2009 seen to be year of global recession with worst still ahead

Today's global crisis was triggered by the collapse of the U.S. housing bubble, but it wasn't caused only by it. America's credit excesses were in residential mortgages, commercial mortgages, credit cards, auto loans and student loans.

There were also massive excesses in the securitized products that converted these debts into toxic financial derivatives; in borrowing by local governments; in financing for leveraged buyouts that should never have occurred; in corporate bonds that will suffer massive losses as defaults surge; in the dangerous and unregulated credit default swap market.

Moreover, these pathologies weren't confined to the U.S. There were housing bubbles in many other countries, fueled by excessive and cheap lending that didn't reflect underlying risks. There was a commodities bubble and private-equity and hedge-funds bubbles.

We now are seeing the demise of the shadow banking system, the complex of non-bank financial institutions that looked like banks as they borrowed short term and in liquid ways, leveraged a lot, and invested in longer term and illiquid ways. As a result, the biggest asset and credit bubble in financial history is going bust, with overall credit losses likely to be more than US$2 trillion.

Unless governments rapidly recapitalize financial institutions, the credit crunch will become even more severe as losses mount faster than recapitalization and banks are forced to constrain credit and lending. Equity prices and other risky assets have plunged from their peaks of late 2007, but there are still significant risks for more declines.

An emerging consensus argues that the prices of many risky assets — including equities — have fallen so much that we are at the bottom and a rapid recovery will occur. But in the next few months the macroeconomic news, the earnings and profits reports, and the financial sector news from around the world will be worse than expected. This will put more pressure on prices of risky assets, with a chance of a 20 percent fall in global equity prices.

While the odds of a systemic financial meltdown have been reduced by the actions of the Group of Seven and other economies, severe vulnerabilities remain.

The credit crunch will persist and spread beyond mortgages. Deleveraging will continue, as thousands of hedge funds — many of which will go bust — and other leveraged players are forced to sell assets into illiquid and distressed markets, thus causing price declines and driving more insolvent financial institutions out of business. Credit losses will mount as the recession deepens. And a few emerging-market economies will certainly enter a full-blown financial crisis.

So 2009 will be a painful year of global recession and further financial stresses, losses and bankruptcies. Currently, the probability of an L-shaped, stag-deflation is now rising to a third, while the probability of a severe U-shaped recession is two-thirds. Only aggressive, coordinated and effective policy actions by advanced and emerging-market countries can ensure that the global economy starts to recover — however slowly —in 2010, rather than entering a more protracted period of economic stagnation.

Nouriel Roubini is Professor of Economics at the Stern School of Business, New York University and Chairman of RGE Monitor (www.rgemonitor.com), an economic and financial consultancy.

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