is not too late and our world leaders actual start to demonstrate some real leadership.

Posted by CornwallLad | Report as abusive

The 20th century & early 21st showed us that ANY & EVERY system can fail- communism, capitalism, dictatorship, democracy – you name it; and that’s because Mankind has failed these systems and not the other way around. These all-out efforts in the Eurozone and those in the US have been last-ditch ones to perpetuate unsustainable lifestyles. 20th century business ethics depend upon the unspoken rule -one that has only tacit acceptance, but people in general are not willing to openly admit-and that is: for someone to win somewhere somebody has to lose elsewhere, and badly. Mankind has to grow, to evolve, to learn to do business in which there are no losers. For too long we have been thinking within our boundaries, problems “outside” our borders are NEVER “our”problems. THIS is the problem THE crisis which should teach us to think globally, and realize that if there are starving people elsewhere, then it is OUR problem, because one day these problems will be on our doorstep

Posted by drphaniraj | Report as abusive