Macroeconomic Issues and
Vulnerabilities in the US
and Global Economy
by
Nouriel Roubini
Stern School of Business, NYU
and
Roubini Global Economics
(www.rgemonitor.com)
September 2007
The current major global
concerns are over several “E”s
• These E’s are as follows:
– Economy
– Energy
– Exchange Rates and External imbalances
– Europe/Euro/ECB
– Emerging market economies
– East as in Middle East
– East as in Far East
– Earnings/Equity markets
Economy
• Will the US experience a soft landing (growth below
potential for a while) or a hard landing (a “growth
recession” or an outright recession)?
• The housing recession is worsening rather than
bottoming out
• Spillovers of the housing recession to other sectors of
the economy (autos, manufacturing, consumer durables)
• The US consumers (consumption is 70% of aggregate
demand) are saving-less and debt-burdened
• They are now buffeted by a number of negative shocks:
falling home prices, falling home equity withdrawal, credit
crunch in mortgage markets, high oil prices, slackening
labor markets
• A credit crunch started in the sub-prime mortgage
market; but this is not just a sub-prime problem
Economy
• Spillovers from the sub-prime crisis to other credit
markets. Significant financial markets turmoil and
volatility over the summer. Temporary or persistent?
• This is both a liquidity crunch and a credit crunch driven
by serious solvency problems
• Will the Fed cut the Fed Funds rate and will that cut
prevent a hard landing?
• Most forecasters are still expecting the US to achieve a
soft landing; but bearish forecasts of a hard landing are
growing (Summers, Feldstein)
• Will the rest of the world growth “decouple” from the US
slowdown or hard landing? It depends on how much the
US slows down
Energy
• US/global recessions have been associated with oil
price spikes (1973-74, 1979-80, 1990-91, 2000-2001).
• After the 2003 Iraq war was oil prices remained high and
they spiked in 2004-05 because of high demand
(especially from China and the U.S.), low global spare
production and refining capacity, concerns that terrorism
will lead to supply shortages (“fear premium”) and supply
concerns about Russia, Venezuela and Nigeria.
• The spike in the price of oil and energy since 2004-05
led to concerns about stagflation (low growth plus
inflation) as oil prices have remained around $70 a barrel
or above for several months now.
• Why didn’t the 2004-2005 oil shock lead to an economic
slowdown? It was driven by high demand rather than
stagflationary supply shocks
• Will the recent high oil prices contribute to a U.S. and
global slowdown in 2007-08?
Exchange rates and External
imbalances
• The strength of the U.S. in the 1990s relative to Euro,
Yen and other currencies led to a large a growing current
account deficit in the US as the US lost competitiveness
• After 2000, the US current account deficit worsened
further as the fiscal deficits mushroomed (“twin deficits”)
and as the private savings rate sank close to zero
• Is this current account deficit sustainable or is going to
lead to a crash in the value of the US dollar and/or a
spike in US interest rates (dollar hard landing)?
• The dollar peaked and started to decline in 2002-2004,
especially relative to the Euro, but then it sharply
appreciated again in 2005 as interest rates and real
growth differentials favored the dollar relative to the euro
and the yen.
• But the dollar resumed its fall in 2006-07 when the US
had a growth slowdown and the Fed stopped raising the
Fed Funds rate
Exchange rates and External
imbalances
• Will the U.S. dollar continue its fall in 2007 and beyond?
• Will the adjustment of global current account imbalances
be orderly or disorderly?
• How will the Euro perform during the rest of 2007 and in
2008?
• Will the yen weaken or strengthen? Will the “yen carry
trades” unravel?
• Will China let its currency revalue at a faster rate or keep
on accumulating reserves to prevent such a fast
appreciation?
• Will other Asian economies keep on aggressively
intervening – like China - in the forex market to prevent
the appreciation of their currencies relative to the US
dollar?
Europe/Euro/ECB
• Growth was sluggish in Europe in the 1990s relative to
the U.S. given structural impediments to growth; and the
Euro showed significant weakness relative to the US
dollar until mid 2002.
• The Euro then sharply appreciated until the end of 2004
(by about 40%), and again in 2006-07 (after a brief dollar
rally in 2005)
• European growth in 2002-2003 was dismal compared to
the US moderate growth recovery, in part because the
ECB did not ease as much as the Fed (EU policy rate
down to 2%).
• Eurozone growth recovered in 2004 but it remained
substandard (about 2%) and it relapsed further in 2005
to 1.2% following the strength of the Euro in 2004.
• Eurozone growth recovered above 2% since 2006 and
may soon be higher than US growth
Europe/Euro/ECB
• What will the ECB policy be in 2007-2008? The ECB
started raising policy rate in 2006 all the way to 4%; how
far will it go?
• Are ECB’s concerns about inflation valid? Will it pause
now that there is market turmoil?
• Will European growth weaken now that the Euro has
strengthened again relative to the dollar or will the
Eurozone economy show growth resilience?
• What are the prospects for further structural economic
reforms in Europe?
• Will the Euro further strengthen or weaken relative to the
US dollar?
Emerging market economies
• Emerging market (EM) economies experienced many
economic and financial crises in the 1994-2002 period
• 2001 was a dismal year for emerging market (EM)
economies. The slowdown of growth in US and G7, the
tech bust and the reduction of flows of capital to
emerging markets led to a sharp slowdown of growth in
many emerging markets.
• Outright currency and financial crises emerged in Turkey
(February 2001) and Argentina (December 2001). In
2002, severe pressures mounted in Uruguay and Brazil;
Uruguay experienced a severe financial crisis in 2002;
Brazil barely escaped a financial crisis as elections
loomed in late 2002 but then it recovered after Lula
followed moderate policies.
• 2003 was also a poor year for emerging markets
(especially Latin America) as the global economy did not
recover fast enough.
Emerging market economies
• Emerging market economies’ growth recovered sharply
in 2004, especially in Asia but also in Latin America.
Important role of macro and financial reforms after the
EM crises in this growth recovery
• 2004-2007 were excellent years for EMs as global
conditions were ideal: global growth was high, global
interest rates were low, commodity prices were high and
global investors’ risk aversion low (search for yield).
• The turmoil in emerging markets in May-June 2006 was
a signal that rougher times may be ahead, especially for
EMs with greater macro and financial vulnerabilities.
• Will a US slowdown or hard landing hurt emerging
market economies? Which countries could get into
financial trouble and distress?
East as in Middle East
• Further turmoil in the Middle East (a worsening Iraq
security situation; further terrorist attacks in Saudi Arabia
or the Gulf; tensions between Israel and its neighbors;
the risk of a military confrontation with Iran on the
nuclear issue) will affect oil prices that may increase
further.
• Also, such oil market turmoil affects skittish investors’
mood and consumer confidence as it increases
uncertainty and reduces real incomes.
• The Middle East and oil prices are a major source of
geo-political tension on global markets.
• Previous US and global recessions have been
associated with staglationary oil price shocks
East as in East Asia
• After excessive growth overheating in 2003 and early
2004, China tried a soft landing of its economy via policy
tightening measures in 2004; but the Chinese economy
has not experienced any meaningful slowdown.
• In 2005-07 the economy actually accelerated and there
is now a serious risk of overheating. Will the Chinese
authorities be able to achieve a soft landing? How?
• India (and China) is at the center of the debate on
offshore outsourcing. Dynamism of the IT sector in India
contributed to high growth in the last years. But India
faces severe fiscal problems (budget deficits and debt)
and the need for major structural economic reforms.
• Will East Asia be hurt by the coming US
slowdown? Can Asia decouple from the US?
• Is the latest Japanese economic recovery – and exit
from deflation - for real or will it fizzle out again as in
previous recoveries? Recent signals are mixed.
Earnings/Equity markets
• Equity markets in the US and globally have done well in
the 2006-2007 given high global economic growth
• High earnings growth, much improved corporate balance
sheets, easy monetary conditions supported equities
• Profits have sharply increased as a share of GDP even if
their growth may have peaked recently
• The recent market turmoil and volatility in financial
markets has challenged equity markets
• Will this turmoil be temporary or the beginning of a bear
market for equities?
• Much depends on whether the US achieves a soft
landing or a hard landing
• How will equity markets perform in the rest of 2007 and
2008?
• Is the stock market overvalued based on historical
cyclically adjusted P/E ratios?
Earnings/Equity markets
Background on US equity markets in the 2000-2007 period:
• The U.S. and global economic slowdown in 2001 led to a sharp slowdown
of earnings and underperformance of equity markets (on top of the dotcom
bust and Nasdaq collapse in 2000).
• Equity markets also underperformed in 2002 as the stock market rally after
the 9/11 drop was excessive and based on overoptimistic expectations of
growth.
• Stock markets slumped again in the first quarter of 2003 as the concerns
about a war with Iraq led to renewed risk aversion.
• But they then recovered sharply after the war in 2003 as markets started to
expect a sustained economic recovery and a sharp pick-up in profits and
earnings.
• But stock indexes remained mostly flat on average in 2004 and even in
2005 and 2006 (with only a modest uptrend since 2004) even if corporate
balance sheets have improved sharply (with debt de-leveraging) and
earnings growth has been sustained in 2004-2006.
• Equity markets – in the US and abroad – rallied sharply in 2006-2007
U.S. economy vulnerabilities
• Housing bubble that has now turned into a bust: housing
recession and first fall in home prices since the 1930s
• Large current account deficit and a dollar that needs to
fall even more to reduce this imbalance; risk of hard
landing for the dollar and/or for US interest rates
• Low private savings rate; negative household savings
• High levels of household indebtedness (mortgages,
consumer credit, etc.) with debt service costs now rising
because of credit crunch and reset of ARMs
• Vulnerability to further oil shocks and risk that oil at $70
or above will be a tipping point for the economy
• Political risk from global security/military developments
(Iraq, Iran, Mid-East, etc.)
U.S. economy vulnerabilities
• Sluggish labor market with modest employment growth
and weak real wage/income growth
• Risk of a slowdown of household consumption (the main
growing component of aggregate demand) especially as
the housing bubble has burst, the credit crunch spreads
and oil prices stay high
• Limited role for further fiscal policy easing as large
structural fiscal deficits have emerged in the 2000s
• Risk of a systemic financial crisis (as in the 1994 bond
rout or 1998 LTCM crisis) if the current financial markets
turmoil and volatility persist and worsens
• A combination of excessive liquidity, low interest rates,
high leverage, poor risk management, excessive risktaking had possibly led to bubbles in many asset prices
(housing, bonds, commodities, emerging market debt,
equities). Under-pricing of risk until recent re-pricing.
IMF forecasts for US and global
growth
• The latest IMF forecasts, consistent with private
forecasts, suggest the high global growth of
2004-2007 will continue in 2008 (after the
sluggish 2001-2003 years).
• But the latest IMF forecasts are from April 2006
before the summer financial markets turmoil
• The new IMF forecasts will be out at the middle
of September when the new IMF’s World
Economic Outlook (WEO) will be out
Main risk factors for
the continuation of global growth
• US hard landing (recession) leading to global economic
slowdown (no decoupling)
• Bursting of housing bubbles in the US and possibly other
countries (UK, Spain, Ireland, Australia, New Zealand,
etc.)
• Financial markets turmoil spreading around the world
• High oil prices and possible new oil price shocks leading
to a global slowdown
• Geo-strategic risks (terrorism, Iraq, Middle East, Iran)
• Avian flu shock in Asia
• Large and unsustainable US current account deficit and
risk of a hard landing of the US dollar
• Will the global economy perform well in H2:2007 and
2008 as clouds are gathering around the US, financial
markets are in turmoil, global imbalances are still large
and oil prices still high?
Linkages between the U.S. and the rest of
the world occur via various channels
• Trade
• Capital flows and FDI (Europe, Japan, Emerging
markets)
• Value of the US dollar
• US monetary and fiscal policy
• Global stock markets and financial links
• Developments in oil and commodity markets
• Political shocks and risks
• Global investors and corporate confidence
Fed policy since 2001
• The Fed reduced the Fed Funds rates 11 times in 2001,
by 475pbs to a rate of 1.75%.
• The Fed was expected to reverse course and increase
the Fed Funds rate in early 2002 as the economy
recovered. But the faltering in the US recovery in the fall
of 2002 and the risk of a double dip recession led the
Fed to reduce the Fed Funds again, down to 1.25% in
November 2002 and down to 1% in June 2003 as a
jobless recovery emerged during and after the war with
Iraq.
• In 2004, as growth of output and jobs picked up and
inflation started to increase, the Fed started to increase
the Fed Funds rate in 17 consecutive steps bringing it to
5.25% by June 2006 and then pausing in August 2006.
• The risk of a US hard landing and the market turmoil in
the summer of 2007 may lead the Fed to cut rates in the
fall of 2007
US fiscal policy
• What will be the stance of fiscal policy in the
U.S. in 2007?
• The improvement in the fiscal balance in 200507 is partly driven by temporary factors
• The US has a structural budget deficit (due to
rising entitlement costs)
• Can the US afford the 2001 and 2003 tax cuts
and make them permanent?
• A fiscal bailout of the housing crisis may add to
the fiscal deficit
Global current account imbalances
• Are the global current account imbalances (large deficit in the US,
large surpluses in Europe, Japan, China and most emerging market
economies) sustainable over time?
• Is the US current account deficit and external debt accumulation
sustainable?
• Will the adjustment of global imbalances be orderly or disorderly?
• What are the implications of this deficit for the value of the US dollar
in the future?
• How will the major currencies ($, Yen and Euro) perform in 20072008? Will the dollar weaken further? Is there a risk of a hard
landing of the US dollar?
• Will Asian countries (China, Japan, Korea, etc.) allow their currency
to appreciate relative to the US $ (more than the modest and slow
appreciation of the Chinese currency since the 2.1% revaluation in
July 2005) or will they keep on aggressively intervening to prevent
such appreciation?
Global inflation
and commodity prices
• What are the risks of a resurgence of global inflation?
• In 2007 deflation – the worry of the 2001-2003 period was out; rather worries about a resurgence of global
inflation emerged
• Spring of 2007: risks of a rising global inflation due to a
“global reflation” and high energy and commodity prices
• Role of BRICs and emerging markets in pushing up
commodity prices
• But the financial turmoil of the summer of 2007 partially
reduced these global inflation worries
• A US slowdown would reduce global inflationary
pressures; but global growth outside the US remains
robust so far.
Some of the cutting edge issues (and jargon terminology
used) in international macro policy debates
• Will the subprime crisis lead to a wider credit crunch?
• Are we facing a liquidity crunch or a credit crunch/crisis?
• What is the risk of a systemic crisis and what factors could trigger
one?
• What causes asset bubbles? What causes housing bubbles and
bust?
• How should monetary policy react to asset bubbles and asset
bubbles bursting?
• Should we worry about deflation or inflation?
• Why have we had recently a bond conundrum?
• Will we experience a yield curve inversion in the U.S. and what does
such inversion imply?
• Are we back to a Bretton Woods Two regime of exchange rates on a
global scale?
Some of the cutting edge issues in
international macro policy debates
• Are we back to stagflationary shocks?
• Are global external imbalances sustainable or not, and for how
long?
• Are the twin deficits sustainable?
• Will global rebalancing be orderly or disorderly?
• Should we worry about asset protectionism?
• What is the future of offshore outsourcing?
• Will the rest of the world decouple from a US slowdown? Will we
experience a rotation in global growth or a locomotive switch?
• Is Doha as dead as Dodo?
• Are target zones for major currencies necessary and/or desirable?
• Is free trade compatible with flexible exchange rates or does greater
trade integration require managed or pegged exchange rates?
Some of the cutting edge issues in
international macro policy debates
• What is the BBC (Basket, Band and Crawl) exchange rate regime
allegedly chosen by China?
• Are highly-leveraged institutions and hedge funds a source of
systemic risk?
• Is offshore outsourcing a threat or a benefit for the global economy?
• Will the BRICs dominate the world economy in the next decades?
• Is the balance sheet approach the appropriate framework for
thinking about financial crises in emerging economies?
• Are crises due to fundamentals or self-fulfilling liquidity runs?
• What explains sudden stops and reversals of capital inflows?
• What explains the joint eruption of currency, sovereign debt,
systemic banking and systemic corporate crises?
Some of the cutting edge issues in
international macro policy debates
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What is the appropriate form of PSI/bail-in/burden-sharing in crisis
resolution?
Do we need an international lender of last resort (ILOR)?
What explains international contagion, is it reduced lately and if so why?
How to deal with liability dollarization and original sin?
Is debt intolerance an endemic element of sovereign debt markets?
Do we need an international bankruptcy regime for sovereigns?
What is the most desirable sovereign debt restructuring mechanism?
Do emerging markets suffer of fear of floating and if so why?
Should the IFIs maintain their preferred creditor status?
Is unilateral dollarization the way of the future?
Are monetary unions feasible without political unions?
Is sterilization of excessive capital inflows feasible and desirable?
Is Asia on a new Dollar Standard?
What is the desirable reform of the international financial architecture?
Sources of International
Macroeconomic Interdependence
among Economies
• “Macroeconomics” is “international” given the
increasing economic interdependence among
countries and the increased globalization of
trade and finance.
• Trade links:
– Income effects on imports and exports of
goods and services
– Direct and indirect trade links
– Exchange rate effects on trade
Financial channels of
interdependence
• Assets/Liabilities traded internationally
– Stocks
– Bonds
– Derivative instruments
• International financial markets/intermediaries:
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Banks
Capital markets (stock/bond/money markets)
Foreign exchange markets
Commodities markets
Interdependence channels via
common shocks and FDI/MNCs
• Common sectoral/external shocks
– Common oil shocks
– Tech sector technology shock in the mid 1990s and
bust in 2000-2001
– Housing bubbles in the US and other countries; and
bust in 2006-2007?
• Foreign Direct Investment (FDI)/ Multinational
Corporations (MNCs):
– Real investment (FDI, M&A)
– Output/production location decisions
Interdependence via Policy Links
• Domestic effects of macro policies
• International effects of domestic policies if a
country is large (US, Europe, Japan)
• International effects of domestic policies even if
a country is small (international contagion):
– Mexico Tequila effect
– The Asian fever/flu
– The Russian virus (contagion to emerging markets –
Brazil, LatAm - and advanced markets – LTCM & US
capital markets)
– The Turkish influenza in 2001
– The modest contagion from Argentina in 2001-2002
Many Financial Crises in Emerging Markets
and G7 Economies in the last two decades
• Currency/Financial Crises in Emerging Markets:
– 1980s debt crisis in Latin America
– Mexico, East Asia, Russia, Brazil in the 1990s;
– Turkey and Argentina in 2001; Uruguay in 2002;
Brazil mini-crisis in 2002; Dominican Republic in 2003
– Market turmoil (mini-crisis) in EMs in May-June 2006
– Partial recent contagion of US sub-prime turmoil to
emerging markets
Crises and financial stresses in
Advanced/G7 Economies
• S&L crisis in US in early 1990s
• Corporate/Banking crisis in Japan in 1990s after bursting
of the 1980s asset price bubble
• European Monetary System (EMS) currency crisis in
Europe in 1992-93 (Italy, UK, France, Sweden)
• Banking crisis in Finland and Sweden in early 1990s
• Bond market crash in the US in 1994 as the Fed
unexpectedly tightened monetary policy.
• Sharp fall of the value of the US dollar in 1994-1995
• LTCM crisis in 1998 and seizure of U.S. capital markets
Crises and financial stresses in
Advanced/G7 Economies
• Bursting of the US asset price bubble in equity markets
in 2000-2002; IT and dot.com crash.
• US corporate and accounting scandals in 2002-2003
(Enron, Sarbox legislation, etc.)
• GM-Ford downgrade in 2005 and turmoil in credit
derivatives markets
• Equity market turmoil in the spring of 2006 during the
“inflation scare”
• Housing bust and sub-prime crisis in the US (2006-2007)
• US and global financial markets turmoil and volatility in
the summer of 2007. Temporary or persistent?
Major macro and financial events of the last 20
years: Advanced Economies
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1987: Greenspan becomes chairman of the Fed. Stock market crash in the
US in 1987.
S&L (Saving and Loans) financial crisis in the late 1980s; evidence of a
“credit crunch” in the US.
US and global recession in 1990-91 during the Gulf War.
Persistent stagnation of Japanese economy in the 1990s (4 recessions in
the 1990s decade) after the bursting of the 1980s asset bubble
Currency crisis in the European Monetary System in1992-93
European Monetary Union (1999 introduction of Euro) and mediocre
economic/growth performance of Europe in the 1990s
Large swings in the value of G3 currencies ($, Yen, Euro)
Global financial crisis in 1998 following Russian crisis and LTCM collapse
“New Economy”, internet and technology boom: the U.S. boom years (19952000): high growth, low inflation, high productivity growth, low
unemployment rate, boom in equity markets, budget surpluses, strong
dollar, large current account deficits.
Bust of the IT bubble in 2000-2001; sharp fall of investment leading to
economic slowdown in the US.
Major macro and financial events of the last 20
years: Advanced Economies
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The oil shock in 2000 contributing to the global slowdown
Fed tightening of monetary policy between mid 1999 and mid 2000 as the
economy was “overheating”.
US slowdown and recession and global slowdown in 2001; it started before
9/11 but was exacerbated by it.
Third and final stage of EMU (“Euro” supplanting domestic currencies)
started in 2002.
A de facto “Bretton Woods II” regime since 2001 as China and Asia
effectively pegged their exchange rates to the U.S. dollar through
aggressive foreign exchange intervention.
Tentative U.S. and global economic recovery in early 2002 that slowed
down in the spring and in the fall. Slow growth in H1-2003 (given Iraq war
uncertainty); U.S. and global recovery in second half of 2003 and Q1:2004
but with poor job growth (“jobless recovery”). Higher US and global growth
in 2005-2006
Evidence of a bursting of the US housing bubble and a housing bust since
mid 2006. Risk of a US hard landing
Sub-prime mortgage crisis in the US (2007)
US and global financial markets turmoil and volatility in the summer of 2007
Major macro and financial events of the last
20 years: Emerging markets
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Latin American debt crisis (in the 1980s) and its solution (Brady Bonds) in
the late 1980s and early 1990s
Large capital flows to emerging markets in the 1990-95 period.
Transition to a market economy in Central and East European countries.
Mexican currency crisis in 1994-95
Asian currency and financial crisis (Thailand, Indonesia, Korea, Malaysia) in
1997-98
Russian financial and currency crisis (8/98) and its contagion to emerging
markets and advanced economies financial markets (LTCM)
Currency crisis in Brazil in 1/99
Financial turmoil and IMF rescue packages in Argentina and Turkey in
November-December 2000
Sovereign debt restructurings after partial/full default in Ecuador, Russia,
Ukraine and Pakistan in 2000-2001
Turkish currency and financial crisis in February 2001
Major macro and financial events of the last
20 years: Emerging markets
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Argentina currency and financial crisis and default of 2001-2002
Financial/currency crisis in Uruguay in 2002
Risk of a financial crisis in Brazil as October 2002 elections were
looming. Financial recovery after the election. Weak economic performance
of Latin America in 2003 with growth recovery in 2004-2005.
Accession of 10 emerging markets (mostly transition economies) to the
European Union in 2004.
Rapid growth of emerging market economies in 2004-2006 on the back of
macro/financial reforms and benign global conditions (high global growth,
high commodity prices, low G7 interest rates). International investors
rediscover emerging markets.
Boom in commodity prices exported by EMs.
2006-2007: Africa as the new EMs growth story and asset class?
Turmoil in EM financial markets in May-June 2006, especially for countries
with external vulnerabilities
Turmoil in global financial markets in the summer of 2007 with partial
contagion to EMs.