Financial gain, economic pain

July 9, 2009

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NEW YORK — In the past threemonths, global asset prices have reboundedsharply: stock prices have increasedby more than 30 percent in advancedeconomies, and by much more in mostemerging markets. Prices of commodities— oil, energy and minerals — havesoared; corporate credit spreads (thedifference between the yield of corporateand government bonds) have narroweddramatically, as government-bond yieldshave increased sharply; volatility (the“fear gauge”) has fallen; and the dollarhas weakened, as demand for safe dollarassets has abated.But is the recovery of asset pricesdriven by economic fundamentals? Isit sustainable? Is the recovery in stockprices another bear-market rally or thebeginning of a bullish trend?While economic data suggests thatimprovement in fundamentals has occurred— the risk of a near depression hasbeen reduced; the prospects of the globalrecession bottoming out by year end areincreasing; and risk sentiment is improving— it is equally clear that other, lesssustainable factors are also playing a role.Moreover, the sharp rise in some assetprices threatens the recovery of a globaleconomy that has not yet hit bottom.Indeed, many risks of a downward marketcorrection remain.First, confidence and risk aversion arefickle, and bouts of renewed volatilitymay occur if macroeconomic and financialdata were to surprise on the downside— as they may if a near-term and robustglobal recovery (which many peopleexpect) does not materialize.Second, extremely loose monetarypolicies (zero interest rates, quantitativeeasing, new credit facilities, emissionsof government bonds, and purchases ofilliquid and risky private assets), togetherwith the huge sums spent to stabilize thefinancial system, may be causing a newliquidity-driven asset bubble in financialand commodity markets. For example,Chinese state-owned enterprises thatgained access to huge amounts of easymoney and credit are buying equities andstockpiling commodities well beyondtheir productive needs.The risk of a correction in the face ofdisappointing macroeconomic fundamentalsis clear. Indeed, recent data from theUnited States and other advanced economiessuggest that the recession may lastthrough the end of the year. Worse, therecovery is likely to be anemic and subpar— well below potential for a coupleof years, if not longer — as the burden ofdebts and leverage of the private sectorcombine with rising public sector debts tolimit the ability of households, financialfirms, and corporations to lend, borrow,spend, consume and invest.This more challenging scenario ofanemic recovery undermines hopes fora V-shaped recovery, as low growth anddeflationary pressures constrain earningsand profit margins, and as unemploymentrates above 10 percent in most advancedeconomies cause financial shocks tore-emerge, owing to mounting losses forbanks’ and financial institutions’ portfoliosof loans and toxic assets. At thesame time, financial crises in a numberof emerging markets could prove contagious,placing additional stress on globalfinancial markets.The increase in some asset prices may,moreover, lead to a W-shaped double-diprecession. In particular, thanks to massiveliquidity, energy prices are now rising toohigh too soon. The role that high oil pricesplayed in the summer of 2008 in tippingthe global economy into recession shouldnot be underestimated. Oil above $140 abarrel was the last straw — coming on topof the housing busts and financial shocks— for the global economy, as it representeda massive supply shock for the UnitedStates, Europe, Japan, China and other netimporters of oil.Meanwhile, rising fiscal deficits in mosteconomies are now pushing up the yieldsof long-term government bonds. Someof the rise in long rates is a necessarycorrection, as investors are now pricing aglobal recovery. But some of this increaseis driven by more worrisome factors: theeffects of large budget deficits and debton sovereign risk, and thus on real interestrates; and concerns that the incentive tomonetize these large deficits will lead tohigh inflation after the global economy recoversin 2010-11 and deflationary forcesabate. The crowding out of private demand,owing to higher government-bondyields — and the ensuing increasein mortgage rates and other privateyields — could, in turn, endanger therecovery.As a result, one cannot rule out thatby late 2010 or 2011, a perfect stormof oil above $100 a barrel, risinggovernment-bond yields, and tax increases(as governments seek to avoiddebt-refinancing risks) may lead to arenewed growth slowdown, if not anoutright double-dip recession.The recent recovery of asset pricesfrom their March lows is in part justifiedby fundamentals, as the risks ofglobal financial meltdown and depressionhave fallen and confidence hasimproved. But much of the rise is notjustified, as it is driven by excessivelyoptimistic expectations of a rapid recoveryof growth towards its potentiallevel, and by a liquidity bubble thatis raising oil prices and equities toofast too soon. A negative oil shock,together with rising government-bondyields — could clip the recovery’s wingsand lead to a significant further downturnin asset prices and in the real economy.

Nouriel Roubini is professor of economics at the Stern School of Business, New York University, and chairman of RGE Monitor (www. rgemonitor.com).