The Nightmare Scenario

A Japanese businessman looks at stock prices in downtown Tokyo. (AP/Koji Sasahara)

Global markets seem increasingly spooked by a drumbeat of bad news. New U.S. housing data shows single-family home prices have fallen about 9 percent in the last year, and declines are accelerating (CNN). Despite steep rate cuts by the U.S. Federal Reserve, which Fed Chairman Ben Bernanke says are likely to continue (PDF), the Dow Jones Industrial Average has fallen 10 percent from October 2007 highs. World markets, too, are feeling the pain amidst concerns over rising inflation and worries that U.S. banks might hold substantially more bad debt than analysts initially thought. Panicky predictions come a dime a dozen in a bear market, but of late, some highly respected economists have broached particularly frightening scenarios.

Nouriel Roubini, a professor at New York University’s Stern School of Business, recently wrote in his widely read RGE Monitor blog that current financial woes create the “rising probability of a ‘catastrophic’ financial outcome.” Responding to Roubini, Financial Times columnist Martin Wolf agreed that the United States risks “the mother of all meltdowns.” The first step—Wolf and Roubini both say—would involve deepening problems in the U.S. housing market. Roubini envisions “the worst housing recession in U.S. history,” with home values falling 20 percent to 30 percent across the United States, bringing $4 billion to $6 billion in economic losses. This, he says, could prompt continued blowups at major financial institutions as more of their debt-backed securities implode. Repeated financial blowups could wreak havoc on market psychology and fuel a deepened recession, Roubini says, adding that this could bring defaults on loans well beyond the housing market.

Wolf adds a different element of gloom, saying the U.S. Federal Reserve is not as well equipped to deal with this kind of scenario as most people assume. The available policy fixes, he says, are all “poisonous”—like the U.S. government assuming the burden of some combination of bad debt and inflation through bailouts. Analysts say bubbling inflation already limits the options of monetary policymakers, and many have shied away from cutting interest rates to boost markets, citing upward price pressures as a more serious concern. These circumstances raise the specter of stagflation (BusinessWeek)—the phenomenon characterized by a lengthy period of high inflation, high unemployment, and low growth rates. Climbing oil prices add to the risk. CFR’s Brad Setser worries that a “less than-ideal-global policy mix” might keep trade imbalances large, as debtor countries like the United States implement expansionary policies to support output while creditor countries, particularly those who link their currency to the U.S. dollar, adopt lending controls and tighten fiscal policies to keep their economies from overheating. All told, Roubini predicts a meltdown could lead to global financial losses of $1 trillion, which would suck as much as $10 trillion out of the world’s credit markets.

A number of economists say the chance of a doomsday scenario remains small—but is growing. Laurence Meyer, a former governor of the U.S. Federal Reserve, said in a recent CFR meeting that the Fed typically considers low-probability meltdown risks and makes short-term rate cuts to try to ward off a disaster. Meyer says recent rapid rate cuts—the Fed had cut its benchmark rate by seventy-five basis points at the time of the meeting, and slashed another fifty basis points thereafter—represent just such a precaution. Even so, the economic storm clouds seem likely to dominate discussion among Washington policymakers. One stimulus package has already passed. Another, linked more closely to the housing sector, is now in the wings (WSJ).