Steve Forbes interviews Nouriel Roubini “The Roubini Recovery”

Author: Nouriel Roubini  ·  April 20th, 2009  ·  256476http%3A%2F%2Fwww.economonitor.com%2Fnouriel%2F2009%2F04%2F20%2Fsteve-forbes-interviews-nouriel-roubini-the-roubini-recovery%2FSteve+Forbes+interviews+Nouriel+Roubini+%22The+Roubini+Recovery%222009-04-20+10%3A41%3A57Nouriel+Roubinihttp%3A%2F%2Fwww.economonitor.com%2Fnouriel%2F2009%2F04%2F20%2Fsteve-forbes-interviews-nouriel-roubini-the-roubini-recovery%2F › Share This Print

4/20/2009 – Intelligent Investing with Steve Forbes – Steve Forbes interviews Nouriel Roubini (click here for video)

Steve Forbes interviews Nouriel Roubini, chairman of Roubini Global Economics and professor at the Stern School of Business at New York University. 

Steve: A Destructive Court

Welcome, I’m Steve Forbes. It’s a privilege and pleasure to introduce you to our featured guest, New York University professor and economist Nouriel Roubini. Nouriel had amazing prescience calling the markets’ downtown, earning his infamous moniker, “Dr. Doom.” Now he’ll tell us why he thinks there’s a glimmer of hope for the economy.

Our conversation follows in a minute. But first …

Innovation flourishes in a benign environment of low taxes, common-sense regulation and a sensible, restrained judiciary. The U.S. Supreme Court certainly fell short of those principles when it ruled against medical innovation in Wyeth v. Levine .

The court gave a green light to the plaintiff’s lawyers, who would steamroll pharmaceutical companies at the cost of lifesaving drugs and treatments for the rest of us.

The plaintiff in this case lost an arm to gangrene after she was injected with the Wyeth drug Phenergan. The drug was clearly labeled with a warning that gangrene could result if the drug were directly injected into a patient’s vein, and the tragedy was the result of a mistake of a doctor’s assistant.

She sued the hospital and won. But she also sued Wyeth, arguing that a stronger warning should have been provided.

Wyeth’s warning label has been specifically approved by the FDA. The plaintiffs don’t deny that. The hospital employee that made the mistake acted outside of Wyeth’s control. Again, the plaintiffs don’t deny that. She also prevailed in her suit against the hospital. A court can’t make everything right or take away the pain of such a loss, but the victim had, and pursued her case against a legitimate defendant.

In the wake of this precedent, companies can now be held liable and suffer substantial losses when a third party misuses their products, even though they’d been amply warned in language approved by the federal government. This is destructive to innovation, imagination and, ultimately, to the health of the nation.

In a moment, my conversation with Nouriel Roubini.

Glimmer of Hope

Steve Forbes: Well, thank you for joining us. You have acquired quite a reputation for calling the extent of the credit crisis two or three years ago–that something was rotten in the state of Denmark or Wall Street or whatever. But you see some glimmers that things might be improving a smidgen, later this year and early next year?

Nouriel Roubini: They are improving in the following sense: that the degree of economic contraction is not going to be as severe as the last quarter of last year and first quarter of this year. So, from -6 [percent] growth, we are going to go toward -2 [percent] toward the end of the year.

But compared to the optimists that see already a recovery of positive growth by the second half of this year are more bearish and for next year, the consensus thinks a growth rate close to 2%, maybe it is going to be below one 1% and unemployment rate above 10%. So while we are going to be technically out of a recession, you know, it is going to feel like a recession.

So more optimist in the sense that the thing that the policy action are going to avoid L-shaped near-depression, like the one that Japan experienced. We are in the middle of a severe U-downturn. And we are going to eventually get out of it by sometime next year.

So the tail risk of a depression has been reduced. That is good news. And the rate of contraction is going to be less than otherwise. Secondary, rates are becoming positive. But I do not see yet the light at the end of the tunnel the same way the consensus sees it.

Steve Forbes: And so that, in turn, means that next year, 2010, if you only have a 1% or even a less than 1% growth rate, unemployment will go up. Will it stop at 10%? It is already at 8.5% now.

Nouriel Roubini: It is. And in my view, probably is going to peak above 10%, might be more close to 11%. And even today, if you take a broader measure of an unemployment rate that includes those who are partially employed and those who are discouraged, that have left the labor force, the number is already 15%. So by some standards, this is really rough worse than losing 600,000 to 700,000 jobs per month. It’s very painful.

Stay on the Sidelines

Steve Forbes: And what does this mean for investors? You have recommended in the past, hold cash. Don’t be plunging into these bear-market rallies. Do you see the current rally as another bear market rally and it is just prudence should be the dictate?

Nouriel Roubini: Yeah, I would be prudent for the following reason. You know, people usually joke and say the stock market has predicted 12 out of the last nine recessions, because sometimes it falls and there is no recession.

Steve Forbes: You have an even better description.

Nouriel Roubini: Yeah, this time around, the stock market predicted six out of the last zero economic recoveries, because six times around, the last two years, markets fell because of the bad news on banks. The economy, then there is radical policy action. They recover, and then the bad news, macrofinancial earnings and then you reach a new low.

Now of course, the lower you go, at some point, you might be closer to a true bottom and more time passes, with the policy action, the closer we might be to the bottom of earnings of the economy. Now is this rally a robust one? Is this going to be the beginning of a real boom-market rally?

I am still skeptical for three reasons. One is that if I am right on the macro view, -2% rather than +2% [in Q4] and weak recovery [in 2010], then there will be surprises on the downside in terms of the macroeconomic, U.S. and abroad. The second reason is that I think that earnings are going to surprise–not just this quarter, but also the next few quarters–on the downside, because we have a weak economy. And with deflationary pressures, then the pricing power, the corporate side, is going to be limited.

Therefore, margins are going to be compressed. To have a very big rally of earnings like people predict for next, you need a boom of the economy, going to potential above and then going away from deflation. And I see deflationary forces for the next two or three years. So I see compression of earnings are going to last and surprise people on the downside.

And three, I see financial shocks. Some banks will be found insolvent. We will have to probably take them over, do something with them. That is going to be bad news. We will have many financial institutions are going to go out of business, like many hedge funds. And deleveraging by them and selling liquid assets in liquid markets going to be negative.

And third, some emerging markets, in spite of IMF help, may have a fully fledged financial crisis. And then may have contagious effect. So, all in all, I think that over the next few months, surprise on the macro side, on the earnings side, in terms of the financial shocks, may imply that the previous lows might be tested again.

Steve Forbes: So, in terms of an investor, just stay on the sidelines for now.

Nouriel Roubini: I would stay on the sidelines. You know, people worry about not getting the rally that is going to start. But if it is going to be a robust rally, it is not going to be [only] 20, 25 [percent]. You know, we know eventually we’ll have a recovered economy. We will get it cleaned up, and actually, I’m not a permabear. I believe that actually, if we do the right things, the U.S., Europe, Japan, but especially emerging markets, can have a bright future of high economic growth.

So for the middle term, I am actually quite bullish about the global economy and that high global economic growth, once we fix the problems. Equities should be outperforming other asset classes. But I would not worry about losing the first 20%, because you might have another bear-market rally. [I] would wait until the data show more robust and consistent, persistent improvement of the real economy, of earnings. And then the market, they are going to rally on a more robust basis.

Fed’s Easy Money

Steve Forbes: Could this bubble, this disastrous bubble, have reached the proportions it did if the Fed hadn’t been so easy with money in the early part of this decade?

Nouriel Roubini: There were many mistakes. Certainly one of them was that the Fed cut rates and kept them too low, from six and a half down to one [percent], for too long. In addition to that mistake, the normalization from 1% back to 5.25%, was these moderate pace, step-by-step, 25 basis points every six weeks. And that is one of the last things. It is not just how long you keep it low but then, when you get out of this recession, we have to normalize it fast enough.

That is going to be one little lesson. But there are also broader issues about poor supervision and regulation of financial institutions. I think that, while deregulation is positive of the economic financial institution, we took it to an extreme, you know. Even financial markets need laws, institution, rules; otherwise it is the law of the jungle. Greed is good. There is nothing bad with greed. You know, that’s what drives capitalism. But greed has to be contained by fear of losses and also [the] realization [that] you are not going to be bailed out in bad times. And I think there were a number of distortions that Greenspan put, easy money, easy credit, lack of supervision and regulation of the proper form.

Steve Forbes: In terms of where we go from here, in terms of what new regulations, rules, transparency, one suggestion has been made: We do need real exchanges, clearing houses for some of these exotic instruments, so they become standardized. People can actually see what is out there, what the volumes are, what the trades are. And therefore, we can get some proper collateral behind them. What other things do you think need to be done to prevent a repetition of this in the future?

Nouriel Roubini: Well, many things. I think we have learned that, all in all, financial institutions need more capital compared to what they had and what the requirements were. That they probably have to be required to have less leverage, both banks and on banks, shadow banks, that the liquidity risk is big and therefore liquidity buffers are important.

There is a whole issue with compensation. I think that the issue is not with bonuses. Yes, last year and so on. But if you have a system in which you are having incentive maximize the risk in the short run and essentially do things like insurance over cataclysmic effect, events. And therefore, for a few years, you are making lots of profits and revenues. You are paid that way. And when things go bust because you took a big risk, the financial institutions go bad. Compensation is not [set [properly on a risk adjusted basis] …

Better Bonuses

Steve Forbes: Do you think that is an area, where if you are a regulated financial institution, where the government should say, “A bonus has to be paid out over five years,” or is this something boards of directors will learn if they know they can actually fail?

Nouriel Roubini: Ideally, you want a world in which a board of directors would do that if you have appropriate corporate governance. You don’t want the government to impose it. But we saw also failure of corporate governance. You know, there are the typical agency problems within principal and agents shareholders and managers. And in financial institutions, those agency problems are bigger because the symmetric information is bigger.

There’s no way a CEO or a board can essentially know what the action of thousands of P&Ls were taking risks and trades and so on doing.

Steve Forbes: Right

Nouriel Roubini: Therefore, you need a system of compensation as bonusing models. They are changing. Some institutions are now having these bonus models, but there is an element of worries about stigma, of losing the best kind of talent.

Therefore, at least the government, not forcing, but the frame-up right now [that] was agreed [on] by the G-20, one in which there has to be reform of compensation. I would let institutions do it their own. If they do not do it, then, in the context of that regulation supervision, the form of compensation should be one of the measures of whether you have an appropriate risk management system, because [an]appropriate risk management system means make sure that risk management is done properly. And one element of it is compensation.

Steve Forbes: Do you feel the credit system is now going to start to function again? Right now, we still have very wide spreads between Treasuries and, say, single-A, triple-B corporate [bonds]. Do you see any sign that that is going to narrow, where credit is going to naturally start to flow again?

Nouriel Roubini: It is going to be a very slow process in my view. Of course, compared to the disaster after Lehman, when everything was frozen–commercial paper, high grade, high yield–at least right now, the money-market spreads are lower. Corporates that are high-grade can borrow again. In the high-yield spreads, the spreads are still too wide. The market is shut down.

We will see whether TARP is going to work. Other actions reduce market spreads, mortgage rates by buying MBSs and mortgage-backed securities. I think it will be a very, very difficult process because a lot of the shadow banking system has collapsed. And a lot of the intermediation was not through banks, but through securitization or through capital markets. We have essentially destroyed a good chunk of our capital market. We want to rebuild it. It is going to take time.

Bank Nationalization

Steve Forbes: You proposed, a few weeks ago, nationalizing some of the banks. Do you feel that is still going to happen before this over?

Nouriel Roubini: Oh, I think some of them will have to be taken over. I mean, I proposed these from a market-friendly point of view. Nobody is in favor of medium- or long-term ownership of financial institutions by the government. But in my view, paradoxically, the temporary nationalization is a more market-friendly solution, because you know, if you don’t do it, then you end up with zombie banks, and the fiscal costs are going to be large.

That’s why, you know, fiscal conservatives have been in favor of it. That is why people like Lindsay Graham, conservative Republican from Carolina, is in favor. That’s why Alan Greenspan, high priest of laissez-faire capitalism, has said we may have to nationalize some banks. We will have to do it carefully, choose only the ones that are really beyond pale, that even if you give time, time is not going to heal their wounds.

We’ll see. But I think, in some cases, that might be the appropriate thing. And if it is not market-friendly–take IndyMac, [which] was taken over middle of last year, cleaned up, separated. And now, the bunch of investors, George Soros and John Paulson [and] others, we bought it back and privatized it. It took six months. [It] does not have to take three years if you do it right.

Geithner’s Gamble

Steve Forbes: What is your feeling about the latest Geithner plan?

Nouriel Roubini: My view of it is, actually, that it can work for dealing with the toxic assets of banks that are solvent, because even after you do this stress test and you do a triage within solvent, insolvent. With the insolvent ones, you cannot apply the Geithner plan because the losses are so big that if you apply [that] to them, they are underwater. You have to take them over.

But even with a solvent one, you have to still separate good and bad assets. Now there are five different ways of doing them. We do not have time to go into each detail. Each one of them has merits and some flaws. These ones are among the five different ways in which you can separate good and bad assets of solvent banks–is not the worst. There [are] some design issues, some flaws in which the way the design can be fixed. In my view, all in all, it is actually a reasonable plan.

Steve Forbes: And are you upset at all about some of the details coming out about it, that he wants to restrict it to only a handful of large institutions? Should it be more open if an institution wants to or if a group wants to be part of it? It should not be excluded?

Nouriel Roubini: That was actually, absolutely one of the important flaws. I think they have just announced that actually, they are going to open up the bidding process also to smaller financial institutions. You do not have to have $10 billion-plus of assets and so on, in order to do that. So, I think, you know, they have been responsive to some of the criticism.

I think that by the time they implement it, there will be a number of other things you have to fix it. And there may be even incentives for insiders to buy at face value, you know, the stuff and then get a cost-only loan and default on it. So you should make sure that banks cannot buy their own things. This idea of rivals buying each other’s assets also is subject to gaming. And plus, the whole point is about making sure banks do not have toxic assets, not to buy more of them. So I think there are many things in the design you can fix.

Steve Forbes: Now, the Federal Reserve surprised some of us that between December and March, they actually shrunk their balance sheet, after expanding it in the fall, shrunk it by $400 billion. Now they are gingerly bringing it up. Is the Fed being aggressive enough in this, right now? Should it be more buying [of] mortgage-backed assets and the like to try to get the system more, better functioning?

Nouriel Roubini: I would say they have been very aggressive, you know, with ups and downs. You know, yeah, the balance sheet went from, you know, 800, 2.2, now down to a 1.8. But now, with the new initiative, is going to be about $3 trillion. It is zero interest rates. It is quantitative easing.

And it is a variety of unconventional things, like buying Treasuries, buying an agency-backed, a mortgage-backed security, reduced mortgage rates. You know, intervening in the securitization market with the tariffs and other things that, over time, are going to restore credit and securitization. They are very aggressive. And so are their central banks, like the Bank of England, the Swiss national banks, the Japanese.

Even Europe eventually is going to get to zero rates and quantitative easing and some of the unconventional stuff. Unfortunately, you know, traditionally, since the banks are the lender of last resort in this crisis, since banks do not lend to each other, they do not lend to non-banks. They [did] not lend even to the corporate sector for a while.

The central banks have become the lender of first and only resort. I mean, that is the paradox of the market failure we have been observing. It is not a normal situation. We do not want it to be permanent, but that is the current situation. And I think the margin, those policy actions, are actually the correct ones.

Risky Leverage

Steve Forbes: You had mentioned earlier that banks are going to have to, in the future, deal with less leverage. What have we learned about risk in this crisis?

Nouriel Roubini: We have learned that, you know, leverage can be dangerous and is excessive. That you have to have a system of incentives and compensation that avoids excessive risk-taking, regardless of leverage. That liquidity risk is important. That shadow banks, in many ways, look like banks, because they were borrowing short, highly leveraged, lend-only liquid.

But unlike banks, they did not have access to the lender of last resort support or deposit insurance. Therefore, the entire collapse of the shadow banking system is an example of what happens when you have a run on bank-like institutions. And therefore, to have a safer system for these known banks. You know, was non-bank mortgage lender went by … hedge funds, you know, broker-dealers, now … [a] financing crisis for private equities. Just a variant of the same idea.

If you borrow short overnight, you leverage 30 times. You lend only liquid. Eventually, you are going to get in trouble. That is not a stable system. That is why I predicted–over a year ago, before Bear Stearns–the collapse of major broker-dealers. I said, “Two of them are going to go bust. In a matter of two years, none of them is going to remain independent.” I was too optimistic: it did not take two years, it took seven months [for Bear Stearns and Lehman to go bust, for Merrill to be forced to merge with Bank of America and for Morgan Stanley and Goldman Sachs to be forced to convert into bank holding companies].

Steve Forbes: By the way, do you think, in the future, partnerships are going to come back, where, if you do have an investment house, you know it is your money on the line and not somebody else’s?

Nouriel Roubini: Certainly either partnership or a situation which then shareholders or bankers have some of their own skin in the game, because again, you want to avoid excessive retaking. Paradoxically, crisis not of hedge funds but more crises of traditional banks. Why? Because hedge funds, the owners have some of the skin in the game.

Therefore, the risk management is different. So whether it is going back to partnership or other things, whatever implies more capitals, more of the skin in the game, so that you avoid excessive risk-taking, should be part of, makes valuable financial institutions.

Steve Forbes: What is the big one misplaced assumption, still, out in the markets today that you see?

Nouriel Roubini: I would say that, you know, there is excessive optimism about the system being able to heal itself without taking the proper action. Monetary, fiscal, credit policy, clean up the banks, proper forms of forbearance, helping emerging markets. I think we still need aggressive policy action. I think that the system, unfortunately, as well as a significant market failure, is not going to heal itself. And that means that also the appropriate balance between the markets, because we all believe in markets and having the appropriate forms of government regulations is going to be a challenge.

Bail Out Balkan Banks

Steve Forbes: Looking here and briefly around the world, what has not been done that needs to be done?

Nouriel Roubini: Oh, some countries are behind the curve. The ECB are behind the curve. Fiscal and stimulus in Europe could be a little bit larger than otherwise. I think that, for the banks that are insolvent in U.S. and other countries, [they should] be taken over, not to end up with zombie banks like Japan. I think that more aggressive policies to reduce the risk of mortgage foreclosures should be done.

Steve Forbes: Do you think the Fed, maybe some other central banks, are ready to help out, say, banks in Ukraine or Central and Eastern Europe that, if allowed to fail, could have systemic risk?

Nouriel Roubini: They may be doing it directly, like you see, we give money directly to Hungary. The Europeans are going to be helping some of emerging Europe. But the way it has been done internationally now is that the G-20 and agreement to triple the resources of [the] IMF, so that the IMF can give money to some of these countries.

Now emerging market have two groups, those that are victims of collateral damage, with good fundamentals–the Chiles and Brazils of the world–and then there are the other countries, some of them in emerging Europe, that have massive financial, fiscal vulnerabilities and policy mistakes. For those countries, it is not enough to give them money. They need policy correction. If you give them money and there is no policy correction, you end up like Argentina or like Russia or like Ecuador. So you need the combination of money and appropriate policy actions.

Steve Forbes: What is the best financial lesson you have ever learned?

Nouriel Roubini: It is that, you know, it is better to be safe and be cautious and not to leverage too much. You know, leverage can be deadly. I mean, I think it is crucial that all of capital and equity, in corporations, in financial institution and also in the household sector. You know, when your households that were buying homes with zero down payment, the leverage was infinite, was even worse than financial institutions. So I think leverage is deadly. I think that is the lesson. We need more capital or equity. A little bit less debt, relatively speaking.

The Great Crash

Steve Forbes: And finally, other than your own books, what is the best book you have ever read, [the best] financial book?

Nouriel Roubini: Some of the classic selections, you know, The Great Crash by Galbraith. You know, you go and reread those books and you change the dates, and it is amazing how much things look like exactly the same. It means that history repeats their selves, you know? In many ways, financial crisis are very similar to each other. And as we know, if we do not learn from the past, we are going to be bound to repeat the same mistakes. Hopefully, next time around, we will learn the lesson and we will have a more robust system.

Steve Forbes: [There's] one final thing I just want to ask you, given your historic perspective, and that is, we’ve had bubbles in the last 30 years. We had the great inflation of the ’70s. We had the problems in Asia, Russia. [A] high-tech bubble much bigger than the normal, new industry bubble, what happened in housing. Do we need a new international monetary system, like we had before 1971 or what we had before World War I?

Nouriel Roubini: We will have to think about the redesign. I am not convinced about things like going back to gold or a system of fixed exchange rates. I think that that is not going to be likely and desirable, overall. But having a system [in] which these imbalances, these excesses, do not occur. We will have to rethink, also … all of reserve currencies and so on.

So first, we have to fix this crisis. Then we have to fix the banks. Then we have to think about how we design a new international monetary system. Things are going to take a while. For the time, we have already our hands full of problems. And having to fix them.

Steve Forbes: Well, thank you very much. Appreciate it.

Nouriel Roubini: It was a great pleasure being with you today. Thanks.