Roubini: Global Economy faces uncertain Future--including possible double dip--in 2013

Roubini: The Global Economy faces an uncertain Future in 2013

The American Economist Nouriel Roubini (Dr. Doom) predicted an uncertain scenario for the world economy in 2013, a year in which Europe could deepen its crisis, while China slow their growth and United States would fall into a situation of stagnation. The Economist was in the Argentina and during his talk highlighted as a favorable factor in the situation of globalization that promotes sharing and investments.

Nobel Prize in economics 2009 and famous for having predicted the crisis of 2007, Roubini spoke yesterday at the World Business Forum which took place in Buenos Aires last week. The American economist born in Turkey also drew attention to the risk posed the possibility of a confrontation between Israel and Iran for the world economy and that match the rest of its forecasts, it set a 'perfect storm' next year.

Roubini: "My prediction for the perfect storm is not this year but 2013 , because everybody is kicking the can down the road , we going to have a problem in the US after the election if we do not resolve our fiscal problem , China is overheating and at fix investment of 60 percent of GDP eventually it going to get a hard landing,  The Europeans are pushing their problems but Greece Ireland Portugal need to restructure their debt they are insolvent that's going to be on 2013 , Japan is going to shorten its stimulus it is going to slack again in a year from now , so I se every country in the world trying to push their problems to the future , we started with private debt public debt super national debt we are kicking the can down the road and eventually all this is going to come to a an end in 2013." - in CNBC

In the United States, the latest economic data – including a weak labor market – confirm that growth is anemic, with output in the second half of 2012 unlikely to be significantly stronger than the 1.6% annual gain recorded in January-June. And, given America’s political polarization and policy gridlock, we can expect more fights on the budget and the debt ceiling, another rating downgrade, and no agreement on a path toward medium-term fiscal consolidation and sustainability – regardless of whether President Barack Obama is reelected in November. On the contrary, we should expect agreement only on the path of least political resistance: avoidance of tough fiscal choices until the bond vigilantes eventually wake up, spike long rates, and force fiscal adjustment on the political system. - in project-syndicate

"It became clear in 2012 that this game of `kicking the can down the road` is a zero-sum game," he wrote in an article published on the Financial Times website "By 2013 at the latest, but possibly already in 2012, a perfect storm of a double-dip recession in the U.S., a disorderly scenario in the euro zone and a hard landing in China could materialize," he added - via CNBC

+++++++

I've been reading and listening to Dr. Doom (Roubini), Paul C. Roberts, and Gerald Celente, among others, since 2005, and I credit them totally that my wife and I were well aware ahead of time that the economic crisis which hit us in late 2007 was coming. Not like we had an overwhelming investment portfolio to secure, but our lives didn't get turned upside down by it and we didn't lose any money because of it, and we were able to warn friends and family it was coming. Whether or not they took us seriously or thought we were crazy is up for debate, but we still listen to them, and if Roubini says another one is coming, I believe him and you should too.--jef

Is China Headed for a High Speed Crash?

Dr. Doom and the Chinese EconomyBy PETER LEE

China's Ministry of Railways recently announced its high-speed trains will run slower in order to cope with problems of high operating costs and low passenger figures. This was promptly seized upon as a matter of important symbolism ... for the United States.

Charles Lane, an irregular contributor to the Washington Post's famously right-wing op-ed page, echoed the view of many conservative pundits when he wrote that the Chinese move vindicated Republican opposition to President Barack Obama's plans for high-speed rail in the United States.

Lane wrote:

Meanwhile, in the United States, Obama's high-speed rail plan, originally set at $53 billion over six years, has gotten a thorough democratic vetting. Three freshly elected Republican governors spurned federal dollars for high-speed rail, fearing a long-term burden on their budgets; homeowners in liberal Northern California are fighting construction through their neighborhoods; and the president agreed with Congress to trim current-year spending as part of a budget deal.

On the whole, I'd say China should envy us. [1]

In Lane's view, partisan gridlock will allow the United States to avoid the perils of socialist big-government planning and enjoy the enviable economic trifecta of decaying infrastructure, sluggish growth, and high employment.

By way of instructive contrast, the financial year 2011 cost of US military operations in Iraq and Afghanistan is expected to exceed US$171 billion (for a cumulative total of over $1.2 trillion to date). Fortunately this exercise in financially irresponsible big-government paternalism is discretely piling up corpses and blasting holes overseas, instead of affronting the eyes of value-conscious American taxpayers with the infuriating spectacle of shiny new high speed trains in their backyards. [2]

Nouriel Roubini observed the same Chinese trains and was able to extract some useful lessons for the Chinese economy.

China has grown for the last few decades on the back of export-led industrialization and a weak currency, which have resulted in high corporate and household savings rates and reliance on net exports and fixed investment (infrastructure, real estate, and industrial capacity for import-competing and export sectors). When net exports collapsed in 2008-2009 from 11% of GDP [gross domestic product] to 5%, China's leader reacted by further increasing the fixed-investment share of GDP from 42% to 47%.

Thus, China did not suffer a severe recession - as occurred in Japan, Germany, and elsewhere in emerging Asia in 2009 - only because fixed investment exploded. And the fixed-investment share of GDP has increased further in 2010-2011, to almost 50%.

The problem, of course, is that no country can be productive enough to reinvest 50% of GDP in new capital stock without eventually facing immense overcapacity and a staggering non-performing loan problem. China is rife with overinvestment in physical capital, infrastructure, and property. To a visitor, this is evident in sleek but empty airports and bullet trains (which will reduce the need for the 45 planned airports), highways to nowhere, thousands of colossal new central and provincial government buildings, ghost towns, and brand-new aluminum smelters kept closed to prevent global prices from plunging further. In the short run, the investment boom will fuel inflation, owing to the highly resource-intensive character of growth. But overcapacity will lead inevitably to serious deflationary pressures, starting with the manufacturing and real-estate sectors.

Eventually, most likely after 2013, China will suffer a hard landing. All historical episodes of excessive investment - including East Asia in the 1990s - have ended with a financial crisis and/or a long period of slow growth. [3]

The views of Dr Roubini, a professor at New York University and lord of an extensive econometrics and punditry empire, carry significant weight in China because of his reputation as "Dr Doom" - the economist who, as early as 2005-6 and virtually alone among his peers, predicted the catastrophic popping of the US real estate bubble and the subsequent unraveling of the world financial system.

Dr Doom's diagnosis of the problem is widely accepted. China engaged in an orgy of infrastructure building to stimulate industrial - as opposed to consumer - demand in order to dodge the 2008 recessionary bullet.

China's extravagances, most notably in the area of high-speed rail, do need some paring back.

As for the prognosis - that China will finally, in 2013, experience the hard landing that economists have continually predicted since the economy of the People's Republic kicked into high gear - views are considerably more mixed.

Morgan Stanley's analysts weighed in with an optimistic prediction that the Chinese consumer will, at long last, step up and drive the restructuring of the Chinese economy away from export-oriented industries and immense infrastructure projects that generate much more prestige than cash flow:

Most controversially perhaps, the analysts predict what they call "a golden age of consumption". China's consumption as percentage of GDP is currently among the lowest in the world, which many analysts attribute to cautious Chinese families saving money for their retirements or to pay for healthcare bills. But Mr Wang says Chinese consumers aren't waiting for the government to build a new social safety net before they spend more. They're waiting to make more money, which they'll do as labor demand boosts wages over the coming decade. Consumer spending zoomed in [South] Korea and Japan after those countries reached the $7,000 mark. [4]

Shaun Rein of the China Marketing Group put some factual - or at least statistical - meat on the rhetorical bones in an an op-ed for CNBC:

My firm interviewed 5,000 Chinese in 15 cities last year. It is true consumers over the age of 60 reported savings rates near 60% because they feared soaring medical and housing costs. After living through decades of upheaval and missing out on the recent economic boom, they remain thrifty. Little can be done to change decades of ingrained habits.

Our research suggests the key metric Roubini misses is shifts in how younger Chinese spend. Respondents under 32 years old had effective savings rates of zero. They remain confident about their money-making potential. Secretaries earning $600 a month commonly save two month's salary to buy the latest Apple iPhone or Estee Lauder cosmetics.

Consumer finance reforms are also spurring more consumption for younger Chinese. Total credit cards in circulation rose from 13.5 million in 2005 to 240 million in 2010 and will rise 22% annually for five years. More than 80% of the 18 million auto sales there last year were paid 100% up front. Brands like Toyota and General Motors are starting to push financing options, which will further unlock consumption. The data dispels the myth that Chinese are culturally high savers. [5]

Xinhua took note of Roubini's arguments and the rebuttals in a Chinese-language article.

The basic theme was polite skepticism, pointing out that China's growing economy had in the past defied predictions of overbuilding by catching up to the infrastructure and productive capacity poured into the economy.

But as for the future...

However, Roubini is perhaps quite correct in one respect. He believes that China's infatuation with excessive investment will lead to enormous waste and a significant decrease in the growth rate in the future. This view of his is very persuasive. [6]

A Caixin article picked up on the "future" theme, pointing out that the 2008 infrastructure investment bulge was a temporary measure to counteract the global economic slump.

An academic at Beijing Normal University, Li Shi, was interviewed by Caixin. He also pinned his hopes on the Chinese consumer. According to Li:

In the past, increases in individual incomes have lagged behind GDP growth. However, the 12th Five Year Plan intends to change this. It should be said it can be changed, because in the coming years there will be a major change in China's entire economic structure. If the economic structure can change, urbanization will accelerate, excess labor capacity in the villages will be mopped. It is possible that within three to five years, if the labor market experiences conditions of demand exceeding supply, worker's wage growth will accelerate. This would change the problem of excessively low personal incomes.

Also, China has been continually upgrading the social safety net ... which will, to a certain extent, contribute to an increase in individual consumption..

Maintaining 7% growth and maintaining relatively full employment while at the same time the government structurally adjusts its outlays and use a greater proportion to meet the demands for improved people's well-being, all can increase personal consumption.

Lot of conditionals, ifs, cans, coulds, and shoulds in Mr Li's observations. [7]

Roubini identifies some deeply embedded structural issues for the Chinese economy that he defines as critical and fears will take "two decades" to reform, rendering moot hopes of a soft landing in the next couple years:

To ease the constraints on household income, China needs more rapid exchange-rate appreciation, liberalization of interest rates, and a much sharper increase in wage growth. More importantly, China needs either to privatize its SOEs [state-owned enterprises], so that their profits become income for households, or to tax their profits at a far higher rate and transfer the fiscal gains to households. Instead, on top of household savings, the savings - or retained earnings - of the corporate sector, mostly SOEs, tie up another 25% of GDP.

But boosting the share of income that goes to the household sector could be hugely disruptive, as it could bankrupt a large number of SOEs, export-oriented firms, and provincial governments, all of which are politically powerful. As a result, China will invest even more under the current Five-Year Plan.

Continuing down the investment-led growth path will exacerbate the visible glut of capacity in manufacturing, real estate, and infrastructure, and thus will intensify the coming economic slowdown once further fixed-investment growth becomes impossible. Until the change of political leadership in 2012-2013, China's policymakers may be able to maintain high growth rates, but at a very high foreseeable cost.

Dr Roubini has a point. The 12th Five-Year Plan is not a glorious political and economic document. Its apparent priority is to kick the can down the road rather than risk the big reforms that might upset the applecart prior to the leadership handover.

Instead of moving openly and aggressively on the issue of the real estate bubble - thereby gutting the finances of the SOEs and local governments that rely on the real estate boom for significant revenues - the Five-Year Plan puts a political band-aid on the problem by mandating the construction of low-income housing for citizens priced out of the private sector residential market.

The perpetual lure of the bubble, combined with access to virtually cost-free money courtesy of China's inflation-beleaguered individual depositors, continues to drive runaway bank lending, despite government efforts to cool things down by raising interest rates, boosting reserve requirements, limiting the leverage available to buyers of first and second homes - and trying to reduce local government dependence on revenues from real estate boondoggles by introducing a property tax.

As Reuters reported:

"Net interest margins for the quarter were higher, and that's the most important factor for Chinese banks," said James Antos, a banking analyst with Mizuho Securities. [8]

Higher "net interest margins" translated into expected average profit margin gains of 29% for the banking sector in just one quarter over last year.
The undervalued yuan is still one of the best bargains on the planet, especially since the burgeoning Chinese economy offers plenty of places to invest it. China's exchange rate policy continues to suck in dollars - hot money and investment dollars as well as export earnings - that contribute to the real estate and stock market bubbles.

China's forex reserves are ballooning to ridiculous levels - ridiculous as in $3 trillion. The immense reserves - and the exchange rate policy that enabled them - are no longer a source of reflexive national pride. They are a source of anxiety, as Zhou Xiaochuan, the head of the People's Bank of China, conceded:

"Foreign-exchange reserves have exceeded the reasonable levels that we actually need," Zhou said. "The rapid increase in reserves may have led to excessive liquidity and has exerted significant sterilization pressure. If the government doesn't strike the right balance with its policies, the build-up could cause big risks," he said, without elaborating. [9]

In the current environment, an ever-growing mountain of foreign exchange represents a double headache. Forex inflows have to be purchased using yuan, and then yuan bonds issued to sop up the excessive liquidity - the sterilization pressure Zhou is talking about, and a most unwelcome contributor to China's worrisome inflation rate. Meanwhile, the forex has to generate some kind of return, but there's no good place to put $3 trillion - thanks in part to the inrush of Chinese dollars, the rate on short term US Treasury paper is near zero.

Raising interest rates in a global environment of rock-bottom interest rates is not a recipe for success, as Brazil is learning. Rapid appreciation of the yuan is emerging as a possible measure to curb inflation and cool the economy.

Even so, allowing rapid yuan appreciation in order to put China's financial and forex policy on an even keel is an unnerving leap into an unknown of diminishing exports and growing unemployment that the Chinese government is still hesitant to make.

In sum, China's response to its overheating and structurally unbalanced economy is not a profile in courage. Maybe it's a disaster waiting to happen. Over at the quant-hive Seeking Alpha, Craig Pirrong pontificated:

... whether Chinese economic management can avoid the kind of catastrophe that Roubini and I consider to be likely depends on your view of the efficacy of centralized economic management of the type that China practices. The Thomas Friedmans of the world, and arguably Obama, believe that such dirigisme is superior to the messy, decentralized, unplanned and non-centrally coordinated actions of greedy individuals in markets. People like me, conversely, believe that the visible hands of greedy, largely ignorant, and short-sighted politicians and bureaucrats is likely to lead to inferior outcomes.

Pirrong's smug celebration of free-market omniscience is a little harder to digest when one remembers that, in 2006-2008, the invisible hand was not efficiently allocating capital. Instead it was engaged in busy, sticky self-gratification as hedge funds and investment banks pumped subprime debt into the financial markets to give them an excuse to sell more derivatives and borrow more money until leverage was over 35:1... so they could buy and sell more derivatives.

The credit default swap (CDS) market grew to $60 trillion - or $38 trillion, depending on how you keep score (for comparison purposes, total US GDP is $14 trillion).

A delicious vagueness was part of the whole CDS magic. The swaps were almost entirely synthetic, written and purchased by financial institutions that had no exposure to the underlying security or commodity. The market was unregulated, open only to the so-called "experienced", ie deep-pocketed investors, and characterized by fearsome information asymmetries.

Despite declarations of its defenders that the existence of this global casino promoted efficiency and liquidity, the global market's fundamental lack of transparency came back to bite it. As the real estate market finally soured, a spasm of panic and mistrust in 2008 caused the entire financial system to seize up; the market lost the ability to price the complex and opaque swaps, capital flowed out of the financial companies, and credit was unobtainable. Titanic leveraging converted into titanic deleveraging and the financial markets were overwhelmed.

The financial companies thereupon slunk back to the public trough like whipped hounds to convert to bank holding companies to avail themselves of government-insured deposits, or to obtain government assumption of toxic waste debt in order to enable mergers between stronger firms and their crippled rivals.

The public - the "little guys" who were disqualified from participating in the derivatives financial orgy in the first place - were not allowed to simply play the role of fascinated and eventually horrified bystanders. When the mess unraveled, they paid the toll in lost retirement savings, lost homes, lost jobs, and the cutbacks in public services that came with collapse of tax revenues in the recession.

The only force to survive intact was the industry's invincible self-regard, made possible only by its convenient and conveniently short memory, the tender mercy of bespoke politicians and regulators worldwide, and the co-dependent driveling of the fanboy financial press.

In contrast to the United States, China's financial system is biased toward regulation, government management, keeping a lid on international capital flows, and ignoring calls for financial innovation that serve primarily to enlarge and fatten the profits of the financial sector.

China's wishlist for reform of the international financial system is incorporated in the April 14 declaration at Sanya, Hainan, after a summit of the leaders of Brazil, Russia, China, India and South Africa - the BRICS group of nations.

The declaration makes it clear that the PRC believes that the current default attitude - ignoring the role of the sizable Chinese government stimulus in averting a global recession and finger-wagging China for its exchange-rate peccadilloes while disregarding the Western world's colossal financial fail - should be abandoned.

Instead, the PRC is yearning for an endorsement of China's government-knows-best financial policy on a global scale: a coordinated international effort to make the international flow of capital and trade in derivatives more transparent and susceptible to multilateral intervention.

The conclusion that the United States, by reason of its serial regulatory and fiscal transgressions, is no longer fit to lead the international financial system (or impose fealty to its free-market nostrums) is also made clear by the call for a new reserve currency protected from the machinations of the US Federal Reserve.

16. Recognizing that the international financial crisis has exposed the inadequacies and deficiencies of the existing international monetary and financial system, we support the reform and improvement of the international monetary system, with a broad-based international reserve currency system providing stability and certainty. We welcome the current discussion about the role of the SDR [the special drawing rights of the International Monetary Fund] in the existing international monetary system including the composition of SDR's basket of currencies. We call for more attention to the risks of massive cross-border capital flows now faced by the emerging economies. We call for further international financial regulatory oversight and reform, strengthening policy coordination and financial regulation and supervision cooperation, and promoting the sound development of global financial markets and banking systems.

17. Excessive volatility in commodity prices, particularly those for food and energy, poses new risks for the ongoing recovery of the world economy. We support the international community in strengthening cooperation to ensure stability and strong development of physical market by reducing distortion and further regulate financial market. The international community should work together to increase production capacity, strengthen producer-consumer dialogue to balance supply and demand, and increase support to the developing countries in terms of funding and technologies. The regulation of the derivatives market for commodities should be accordingly strengthened to prevent activities capable of destabilizing markets. We also should address the problem of shortage of reliable and timely information on demand and supply at international, regional and national levels. The BRICS will carry out closer cooperation on food security. [10]

Good luck with that.

The counterintuitive lesson that the US and Europe seem to have derived from the financial meltdown is that debt, stimulus, reform, and regulation are only going to make matters worse. With an unwillingness to regulate capital and derivative markets domestically, the will to regulate them internationally is non-existent.

The most interesting social experiment in the world today is communist China's attempt to manage economic stresses through classic national Keynsianism, while the United States gyrates in an apparent death spiral of deregulation, austerity, and defunding of its national and local government services.

To be sure, China has to date displayed a distinct aversion to the hard choices that would reform its economy and put it on a firm footing for sustainable growth - such as pricking the real estate bubble and undertaking a major and risky appreciation of the yuan.

The difference is that Chinese Keynesianism retains the fiscal, regulatory, and political means for intervention, adjustment, redirection, and if desirable, deregulation and privatization.

In the United States, once the revenue and regulatory apparatus is gutted as a result of political calculation and national disillusionment, will there be any turning back?

Perhaps that's the real approaching train wreck.

Notes:
1. China's train wreck, Washington Post, Apr 21, 2011.
2. Estimated War-Related Costs, Iraq and Afghanistan, Infoplease, by end of the fiscal year of 2011.
3. China's bad growth bet, Aljazeera, Apr 18, 2011.
4. Great China Debate Continues: How Fast, How Long?, Wall Street Journal, Apr 25, 2011.
5. Why Nouriel Roubini Is Wrong on China's Economy, Apr 19, 2011.
6. Click Here for the Chinese text of Xinhua.
7. Click Here for the Chinese text on Sina.com.
8. Hefty Chinese bank profits expected despite govt tightening, Reuters, Apr 25, 2011.
9. Zhou Says $3 Trillion China Reserves Have Risen Beyond 'Reasonable' Level, Bloomberg, Apr 19, 2011.
10. Sanya Declaration of the BRICS Leaders Meeting, Chinese Embassy in Norway, Apr 14, 2011.

The US Economy is A Giant Ponzi Scheme

Prosecuting Wall Street Fraud: 

Washington's Blog

Bill Gross, Nouriel Roubini, Laurence Kotlikoff, Steve Keen, Michel Chossudovsky and the Wall Street Journal all say that the U.S. economy is a giant Ponzi scheme.

Virtually all independent economists and financial experts say that rampant fraud was largely responsible for the financial crisis. See this and this.

But many on Wall Street and in D.C. - and many investors - believe that we should just "go with the flow". They hope that we can restart our economy and make some more money if we just let things continue the way they are.

But the assumption that a system built on fraud can continue without crashing is false.

In fact, top economists and financial experts agree that - unless fraud is prosecuted - the economy cannot recover.

Fraud Leads to a Break Down in Trust and Instability in the Markets

As Alan Greenspan said recently:

Fraud creates very considerable instability in competitive markets. If you cannot trust your counterparties, it would not work

Similarly, leading economist Anna Schwartz - co-author of the leading book on the Great Depression with Milton Friedman - told the Wall Street journal in 2008:

"The Fed ... has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible."

So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."

***

Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value."

"Why are they 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them, you don't know what they're worth, your balance sheet is not credible and the whole market freezes up. We don't know whom to lend to because we don't know who is sound. So if you could get rid of them, that would be an improvement."

And economics professor and former Secretary of Labor Robert Reich wrote in 2008:

The underlying problem isn't a liquidity problem. As I've noted elsewhere, the problem is that lenders and investors don't trust they'll get their money back because no one trusts that the numbers that purport to value securities are anything but wishful thinking. The trouble, in a nutshell, is that the financial entrepreneurship of recent years -- the derivatives, credit default swaps, collateralized debt instruments, and so on -- has undermined all notion of true value. 

Robert Shiller - one of the top housing experts in the United States - said recently that failing to address the legal issues will cause Americans to lose faith in business and the government:

Shiller said the danger of foreclosuregate -- the scandal in which it has come to light that the biggest banks have routinely mishandled homeownership documents, putting the legality of foreclosures and related sales in doubt -- is a replay of the 1930s, when Americans lost faith that institutions such as business and government were dealing fairly.

Nobel prize-winning economist Joseph Stiglitz says about the failure to prosecute Wall Street fraud:

The legal system is supposed to be the codification of our norms and beliefs, things that we need to make our system work. If the legal system is seen as exploitative, then confidence in our whole system starts eroding. And that's really the problem that's going on.

***

I think we ought to go do what we did in the S&L [crisis] and actually put many of these guys in prison. Absolutely. These are not just white-collar crimes or little accidents. There were victims. That's the point. There were victims all over the world.

***

Economists focus on the whole notion of incentives. People have an incentive sometimes to behave badly, because they can make more money if they can cheat. If our economic system is going to work then we have to make sure that what they gain when they cheat is offset by a system of penalties.

Wall Street insider and New York Times columnist Andrew Ross Sorkin writes:

“They will pick on minor misdemeanors by individual market participants,” said David Einhorn, the hedge fund manager who was among the Cassandras before the financial crisis. To Mr. Einhorn, the government is “not willing to take on significant misbehavior by sizable” firms. “But since there have been almost no big prosecutions, there’s very little evidence that it has stopped bad actors from behaving badly.”

***

Fraud at big corporations surely dwarfs by orders of magnitude the shareholders’ losses of $8 billion that Mr. Holder highlighted. If the government spent half the time trying to ferret out fraud at major companies that it does tracking pump-and-dump schemes, we might have been able to stop the financial crisis, or at least we’d have a fighting chance at stopping the next one.

Economics professor James Galbraith says:

There will have to be full-scale investigation and cleaning up of the residue of that, before you can have, I think, a return of confidence in the financial sector. And that's a process which needs to get underway.

No wonder Galbraith says that economists should move into the background, and "criminologists to the forefront"

Failure to Stop Fraud and Prosecute Criminals Causes a Loss of Trust in Government, Which Makes Government Less Effective

As Shiller stated in the quote above, the failure of government officials to stop fraud and prosecute the financial fraudsters has caused a lack of trust in government itself.

Indeed, polls show that people no longer trust our economic "leaders". See this and this.

A psychologist wrote an essay published by the Wharton School of Business arguing that restoring trust is the key to recovery, and that trust cannot be restored until wrongdoers are held accountable:

According to David M. Sachs, a training and supervision analyst at the Psychoanalytic Center of Philadelphia, the crisis today is not one of confidence, but one of trust. "Abusive financial practices were unchecked by personal moral controls that prohibit individual criminal behavior, as in the case of [Bernard] Madoff, and by complex financial manipulations, as in the case of AIG." The public, expecting to be protected from such abuse, has suffered a trauma of loss similar to that after 9/11. "Normal expectations of what is safe and dependable were abruptly shattered," Sachs noted. "As is typical of post-traumatic states, planning for the future could not be based on old assumptions about what is safe and what is dangerous. A radical reversal of how to be gratified occurred."

People now feel more gratified saving money than spending it, Sachs suggested. They have trouble trusting promises from the government because they feel the government has let them down.

He framed his argument with a fictional patient named Betty Q. Public, a librarian with two teenage children and a husband, John, who had recently lost his job. "She felt betrayed because she and her husband had invested conservatively and were double-crossed by dishonest, greedy businessmen, and now she distrusted the government that had failed to protect them from corporate dishonesty. Not only that, but she had little trust in things turning around soon enough to enable her and her husband to accomplish their previous goals.

"By no means a sophisticated economist, she knew ... that some people had become fantastically wealthy by misusing other people's money -- hers included," Sachs said. "In short, John and Betty had done everything right and were being punished, while the dishonest people were going unpunished."

Helping an individual recover from a traumatic experience provides a useful analogy for understanding how to help the economy recover from its own traumatic experience, Sachs pointed out. The public will need to "hold the perpetrators of the economic disaster responsible and take what actions they can to prevent them from harming the economy again." In addition, the public will have to see proof that government and business leaders can behave responsibly before they will trust them again, he argued.

Government regulators know this - or at least pay lip service to it - as well. For example, as the Director of the Securities and Exchange Commission's enforcement division told Congress:

Recovery from the fallout of the financial crisis requires important efforts on various fronts, and vigorous enforcement is an essential component, as aggressive and even-handed enforcement will meet the public's fair expectation that those whose violations of the law caused severe loss and hardship will be held accountable. And vigorous law enforcement efforts will help vindicate the principles that are fundamental to the fair and proper functioning of our markets: that no one should have an unjust advantage in our markets; that investors have a right to disclosure that complies with the federal securities laws; and that there is a level playing field for all investors.

If people don't trust their government to enforce the law, government will become more and more impotent in addressing our economic problems. If government leaders take action, the market will not necessarily respond as expected. When government leaders make optimistic statements about the economy, people will no longer believe them.

Trying to Cover Up the Truth Extends Financial Crises

Elizabeth Warren, William Black and others say that attempting to cover up the truth extended Japan's financial problems into an entire "Lost Decade".

As Joseph Stiglitz said about Wall Street fraud:

So the whole strategy of the banks has been to hide the losses, muddle through and get the government to keep interest rates really low.

***

As long as we keep up this strategy, it's going to be a long time before the economy recovers ....

Pam Martens - who worked on Wall Street for 21 years - writes:

To the extent that the government tries to cover up - instead of openly discuss - financial fraud, it will only extend America's economic malaise.

Failing to Prosecute Fraud Encourages Financial Players to Take Bigger and More Blatantly Illegal Actions

Nobel prize winning economist George Akerlof has demonstrated that failure to punish white collar criminals - and instead bailing them out- creates incentives for more economic crimes and further destruction of the economy in the future. Joseph Stiglitz, Professor Black, and many others agree. See this, this and this.

It was largely fraud which brought down the financial system in 2008. Unless we prosecute the fraudsters, they will do even bigger, stupider and more blatantly illegal things in the future which will lead to even bigger crises.

Failure to Prosecute Fraud Exacerbates the Sovereign Debt Crisis

The governments of the world have spent trillions trying to paper over the fraud and prop up the big, insolvent banks, instead of forcing them to restructure and forcing bondholders and shareholders to take a haircut.

A study of 124 banking crises by the International Monetary Fund found that propping banks which are only pretending to be solvent drives up the costs to the country:

Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.

Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.

***

All too often, central banks privilege stability over cost in the heat of the containment phase: if so, they may too liberally extend loans to an illiquid bank which is almost certain to prove insolvent anyway. Also, closure of a nonviable bank is often delayed for too long, even when there are clear signs of insolvency (Lindgren, 2003). Since bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.

The American banks and government have certainly pretended that all of the big banks are solvent. As ABC wrote in October 2009:

The Treasury Department and the Federal Reserve lied to the American public last fall when they said that the first nine banks to receive government bailout funds were healthy, [the special inspector general for the Troubled Asset Relief Program] states in a new report released today.

Similarly, the stress tests were a complete and utter sham.

The government has given the giant banks huge amounts in loans and guarantees based upon their false representations about their financial health. The Fed has larded up its balance sheet with toxic assets from the banks.

Debt levels are also getting dangerously close to the level that they become a drag on the economy. See this and this. When Keynesian economists argue that debt does not harm the economy, they are talking about debt incurred to pay for stimulus and productive things for the economy. But throwing trillions at the giant banks - who are mainly using the money to gamble - is not stimulus. It helps the executives of the big banks and their shareholders and bondholders, but not the broader economy.

Indeed, attempting to prop up big, insolvent banks is preventing stimulus from getting out into the economy.

Fraud Causes Growing Inequality, Which Undermines the Economy

Growing inequality is very harmful to our economy. Indeed, if wealth is concentrated in too few hands, the "poker game" ends, as only too few fat cats are left with all of the chips. See this, this, this and this.

Fraud benefits the wealthy more than the poor, because the big banks and big companies have the inside knowledge and the resources to leverage fraud into profits. Joseph Stiglitz noted in September that giants like Goldman are using their size to manipulate the market. The giants (especially Goldman Sachs) have also used high-frequency program trading (making up between 40- 70% of all stock trades) which not only distorts the markets, but which also lets the program trading giants take a sneak peak at what the real traders are buying and selling, and then trade on the insider information. See this, this, this, this and this. 

Similarly, JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley together hold 80% of the country's derivatives risk, and 96% of the exposure to credit derivatives. They use their dominance in the market to manipulate the market.

Fraud disproportionally benefits the big players (and helps them to become big in the first place), increasing inequality and warping the market.

Fraud Increases the Severity of Boom-Bust Cycles

More and more people - such as the Bank of International Settlements and Barons - are saying that bubbles inevitably lead to busts, thus destabilizing the economy.

Professor Black says that fraud is a large part of the mechanism through which bubbles are blown.

Without strong laws against fraud, bubble after bubble will be blown, guaranteeing that the financial system cannot be stabilized in a fundamental sense.

Failure to Prosecute Fraud Is Worsening the Housing Crisis

Finally, failure to prosecute mortgage fraud is arguably worsening the housing crisis. See this and this.

How Obama can save the fragile economy from going back into a tailspin

Avoid the Double Dip
BY NOURIEL ROUBINI, MICHAEL MORAN | NOVEMBER 2010

Roughly three years since the onset of the financial crisis, the U.S. economy increasingly looks vulnerable to falling back into recession. The United States is flirting with "stall speed," an anemic rate of growth that, if it persists, can lead to collapses in spending, consumer confidence, credit, and other crucial engines of growth. Call it a "double dip" or the Great Recession, Round II: Whatever the term, we're talking about a negative feedback loop that would be devilishly hard to break.

If Barack Obama wants a realistic shot at a second term, he'll need to act quickly and decisively to prevent this scenario.

Double-digit unemployment is the root of the problem. Without job creation there's a lack of consumer spending, which represents 40 percent of domestic GDP. To date, the U.S. government has responded creatively and massively to the near collapse of the financial system, using a litany of measures, from the bank bailout to stimulus spending to low interest rates. Together, these policies prevented a reprise of the Great Depression. But they also created fiscal and political dilemmas that limit the usefulness of traditional monetary and fiscal tools that policymakers can turn to in a pinch.

With interest rates near zero percent already, the Federal Reserve has few bullets left in its holster to boost growth or fend off another slump. This lack of available good options was patently on display in August when Fed Chairman Ben Bernanke spoke with a tinge of resignation about new "quantitative easing" interventions in the mortgage and bond markets -- a highly technical suggestion that, until the recent crisis, amounted to heresy among Fed policymakers. It certainly hasn't helped that the U.S. federal deficit has reached heights that make additional stimulus spending, of the kind that helped kindle the mini-recovery of early 2010, politically impossible.

Yet all is not lost. Obama will face an increasingly partisan and divided Washington over the next two years, but he can take steps to reduce the odds that this dark double-dip scenario comes to pass. This will, of course, require deft politics. To that end, the administration should focus on policies that create a revenue-neutral fiscal stimulus -- one that targets both labor demand and consumption.

Start with the one thing that everyone loves to hate: taxes. Forget the political hot potato over the size and shape of the cuts -- there's an easy way to do this. For the next two years, Obama should reduce payroll taxes for both employers and employees. The reduction for employers will lower labor costs and allow the hiring of more workers; for employees, increased take-home pay will get people spending again. It's not just about increasing foot traffic in the mall; households need to pay down the burden of credit cards, second mortgages, and other legacies of the years of easy credit.

But this tax cut can't bust the budget. How can it be funded? By allowing George W. Bush's tax cuts for people making more than $250,000 to expire while keeping in place those for middle- and low-income earners -- the vast majority of Americans. And whatever trickle-down Republicans in Congress say, Obama will have to remain firm on this.

After two years, when U.S. growth is hopefully more robust and the pace of private-sector hiring has picked up steam, Obama can afford to phase out the payroll tax cuts. But the income-tax increases for the rich? They'll need to stick around. To woo key middle-of-the-road Democrats and moderate Republicans and to maximize the incentives for private-sector hiring, the president should make sharper reductions to payroll taxes paid by employers than to those paid by employees. This makes mincemeat of the argument that high-income individuals invariably resort to -- that higher income taxes will hurt small businesses and curtail hiring. By incentivizing both consumer spending and hiring, this plan goes far beyond the modest tax credits for business investment proposed in September.

As for the employee payroll tax cuts, because low-income workers generally consume more of their salaries when given extra money, the payroll tax cut should be designed to provide a larger percentage break to those on the low end of the income scale. This has another ancillary benefit: "Progressive" Democrats will find this tax cut an easier sell.

But the mixture of employer and employee payroll tax cuts, the latter benefiting the majority of Americans, represents only the beginning of what might be done with a more creative approach to tax policy. After all, everyone agrees that something needs to be done: The president's fiercest political rivals go on the record daily declaring an economic state of emergency.

It's high time to hold U.S. financial institutions to account. The very companies that benefited from the billions of dollars of taxpayer stimulus are currently building up huge cash reserves -- in effect, overinvesting in capital at the expense of jobs. Taxing this capital would reduce the relative cost of labor and get companies hiring again.

Both for policy and political reasons, Obama should emphasize that these changes would be temporary. Absent a new stimulus package -- which appears highly unlikely at this point -- these cuts are the best way to avert another economic disaster. They direct billions of dollars back to the American households that are most likely to spend them and those businesses most likely to hire new employees.

Only a tiny percentage of Americans will end up paying more: the highest-income earners, who have already benefited greatly from the service the government (read: taxpayers) rendered to their brokerage firms and investment banks in 2008. Republicans may rail against increasing taxes on any American, but the complaints of the wealthy, in today's economic climate, will have little credibility among middle-class voters. In exchange for this increase, Obama can fashion a large tax break for employers and employees that jump-starts consumption, encourages hiring, and reduces the risk of a double dip -- all without busting the budget.

Want To Create Jobs? Break Up The Banks.

by Zach Carter on 10-08-10

I attended two big economic gatherings this week, one on financial reform organized by finance blogger Mike Konczal for The Roosevelt Institute, another on the economic outlook, presented by the American Enterprise Institute. Each event was depressing in its own right, but combined, they spell out very big trouble for the U.S. economy. Things are about to get much, much worse for just about everybody, even as big banks deploy their lobbying armies to secure the right to make things even more miserable. Despite all of this bad news, I think we might actually be on the verge of some real economic progress. Let me explain.

The general mood at the Roosevelt Institute forum was one of caution bordering on pessimism. Congress passed Wall Street reform legislation that gives regulators a lot of powers to rein in banks that behave badly. Without intense and sustained pressure from reformers, those powers will not be used, especially if Republicans take control of at least one house of Congress next year, and use it to divert regulatory attention with intentionally meaningless inquiries and investigations. The regulatory battle has just begun, and further legislative action is needed to deal with some of the most pressing problems, particularly too-big-to-fail and the foreclosure mess. With a few exceptions, the thirty or so people who attended the Roosevelt Institute event were the individuals most responsible for getting that legislation through Congress—for them to be sounding the alarm is significant (see Annie Lowrey’s write-up of the conference for more details).

The AEI panel was packed with a cadre of intellectually boring conservatives, notable for the fact that many were actually advocating strong federal action to right the economic ship. But the discussion was unquestionably dominated by the remarks of Nouriel Roubini and Christopher Whalen, two very smart people who don’t work for AEI.

Whalen made the most persuasive case of the group. We haven’t fixed the banking system. Banks aren’t lending, they aren’t trying to lend, and they aren’t going to try until they’ve finished absorbing all the foreclosures embedded in their balance sheets. Left to their own devices, banks will drag that process out as long as possible in order to avoid immediate losses. And the past four years of horrific foreclosure statistics are just the beginning—Whalen thinks we’re, at best, about 25 percent of the way through process.

What’s worse, the mortgage situation is effectively serving as a blockade against economic policy. Any action the government takes is going to be stymied by the fact that millions of American households are struggling to pay of homes that aren’t worth their sticker price.

Fortunately, there’s a solution to that problem. Take over the banks, and write-down the amount that troubled borrowers owe so that they can stay in their homes without pissing away their money to banks that don’t lend. In Whalen’s view, if we want to solve unemployment and get the economy growing again, we have to break up the banks and help troubled homeowners.

That just happens to be my view, as well. Essentially, Whalen—who describes himself as a conservative libertarian—and the progressive braintrusters from the Roosevelt Institute agree about what needs to be done. The critical question is whether there is any political will to do it. And that’s where Nouriel Roubini’s presentation gets scary.

If we don’t fix the banks and don’t fix foreclosures and don’t get serious about fiscal policy to ease unemployment, we’re going to have another financial crisis within a few years. And the next time around, a financial crisis will mean a real fiscal crisis for the U.S.– not just phony fear-mongering by opportunistic traders.

This isn’t the first time Roubini has issued that warning. He said the same basic thing when I interviewed him in May. The trick is, back in May, none of the bank analysts and traders who attended yesterday’s AEI event really took him seriously. Now even those elites believe that the economy is in deep trouble and in need of a major shot in the arm from the federal government.

Perversely, all of this bad news gives me some cause for optimism. Wall Street’s lobbyists are as powerful as ever, but the intellectual debate over the economic path forward is getting more reasonable as the economy deteriorates and people realize that conservative policies and liberal half-measures are simply not working.

That doesn’t mean that securing real reform will be a walk in the park. Both panelists and attendees of the AEI shebang bemoaned the new Basel III capital regime as overly onerous for banks and a barrier to economic recovery—a view which is simply wrong on both points. Given that they’re averse to higher capital requirements for the banking industry—the bare minimum move for greater financial stability—convincing them to break up Bank of America and Wells Fargo will be a major task.

But at least those people aren’t laughing the reformers out of the room anymore. That’s a step in the right direction, and it shows that financial reform isn’t really about any kind of ideological divide between the left and right. It’s about the basic functioning of the economy, and more broadly speaking, of democratic systems. Coupled with the fact that banks have created a legal nightmare for themselves by cutting corners on their mortgage paperwork, there’s quite a bit of room for persuasion.

Dr. Doom says: Double-Dip Days Are Here

Nouriel Roubini | 2010-07-16

NEW YORK – The global economy, artificially boosted since the recession of 2008-2009 by massive monetary and fiscal stimulus and financial bailouts, is headed towards a sharp slowdown this year as the effect of these measures wanes. Worse yet, the fundamental excesses that fueled the crisis – too much debt and leverage in the private sector (households, banks and other financial institutions, and even much of the corporate sector) – have not been addressed.

Private-sector deleveraging has barely begun. Moreover, there is now massive re-leveraging of the public sector in advanced economies, with huge budget deficits and public-debt accumulation driven by automatic stabilizers, counter-cyclical Keynesian fiscal stimulus, and the immense costs of socializing the financial system’s losses.

At best, we face a protracted period of anemic, below-trend growth in advanced economies as deleveraging by households, financial institutions, and governments starts to feed through to consumption and investment. At the global level, the countries that spent too much – the United States, the United Kingdom, Spain, Greece, and elsewhere – now need to deleverage and are spending, consuming, and importing less.

But countries that saved too much – China, emerging Asia, Germany, and Japan – are not spending more to compensate for the fall in spending by deleveraging countries. Thus, the recovery of global aggregate demand will be weak, pushing global growth much lower.

The global slowdown – already evident in second-quarter data for 2010 – will accelerate in the second half of the year. Fiscal stimulus will disappear as austerity programs take hold in most countries. Inventory adjustments, which boosted growth for a few quarters, will run their course. The effects of tax policies that stole demand from the future – such as incentives for buyers of cars and homes – will diminish as programs expire. Labor-market conditions remain weak, with little job creation and a spreading sense of malaise among consumers.

The likely scenario for advanced economies is a mediocre U-shaped recovery, even if we avoid a W-shaped double dip. In the US, annual growth was already below trend in the first half of 2010 (2.7% in the first quarter and estimated at a mediocre 2.2% in April-June). Growth is set to slow further, to 1.5% in the second half of this year and into 2011.

Whatever letter of the alphabet US economic performance ultimately resembles, what is coming will feel like a recession. Mediocre job creation and a further rise in unemployment, larger cyclical budget deficits, a fresh fall in home prices, larger losses by banks on mortgages, consumer credit, and other loans, and the risk that Congress will adopt protectionist measures against China will see to that.

In the eurozone, the outlook is worse. Growth may be close to zero by the end of this year, as fiscal austerity kicks in and stock markets fall. Sharp rises in sovereign, corporate, and interbank liquidity spreads will increase the cost of capital, and increases in risk aversion, volatility, and sovereign risk will undermine business, investor, and consumer confidence further. The weakening of the euro will help Europe’s external balance, but the benefits will be more than offset by the damage to export and growth prospects in the US, China, and emerging Asia.

Even China is showing signs of a slowdown, owing to the government’s attempts to control economic overheating. The slowdown in advanced economies, together with a weaker euro, will further dent Chinese growth, bringing its 11%-plus growth rate towards 7% by the end of this year. This is bad news for export growth in the rest of Asia and among commodity–rich countries, which increasingly rely on Chinese imports.

An important victim will be Japan, where anemic real income growth is depressing domestic demand and exports to China sustain what little growth there is. Japan also suffers from low potential growth, owing to a lack of structural reforms and weak and ineffective governments (four prime ministers in four years), a large stock of public debt, unfavorable demographic trends, and a strong yen that gets stronger during bouts of global risk aversion.

A scenario in which US growth slumps to 1.5%, the eurozone and Japan stagnate, and China’s growth slows below 8% may not imply a global contraction, but, as in the US, it will feel like one. And any additional shock could tip this unstable global economy back into full-fledged recession.

The potential sources of such a shock are legion. The eurozone’s sovereign-risk problems could worsen, leading to another round of asset-price corrections, global risk aversion, volatility, and financial contagion. A vicious cycle of asset-price correction and weaker growth, together with downside surprises that are not currently priced by markets, could lead to further asset-price declines and even weaker growth – a dynamic that drove the global economy into recession in the first place.

And one cannot exclude the possibility of an Israeli military strike on Iran in the next 12 months. If that happens, oil prices could rapidly spike and, as in the summer of 2008, trigger a global recession.

Finally, policymakers are running out of tools. Additional monetary quantitative easing will make little difference, there is little room for further fiscal stimulus in most advanced economies, and the ability to bail out financial institutions that are too big to fail – but also too big to be saved – will be sharply constrained.

So, as the optimists’ delusional hopes for a rapid V-shaped recovery evaporate, the advanced world will be at best in a long U-shaped recovery, which in some cases – the eurozone and Japan – may be long enough to stretch into an L-shaped near-depression. Avoiding double dip recession will be difficult.

In such a world, recovery in the stronger emerging markets – the great hope for the global economy – will suffer, because no country is an island economically. Indeed, growth in many emerging-market economies – starting with China – is highly dependent on retrenching advanced economies.

Fasten your seat belts for a very bumpy ride.

An Interview with Dr. Doom: Nouriel Roubini

This man is a genius. Read what this man has to say...

###

How to Break Up the Banks, Stop Massive Bonuses, and Rein in Wall Street Greed
By Zach Carter and Nouriel Roubini, AlterNet
May 19, 2010

New York University economist Nouriel Roubini is the author of, most recently, "Crisis Economics: A Crash Course In The Future Of Finance." He is considered one of the most prominent and respected economists in the world. When both Wall Street bankers and Bush administration policymakers were insisting that everything was just fine, Roubini was warning about the most dire financial crisis since the Great Depression. In 2007, the financial elite laughed him off, but Roubini was vindicated by the crash of 2008. AlterNet economics editor Zach Carter recently spoke with Roubini about the financial crisis, the subsequent bailout, the financial reform bill moving through Congress, and the global economic outlook.

Zach Carter: How is the financial reform legislation going?

Nouriel Roubini: In my view, the financial reform bill goes in the right direction in terms of what needs to be done, but it doesn't go far enough in a number of dimensions. My view is that if banks are too big to fail, using higher capital charges and an insolvency regime is not going to work. If they're too big to fail, they're just too big, and they should be broken up.

If they're too big to fail, they're also becoming too big to be saved, too big to be bailed out, and too big to be managed. No CEO can monitor the activities of thousands of separate profit and loss statements, and the activities of thousands of different bankers and traders. So that's one dimension. We must be capable of going beyond the Volcker Rule, which is essentially Glass-Steagall-Lite. We need to go all the way and implement the kind of restrictions between commercial banking and investment banking that existed under Glass-Steagall.

ZC: Why do you see the Volcker Rule as insufficient? Why do we need Glass-Steagall?

Roubini: The Volcker Rule goes in the right direction, but in my view, the model of the financial supermarket where within one institution you have commercial banking, investment banking, underwriting of securities, market-making and dealing, proprietary trading, hedge fund activity, private equity activity, asset management, insurance—this model has been a disaster. The institution becomes too big to fail and too big to manage.

It also creates massive conflicts of interest. If you look at the cases against Goldman Sachs and Morgan Stanley, leaving aside whether there was any fraud or illegal activity—that's for a court to decide—there is still a fundamental conflict of interest. These institutions are always on every side of every deal. That's an inherent conflict of interest that cannot be addressed with Chinese walls [internal company barriers between different aspects of its business].

There are no benefits from these economies of scale and scope, as we've seen from the disasters at Citigroup, AIG and others. And there are massive conflicts of interest. So I would separate all of these financial businesses under separate institutions, and I would go back to the kind of restrictions that we had under Glass-Steagall.

ZC: An idea has been pushed by Sen. Blanche Lincoln recently to require the five big bank derivatives dealers to spin-off their swaps desks. Is that a good idea?

Roubini: Yes, I think it's a good idea, and I would go beyond it. I think there is not a good reason for these firms to be involved in dealer's markets where you're not having transactions on exchanges. Whenever you have a dealer market, there is no price transparency. For the same security, you get 10 different quotes, bid-ask spreads are wide, there is not enough liquidity in situations of stress and we've seen it happen.

During the recent financial crisis, things that were traded on exchanges like equities-- there was tumult, there was noise, but there was never a freeze-up of these markets. But in dealer's markets, we had totally frozen markets for bonds, for derivatives, for credit derivatives, for lots of stuff. So I think market-making and dealing is actually only a source of profit for financial institutions-- under the guise of market-making and dealing, they're doing a lot of proprietary trading. I would not just take that away from them, I would also move away from dealers markets altogether to exchanges where there is full transparency, where commissions and fees and bid-ask spread are low.

ZC: A lot of economic observers in the U.S. seemed to be saying recently that the financial sector was finally out of the woods. But what does the developing crisis in Europe say about the state of the global banking system?

Roubini: First of all, we're not out of the woods. The definition of a crisis is when you have a bunch of policymakers who need to spend all day Saturday and Sunday to devise some last-minute rescue before markets open on Monday morning. By that standard, we had that crisis in Bear Stearns, AIG, TARP, you name it. We thought that was over, but just the other weekend, we had all of the finance ministers of Europe getting together a rescue package before markets opened on Monday morning.

These packages are becoming larger—the latest one is $1 trillion. To me, that says that policymakers are desperate, the European Union is in crisis, a lot of the countries using the euro are insolvent, and $1 trillion is not going to be enough. The euro is weakening again, going toward 1.75 times the value of the U.S. dollar. It's not enough because the fundamental problem is that these countries need to do a massive amount of fiscal conservation. It will be politically and socially painful, and this conservation, necessary as it may be, is going to reduce economic output. When you raise taxes and cut spending, in addition to public debt and deficit problems, all of these countries have massive problems in terms of loss of competitiveness. Already a decade ago, they were losing market share to China and Asia, then wages and productivity have been leveled off for a decade, and the final nail in the coffin was the appreciation of the euro between 2002 and 2008.

So in order to stabilize the economy to resume growth, in order to resume competitiveness, that requires real depreciation of the euro against other currencies. That's a separate problem from the fiscal problem and the other structural problems. So I think Europe is going to be a mess and very difficult, regardless of whether you have $1 trillion on the table or $2 trillion on the table. All of this money is conditioned on painful fiscal austerity and on painful structural reforms. So I see it being very difficult for countries to find an effective way to solve all of these issues.

ZC: We've had a strong dollar policy in the United States for decades, accompanied by a very large trade deficit. Did either of those factors contribute to the crash in 2008?

Roubini: They contributed in the sense that all of the big problems-- this big housing asset bubble, the U.S. public and private sectors spending more than they had—these were associated with a large current account deficit. And that large current account deficit was associated with a strengthening of the U.S. dollar until the early part of the past decade that also adversely affected the U.S. trade balance.

During the crisis, paradoxically, the dollar strengthened rather than weakened because of an investor flight to safety. Then in the last year, the dollar started to weaken again, and now that trend has started to reverse in the last few months because of the weakness of the euro.

The dollar should be falling much more in order to restore U.S. competitiveness and promote economic growth. But the U.S. needs a weak dollar to grow its exports, Europe needs a weak euro to grow its exports, the U.K. needs a weaker pound to grow its exports and Japan needs a weaker yen to grow its exports. You cannot have all currencies falling relative to each other. By comparison, Europe looks like it's in worse shape than the U.S., so that's why the euro is weakening and the dollar is strengthening.

ZC: So what should be done? If we have five major currencies that need to be weakened, is there a way to sort out this mess?

Roubini: One way to think about it is that major currencies of advanced economies should weaken relative to the currencies of emerging market economies—the Chinese, Asia, all of these countries.

That would be the right thing to do. The trouble is, China has pegged its currency to the U.S. dollar, and then other emerging market countries do not want to be losing market share to China, so they adjust their own currencies and keep them from strengthening against the dollar. So in reality, the necessary adjustment between the currencies of advanced economies and emerging market economies is not occurring, because the Chinese are lagging behind the pace of the problems.

Even when they do let their currency appreciate, they'll do it by so little—3 percent or 4 percent per year—that it will not make much of a difference for dealing with global imbalances.

ZC: So what does that mean for the United States? We haven't seen much serious action on fiscal stimulus since February 2009. Is there anything that can be done to fight what appears to be a long-term structural problem?

Roubini: My forecast is that whatever we do in terms of policy, we'll have to accept that economic growth is going to be subpar and un-dynamic, because the private sector has to de-leverage by spending less and saving more, and soon enough, even the public sector cannot afford having these large fiscal deficits. Otherwise, we're going to end up like Europe and Greece. So over time, we're going to have to raise taxes and cut spending. Ultimately, both the public and private sectors will have to spend less and save more, and that implies that economic growth is going to be weak.

Trying to counter that by drugging the economy with more economic stimulus or more bailouts is not going to work, it's actually going to make the problems worse. Eventually, the bond market vigilantes are going to wake up to the United States the way they've woken up to Greece and Portugal and Spain and the U.K. and Ireland and Iceland. We cannot run a $1 trillion deficit for the next decade without the currency markets developing a panic at some point.

ZC: But what about a short-term plan for more economic stimulus coupled with long-term plans to cut the deficit?

Roubini: In theory, you could certainly afford more stimulus in the short-run. But the reality is that we've already done three rounds of fiscal stimulus, the latest round looks like $138 billion in a job deal. So we're doing some short-term stimulus, but we're not taking any action on medium-term fiscal conservation, or controlling spending or raising taxes. Politically, the Democrats are resisting spending cuts, the Republicans are dead set against tax increases, and this gridlock implies that the deficit is going to remain large. This is an election year, so there's no chance of anything being accomplished until next year, and the parties are so divided, I don't see any bipartisan agreement to do the right thing. So the deficit is going to stay above $1 trillion for the next three years, and something is going to snap in the bond market during that time.

ZC: There are a lot of different types of spending. There are a lot of people like me who would have no problem axing the defense budget, while other people want to gut Social Security. But what about bank bailouts? How expensive are those, and can we endure another bank bailout without a currency crisis?

Roubini: One of the reasons why we have a sovereign debt problem is that we started with a crisis caused by too much debt in the private sector—financial institutions, households, etc. Now we've socialized some of those private losses and put them on the balance sheet of the government. That's why the advanced economies have, on average, a budget deficit of 10 percent of GDP and public debt has doubled to 100 percent of GDP. And that's a problem. Eventually the risk is that we're either going to monetize these deficits like Greece, or for countries that can't do that, default on the debt.

My worry is that the next stage of the financial crisis is not going to be in the private sector but the public sector, which has added a huge amount of leverage. It started with Greece, Portugal and Spain, but in all of the advanced economies we see this phenomenon, and eventually there is the risk of a fiscal train wreck.

ZC: So what should policymakers have done in 2007 and 2008 in the U.S. when the banking system was going off the rails?

Roubini: Many of the things that were done were in fact appropriate. We learned the lessons of the Great Depression and we used monetary policy, we used fiscal stimulus, and even some backstopping of the financial sector was ultimately probably necessary. If Wall Street would have actually collapsed, the damage to Main Street would have been even more severe.

However, I think we still bailed out too many institutions, and we kept too many zombie banks alive. We could have taken the unsecured credit of some of these banks—their debts—and converted them into equity. That's what you do in bankruptcy. You take a firm that's in Chapter 11, and you take some of their debts and you convert them into equity.

If we'd done that, some of the creditors of the banks would have become equity holders, and that would have recapitalized the banks without using public money. We would not have had to bailout the creditors and the shareholders of the banks. I would have done that as part of the solution in order to limit the amount of public money and taxpayer money used for bailouts.

ZC: Has the crisis changed Wall Street significantly?

Roubini: Not really. Right now I fear that we're back to business as usual with prop trading, leverage, and banks generally behaving as if these last few years never happened. They don't even realize that many of them are only alive because there were 10 different government programs that either straightforwardly bailed them out or allowed them to borrow at artificially low rates. The bonuses are getting to be high again, getting to be outrageous and unrelated to long-term performance. It's back to business as usual, and that's dangerous.

ZC: You talk in your book about compensation, both for traders and bankers and also for regulators. Can you talk about that some?

Roubini: Yeah. For what concerns bankers and traders, one of the biggest problems in the crisis was the way they were compensated. There were huge incentives for them to take on a lot of risk and leverage. If the risky investments turn out right, they get large profits and bonuses, and if they turn out to be wrong further down the line, they've already pocketed their bonuses. The worst thing that happens is you don't get another bonus.

I'd prefer a system in which you don't get the bonus right away—there are clawbacks. Your bonus is put into an account, and then we'll wait and see if three years from now, your investments were really good, or if they ultimately contributed to losses. We need to incentivize bankers and traders not to take too much risk.

What concerns regulators, I think we have to make them more independent to try to prevent regulatory capture—this situation where the bank lobbyists totally corrupt the thinking of the regulators. There are lots of things you can do, and one of them is to just pay them better so that they don't have the same incentive to go and work for the private sector as soon as there's a change in the administration.