An Ode to Crisis Economics

Reading through Nouriel Roubini’s new book, “Crisis Economics”, is like tasting a sample of what Nouriel does best: Explain economics in such straightforward English that makes the intricacies of the dismal science feel like an effortless walk in the park.

The team up with Stephen Mihm, a history professor (and journalist), adds a nice breeze to the walk by garnishing the analysis of the recent credit crisis with a barrage of all-too-similar parallels from the past—a reminder that financial crises are “creatures of habit”, “the norm, not the exception”, an inevitable consequence of human psychology and behavior.

The reader is basically taken by the hand and given a comprehensive tour of key milestones in financial, political and regulatory history that contributed to the subprime crisis: From the origins of securitization; to financial de-regulation; to government policies to encourage home ownership; to the emergence of shadow banks; to the global savings glut and the build-up of leverage; and, finally, the “Minsky moment.”

Equally effortless is the walk through the crisis itself and the vast array of policies undertaken to address it. In what amounts to a series of “crash courses” in every aspect of crisis economics, the reader is rewarded with all sorts of gems:

An exhaustive account of the channels of crisis-contagion, from trade, financial and labor linkages to the currency and commodity markets; a comprehensive cataloguing of the fiscal policy toolkit to fight financial crises—from the conventional (cut-tax-spend-more) to the unconventional (guarantee, bailout and recapitalize); or (my favorite!) colloquial English explanations of such esoteric economic jargon as the “liquidity trap”: “You can lead a horse to water, but you can’t make it drink.” (Just replace “horse” with “banks”, “water” with “cash” and “drink” with “lend”).

For this alone, the book is indispensable reading not just for students of economics but also for any non-specialist who has the slightest curiosity to understand why all hell broke loose back in August of 2007.

Nouriel’s tone changes when it comes to policy prescriptions. Here we no longer hear “Roubini the cool minded professor” but the passionate, militant and, often, unedited policy commentator he has recently become known for. (“[..] banks have been able to pretend that their crappy assets are worth far more than any sane assessment would suggest.”)

The prescriptions offered cover a wide range of policy areas and are worth the read, not least because they give a taste of what has been an intense debate among academics, policymakers and market participants about the way forward. So here I’ll just focus on two of the areas where I felt readers were left asking for more.

The first has to do with putting a theoretically appealing framework for crisis resolution into practical use. According to the authors,

“[..] it makes sense to follow the playbook devised by Keynes in the short-term, even if the underlying fundamentals suggest that significant portions of the economy are not only illiquid but insolvent. In the short-term, it’s best to prevent a disorderly collapse of the entire financial system […].

But when it comes to the medium and long term, the Austrians have something to teach us. [..] In the long term, it is absolutely necessary for insolvent banks, firms and households to go bankrupt and emerge anew; keeping them alive indefinitely only prolongs the problem”.

Pragmatic and ideologically inclusive, but… the question is how to identify the point of transition from the “short” to the “medium” term, including in the current crisis. From the tone of the discussion about the looming dangers of public over-indebtedness or the Fed’s bloated balance sheet, you would think that the medium term is already upon us—yet, the urgency for corrective action is hard to square with Nouriel’s view that we’re stuck well inside the belly of a U-shaped recovery for years to come.

Basically, we're missing a set of concrete signposts that would make policymakers confident that the timing for a switch from accommodative, crisis-management policies, to restrictive, structural measures is right. In its absence, the distinction between the “short” and the “medium” term feels as relativistic as the old adage that “old age is always 15 years older than I am.”

Turning to financial regulatory reform… Here the discussion turns so militant as to potentially undermine the credibility of the proposals put on the table (some of which make a lot of sense). What is missing in my view is a rational framework to support the various elements of reform (from bankers’ compensation, to capital requirements to addressing the too-big-to-fail problem). Instead, the discussion felt more like an account of “The Thousand and One Ways to Exterminate Goldman Sachs”!

As I’ve argued in the past, the starting point for financial reform should be a well-researched view on the appropriateness of the current competitive landscape in the financial sector—one that takes into account both economic efficiency (which calls for more competition) and prudential considerations (which, by some academics, might call for less). Reforms on bank size or even bankers' compensation should be an output of that framework, rather than autonomous ends in themselves.

Importantly, the call to separate commercial banks from broker-dealers, hedge fund operations, etc so that “only commercial banks would have access to deposit insurance and government safety net: Everyone else [..] would be on their own”, misses the point in my view.

First, because broker-dealers, investment banks, money-market funds, etc are equally systemic, given their critical role in intermediating finance for both companies and households. And second, because many of the services these institutions provide are very much bank-like—so the right way to go is to subsume them more effectively into the regulatory framework for banks. This should include a deposit-insurance-like scheme to internalize the costs of future bailouts.

“Crisis Economics” puts Nouriel right in his element. It may be easy to forget, amidst the “Dr Doom” clatter, the "ladies in waiting" and the Cannes appearances, that this is a guy who has made an enormous contribution to our understanding of crisis economics for years now—from analytical frameworks as valuable as the “balance sheet approach” to financial crises, to one of the most extensive accounts of addressing crises in emerging markets in his earlier book “Bailouts or Bail-ins?”.

The book also puts Nouriel in his element by demonstrating the huge breadth of his knowledge—from history of economic thought, to CDOs-squared to global economic governance. Indeed, the book’s most important lesson may be precisely this: That successful economic management must rest less on a compartmentalized edifice of knowledge and more on insights drawn from a holistic framework that includes history, economics, philosophy and, above all, common sense.