Oct 16 2008

Those who foresaw the meltdown…

The Huffington Post – Economic Honor Roll

The liberal blog and news site, Huffington Post, has an interesting post sharing excerpts from the writings of some prominent economists over the last several years who foresaw the economic meltdown now underway in the world’s financial markets. It’s interesting to read these passages today and realize that the financial crisis that seemed to take Washington by such surprise in the last few weeks was something economists have seen coming for quite some time.

Nouriel Roubini, NYU professor of economics: from “The Rising Risk of a Systemic Financial Meltdown: The Twelve Steps to Financial Disaster” (subscription req’d), February 5, 2008

…it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt.[…]

Ninth, the “shadow banking system” (as defined by the PIMCO folks) or more precisely
the “shadow financial system” (as it is composed by non-bank financial institutions) will
soon get into serious trouble.[…]

Tenth, stock markets in the US and abroad will start pricing a severe US recession –
rather than a mild recession – and a sharp global economic slowdown.[…]

A near global economic recession will ensue as the financial and credit losses and the
credit crunch spread around the world. Panic, fire sales, cascading fall in asset prices will
exacerbate the financial and real economic distress as a number of large and systemically
important financial institutions go bankrupt. A 1987 style stock market crash could occur
leading to further panic and severe financial and economic distress.
In this meltdown scenario US and global financial markets will experience their most
severe crisis in the last quarter of a century.

Paul Krugman, New York Times columnist (and winner of the 2008 Nobel Price for Economics)

Krugman has been warning about the dangers of the housing bubble for years, and the terrible toll it could take on the economy when it pops. Here is a Krugman warning from August 29, 2005:

These days Mr. Greenspan expresses concern about the financial risks created by “the prevalence of interest-only loans and the introduction of more-exotic forms of adjustable-rate mortgages.” But last year he encouraged families to take on those very risks, touting the advantages of adjustable-rate mortgages and declaring that “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage.

If Mr. Greenspan had said two years ago what he’s saying now, people might have borrowed less and bought more wisely. But he didn’t, and now it’s too late. There are signs that the housing market either has peaked already or soon will. And it will be up to Mr. Greenspan’s successor to manage the bubble’s aftermath.

How bad will that aftermath be? The U.S. economy is currently suffering from twin imbalances. On one side, domestic spending is swollen by the housing bubble, which has led both to a huge surge in construction and to high consumer spending, as people extract equity from their homes. On the other side, we have a huge trade deficit, which we cover by selling bonds to foreigners. As I like to say, these days Americans make a living by selling each other houses, paid for with money borrowed from China.

One way or another, the economy will eventually eliminate both imbalances.

Joseph Stiglitz, Nobel Prize-winning economist: Washington Post, “The Iraq War Will Cost Us $3 Trillion, and Much More,” March 9, 2008

We face an economic downturn that’s likely to be the worst in more than a quarter-century.

Until recently, many marveled at the way the United States could spend hundreds of billions of dollars on oil and blow through hundreds of billions more in Iraq with what seemed to be strikingly little short-run impact on the economy. But there’s no great mystery here. The economy’s weaknesses were concealed by the Federal Reserve, which pumped in liquidity, and by regulators that looked away as loans were handed out well beyond borrowers’ ability to repay them. Meanwhile, banks and credit-rating agencies pretended that financial alchemy could convert bad mortgages into AAA assets, and the Fed looked the other way as the U.S. household-savings rate plummeted to zero.

It’s a bleak picture. The total loss from this economic downturn — measured by the disparity between the economy’s actual output and its potential output — is likely to be the greatest since the Great Depression.

Daniel Altman, author, economic journalist and Huffpo blogger, from “Contracts So Complex They Imperil The System”, February 24, 2002

When companies that rack up huge hidden debts and traders who illicitly amass mountains of risk are exposed, Wall Street’s big players rush to cut their losses and collect on their debts. If that kind of rush were ever to result in a shortage of cash, it would paralyze the financial system. Stock markets would tumble and banks would close, putting the savings of households at risk.

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

One response so far

One Response to “Those who foresaw the meltdown…”

  1. Timon 21 Oct 2008 at 6:04 am

    Not to take away from any of these distinguished academics. They are all much much smarter than I am. Nevertheless, I am reminded of an interview from years ago with Luis Rukeyser, the then host of Wall Street Week.

    If I recall correctly, the interviewer asked what the secret was to making market forecasts. (And I've always said the same about making economic forecasts.)

    Rukeyser said, "If you forecast the direction, don't say when or by how much. If you forecast the extent, don't say when or which direction. And if you forecast when, don't say which direction or by how much." Follow his advice and be patient – eventually you'll be right.