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Saturday, March 26, 2011

Transcript: Relay 431C Nouriel Roubini

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One of the few who called the housing bust and financial meltdown in public was Nouriel Roubini of the Stern School at New York University. In a period of two years, Roubini went from a perpetual outsider, Doctor Doom, Jr., perhaps, to being the toast of the economics set, keynoting conferences from Dubai to London to East Asia.

We featured Roubini in last week's regular podcast, but here he is in complete form, in his keynote to the MIPIM, M - I - P - I - M, Marche' Internationale de Professionels d'Immobilier in my poor French, an international congress of real estate professionals, held as he notes at the site of the Cannes Film Festival.

Comprehensive, clear, coherent if you get past Roubini's thick accent, this presentation should serve as the baseline forecast for the economic world going forward. Demand Side disagrees with everyone, so we also disagree with Roubini, but he IS talking about the right things.

Nouriel Roubini 
Good morning everyone. It is a great pleasure and honor to be here. I remember the last time I was in this hall was last May during the Cannes Film Festival. It was the world of two movies in which I had a little cameo role. One was "Wall Street II," and the other was this documentary on the financial crisis, "Inside Job," that won last week the award for the best documentary at the Oscars. Unfortunately here this morning you are not going to be watching a great film. You will have to listen to me and my views on the global economy. But hopefully there will be some good food for thought, if not entertainment.

So what I want to do is just to give you my outlook for the global economy, what is happening. I was recently in Davos at the World Economic Forum, and the way I characterized the global economy then was as a glass that was half full and a glass that was half empty. There are many positive developments in the global economy, and upside risks, and it think we should recognize them. But there are also clouds over the global economy. And there are downside risks and vulnerabilities. it is worth to be thinking about to be realistic about what may be happening next.

If I could start with the positives. I think many things are actually going on in the global economy today that are actually going in the right direction. We have had the fairly severe economic and financial crisis, but there has been global economic recovery for the last three years. And if you look at the last economic indicators, these forward indicators of economic activity, both in emerging markets and advanced economies, they suggest not only positive growth, but growth that is accelerating -- in the United States, in many parts of Europe, and even in Japan. So there is positive economic growth and growth is accelerating in the last few months.

The second positive in the global economy is that the kind of tail risks that people were worrying about last year: The tail risk of outright deflation, the tail risk of a double dip recession in the U.S. and other advanced economies, the tail risk of a disorderly breakup of the Monetary Union or disorderly default in the Eurozone, those type of risks are today a lower probability event than they were a year ago. Not a zero probability event, but certainly the risk of those tail risks is smaller today than it was a year ago. So that is also positive.

The third positive about the global economy is that if you look at the balance sheet of
and the P&L of corporates, especially the high-grade, low-leverage corporates, in the United States, in Europe, in advanced economies, they are in very good shape. They took the crisis as an opportunity to reduce costs, especially labor costs. That has been painful for the unemployment rate. But these corporates have become lean and mean. They are highly profitable. Earnings have been surprising on the upside quarter after quarter. They are sitting on a pile of cash, $2 trillion of cash, available for investment, for job hiring, for M&A activity, for financial transactions.

As these corporates become more confident about the global economic recovery, they are more willing to spend. Of course, one question is, Are they going to spend, going to hire, in slow-growing advanced economies, or are they going to do most of it in more fast-growing emerging market economies. That's an open question, but certainly their financial conditions are much stronger than they were two years ago.

The fourth positive about the global economy is the rise of emerging market economies. There are now multiple poles of growth -- engines or locomotives of growth -- not just the United States and other advanced economies. And the story is not only about China or India or about the BRIC's, but is also about the rest of emerging Asia, about the positive things that are happening in emerging markets in Latin America, in Central Asia. Even in the Middle East where there is turmoil today, given high oil prices, the opportunity for high economic growth are there. So most emerging markets are growing very fast, and that is not just cyclical. It is a permanent shift of economic power, from West to East, from North to South, from advanced economies to emerging markets.

And for the purposes of this conferences, property and real estate, I would say that the growth of emerging markets is going to be medium- and long-term positive for real estate, commercial and residential. You have fast-growing economies, where income and wages are growing, you have industrialization, you have urbanization, on a massive scale in China today, but it is going to be increasingly so in India and most other emerging markets. And as you have urbanization and industrialization and fast growth,
demand for real estate and property rises. Huge demand for residential real estate investment, for commercial real estate, retail and offices, infrastructure, you name it. So the long-term trends of emerging markets are certainly positive for the property sector.

The fifth positive about the global economy is that the last year last year for financial markets was a story of risk on and risk off. Risk was off and risk aversion was high in the spring during the Greek crisis. Risk was off again in the summer when people were worried about a double dip recession in the United States. But by the fall of last year, things started to improve in financial markets and equity markets started to rise. That was a result of quantitative easing number two by the U.S. Fed, the result of another fiscal stimulus in the United States, the result of the Europeans patching up the problems of the periphery of the Eurozone, and coming up with official financing to backstop banks and governments in trouble. But the year ended actually on a positive note. And that rally in equity markets and reduction in credit spreads continued into the beginning of this year. Of course, the clouds coming from the Middle East have led now to an increasing risk aversion, but the current global equity market correction has been very modest compared to the one we had, for example, in the spring of last year, when the problems a small Greece led to a 20 percent equity market correction globally.

So you can tell a story that as the global economy recovery, and the economies surprise on the upside in terms of recovery, asset prices can go higher. If asset prices go higher, there are positive wealth effects as the reduction in credit spreads further stimulates economic activity. And you could have a virtuous circle when the real economy improves, financial markets improve, as opposed to that vicious circle that you saw between 2007 and 2009, when asset prices were falling and real economic activity was contracting. So you could have positive surprises.

Now these are the positives about the global economy. And I would say we should not underestimate the power of these positive factors that are driving global economic growth, both in advanced economies and in emerging markets.

Let me talk now about what are the potential downside risks and the vulnerabilities. Certainly the one that is key in the minds of investors today is the turmoil in the Middle East and the rise in oil, energy, food and other commodity prices. I'm going to get to that point in a moment, but I'd like first to address a number of the other concerns.

The first observation to make is that in most advanced economies, the recovery is going to be still anemic, subpar, below trend -- more like a U-shaped recovery rather than a V-shaped recovery of previous economic recoveries. Why? The crisis was caused, of course, by too much debt and leverage in the private sector: households, financial institutions, even parts of the corporate sector. Those debt ratios still remain very high in the private sector, while at the same time in the past year, we have seen a massive releveraging of the public sector with large budget deficits.

So over the next few years, the painful process of private and public sector deleveraging is going to occur and everything I've seen implies there will be positive growth in advanced economies, but that growth is going to be weakened by the fact there is this burden of private and public debt. The need to spend less, save more, as a way of reducing this debt burden in the private and public sector.

So that's one constraint to growth.

The second issue is related to the first one, is that as you know there is significant sovereign risk and rising sovereign risk in most advanced economies. Of course, the bond market vigilantes have already woken up in the periphery of the Eurozone, Italy, Spain, Portugal, Greece, Ireland, you name it. But let's not forget we have large budget deficits and large stocks of rising public debt in the United States, in the United Kingdom, in Japan, and most of the other advanced economies. So the question of sovereign risk, of public debt sustainability, of the willingness and ability of governments in the advanced economies to tackle this fiscal problem is going to remain a serious one for many years. In addition to the official public debt, as you know there are also contingent liabilities of the public sector deriving from aging of population in most advanced economies. That is leading to Social Security systems, pension funds being unfunded. The rising cost of health care for the elderly. So you have public debt officially, and you also have contingent liabilities or unfunded debt, as well.

So that's a second problem.

The third problem in the global economy derives from the economic and financial trouble still existing in the periphery of the Eurozone. Greece, Ireland, Portugal, Spain, Italy, potentially other countries. The fundamental problems of these economies are chronic and are not going to be solved any time soon even if the Eurozone is now much more willing to backstop the weak governments and the banks and support the Euro. There are problems of large public debt and deficit, but also problems of large
foreign liabilities of the private sector, especially in countries like Ireland or Spain where there was a housing boom and bubble that went bust. So you have public and private debt and deficits that are significant and have to be rolled over.

You have a problem of a loss of competitiveness of the periphery of the Eurozone. Countries that were losing market shares to Asia already a decade ago because of exports being labor-intensive and low value added. Then a decade of wages rising more than productivity and unit labor cost rising, and then the sharp appreciation of the Euro being the final nail in the coffin of competitiveness.

And then you have the problem that in most of the periphery of the Eurozone, there is either no economic growth or negative economic growth. Greece, Ireland, Spain are still contracting, while economic growth is barely positive in Italy and in Portugal. So you have public and private debt and deficits. You have lack of competitiveness on the external side. Large current account deficits. Lack of structural reform. Lack of economic reform.

How are you going to square these things to restore economic growth? I think even if a disorderly breakup of the Eurozone is unlikely, the challenges to the Eurozone remain.

The fourth problem I think we have to recognize is that while in the short run the United States is doing well. This year it could add economic growth of the order of 3 percent or so, there are significant problems also in the United States. The private sector deleveraging of the household sector has been postponed so far -- this year and next year -- because the household sector received another tax cut or transfer payments of a trillion dollars, but the trillion dollars has been financed through an increase in the budget deficit of a similar amount, another trillion dollars of public debt.

So in the U.S. we are postponing the private sector deleveraging by even more releveraging in the public sector. Eventually the process of deleveraging in the public sector is going to continue again, and that's going to slow down growth, especially starting with next year.

But there are four issues I think that are not addressed in the United States.

One is that the unemployment rate remains high, and job creation is still modest -- just barely enough to satisfy the increase in the labor supply. And therefore the unemployment rate is going to stay high. Including discouraged workers and partially employed workers, actually, unemployment is not 8.9, but rather 16 percent.

The second problem in the United States is that unfortunately if there is one sector of the U.S. economy that is already double-dipping, it is the housing sector. Demand was artificially boosted last spring with a tax credit. Supply was constrained by an effective moratorium on foreclosures. After the tax credit expired, demand fell. Supply now is rising. Since August, unfortunately, home prices started to fall again. That has a negative wealth effect on consumption and pushes a million or more households into negative equity, with the risk of many more of them walking away from their homes. A high unemployment and double dip in housing implies that losses for the financial system may be higher than what the Market is pricing.

The third problem in the United States is the fiscal deficits of the state and local governments that are very severe. They are starting to address them, but it is putting pressure on the municipal bond market.

The fourth problem in the United States is that, while Europe and the U.K. are starting to address their fiscal problems, the U.S. decided to kick the can down the road. There is political gridlock in Congress. Democrats and Republicans are completely divided. Republicans are against tax increases. Democrats are against spending cuts, especially entitlement spending. In a world in which the U.S. can borrow at zero rates on the short end and three and a half on the long end, the path of least resistance politically is to kick the can down the road. Keep on running trillion dollar budget deficits this year, next year, into the next administration. The risk is that at some point the bond market vigilantes are going to wake up in the U.S. the way they did in Europe. There is going to be a bond market revolt. The increase in long-term interest rates is likely to crowd out the recovery.

So those are the risks from the U.S.

Let me talk briefly about emerging market economies. The strength of emerging markets' high economic growth is also a source of vulnerability. In these emerging markets where there is overheating, where there is excessive credit growth, where there is froth in some of the financial markets, there is a risk of rising inflation. And in emerging markets, as you know, two-thirds of the consumption basket is oil, energy, food and transportation. So the rise in food and energy and commodity prices has a much more significant effect on headline and core inflation than in advanced economies, even before you had this shock in the Middle East.

So the question for China and many emerging markets is, Can they tighten monetary policy and use the exchange rate to reduce inflation and maintain economic growth, and achieve a soft landing of their economy rather than a hard landing? Many of these emerging markets are behind the curve in terms of credit controls, in terms of monetary tightening, in in terms of allowing the exchange rate to appreciate to control imported inflation. The risk is that there is going to be a hard landing rather than a soft landing. It is a low risk probability event, but certainly the rise in commodity prices make that trade-off between maintaining high growth and controlling inflation more difficult than it was in the past.

That leads me now to the question about what's going on right now in the Middle East. The reality is that almost nobody predicted this economic and political turmoil, and we don't know whether this political turmoil and uprising is going to stabilize in the next few months or whether it is going to spread to many more countries, with threat to the supply of oil and energy in other countries, other than Lybia.

The reality is that you can tell a scenario where things stabilize politically, and oil prices, while remaining high, they gradually fall to more sustainable levels. But you can tell also a scenario could exacerbate with upside risks to oil and energy prices.

Now what are the effects in the rise of oil prices?

One effect is on inflation. The effect on inflation is going to be much more sharp in overheating emerging markets, where oil, energy, food are a large part of the consumption basket. And these countries are behind the curve in terms of policy tightening, and therefore the risk of double-digit inflation is rising in many of these emerging economies.

In the case of advanced economies where there is a slow recovery from this financial crisis, the risk to inflation is much more modest. Yes, you might have some rise in headline inflation gradually, but core inflation is not going to rise very much. And it is not going to rise very much because you have slack in the goods market, with capacity utilization still being low in the U.S., Europe and Japan. You have severe slack in the labor markets, where the unemployment rate is close to 10 percent. Workers don't have wage bargaining power. Wages are growing less than productivity
and unit labor costs are falling. And in some economies like the U.S., U.K, Ireland, Spain, you also have slack also still in the housing market, where the bust has led to a longer-term slump in terms of excess capacity.

So I worry less about inflation becoming a severe problem at current levels of oil prices in advanced economies. Of course, if oil were to go to $140 or $150 per barrel, this story could be different.

So the impact of oil prices is more significant on inflation in emerging markets, less significant in advanced economies. There is also an impact on economic growth, because rising oil prices are a negative terms of trade effect on advanced economies and lead to a reduction in income and therefore in consumption. So you may expect a slowdown in economic growth. So far it is going to be a slowdown in economic growth, not a double dip recession, but if oil were to reach a level of $140 or $150. If -- and that's a big If -- the turmoil in the Middle East becomes much worse, then certainly the risk of a double dip recession, the risk of a stagflationary shock, where you have recession and rising inflation, would be a bigger risk for many economies. For the U.K., for the periphery of the Eurozone, eventually even for the United States.

So current levels of oil prices are a drag on growth for the global economy, but a modest drag, and they lead to a modest increase in inflation. Further shocks would have more destabilizing effect. They would also negatively affect business confidence, consumer confidence, investor confidence, in a way that could slow down growth more than otherwise. So that's a risk, but we don't know yet what the developments are going to be.

My final observation will be the following one, which will be another downside risk. I said at the beginning that the glass is half full. But it is half full because for the last two or three years we have had on one side a massive amount of monetary liquidity injections in the global economy, near zero policy rates in advanced economies, Quantitative Easing I, Quantitative Easing II in the U.S., in Japan, in other economies. So the glass has become full because liquidity has been huge chasing assets and leading to asset reflation. And on the fiscal side, until recently, we had massive fiscal stimulus in the U.S., in Japan, in emerging markets.

But if you look at the road ahead, there is going to be less monetary and fiscal stimulus. On the fiscal side, the Eurozone is already retrenching -- cutting spending, raising taxes -- because the bond vigilantes are forcing it in the Eurozone and United Kingdom. But even in the United States, where we are kicking the can down the road, there will be fiscal consolidation. It is already occurring at the state and local level. It is going to start to occur at the federal level as the
Republicans in Congress are pushing for spending cuts. So even in the U.S., the fiscal side is going to be a drag on economic growth. Not just in the Eurozone. Not just in the United Kingdom.

On the monetary side, with rising inflation, the European Central Bank has already signalled that they are going to start to increase interest rates, because they are worried about inflation. Inflation is already well above target in the United Kingdom, and the pressure on the Bank of England to raising interest rates if not today, in the next few months is going to be significant. And even in the United States, where policy rates are going to remain at zero, after the end of QE II in June, we are not going to have QE III, most likely. We are not going to have QE III because growth is positive, because inflation at the headline is rising, because Republicans are in control of the House and they are bashing the Fed, saying that the Fed is threatening to debase the currency and lead to inflation. And because a larger number of the members of the FOMC of the Fed, the three new governors are all more hawkish than Ben Bernanke (Kocher Lakota, Prosser, Fisher) and therefore even the Fed is going to be more cautious.

So the closing question is the following one: If the glass is half full because we had monetary and fiscal injections, but in the next few years, we are going to have fiscal austerity and exit from zero rates in the U.K, in the Eurozone, and eventually next year even in the United States, is there enough resilience in the private markets.
Is there enough resilience of consumption, of the corporate sector, of capex, to have resilient economic growth, when part of the monetary and the fiscal stimulus is going to go away.

I think that is an open question. So there are strengths, there are upside risks.
The real economies are doing well, and they are recovering, but certainly some of the downside risks I talked about, certainly those coming from the political risk in the Middle East, the risk of rising food and energy prices, may lead to a slowdown of growth and increasing inflation, and some of the downside risks that I referred to.

So the glass is half full, but it is also half empty, and we are going to still be in a world in which there is macro uncertainty and volatility, not just micro, financial, fiscal, political, policy, and also geopolitical. So it is still an uncertain world in which there are upside risks as well as downside risks.

1 comment:

  1. I am less optimistic about the US. Many of the problems have been kicked down the road. The banks are still very weak and we now have multiple sovereign debt crises to come. Real estate is close to the bottom, but if the US undergoes austerity then all bets are off and it could overshoot and wipe out many more banks. Much of the actions by governments have been to patch up the cracks without any reforms to eliminate the problems in future. So now we have weaker governments unable to protect the banks in future.