How to avoid the horrors of ‘stag-deflation’ is the title of an article Nouriel Roubini penned for the Financial Times. A careful reading of the article however, yields little such advice. He points out the standard cures for recessions have had little effect, so we're down to the last few options for saving the system. The ability of policymakers to manage the crisis is rapidly decaying, given the Fed is almost out of ammunition and massive deficit spending will imperil the very solvency of governments around the world.
Traditionally, central banks are the lenders of last resort but they are becoming the lenders of first and only resort, as banks are not lending. Central banks are becoming the only lenders in the land. With consumption by households and capital spending by corporations collapsing, governments will soon become the spenders of first and only resort as fiscal deficits surge.
The financial crisis has already become global as financial links transmitted US shocks globally. The overall credit losses are likely to be close to a staggering $2,000bn. Thus, unless financial institutions are rapidly recapitalised by governments the credit crunch will become even more severe as losses mount faster than recapitalisation.
But with governments and central banks bringing private sector losses on to their balance sheets, fiscal deficits will top $1,000bn for the US in the next two years. The Fed and the Treasury are taking a massive amount of credit risk, endangering the long-term solvency of the US government.
In the next few months, the flow of macroeconomic and earnings news will be much worse than expected. The credit crunch will get worse, with deleveraging continuing as hedge funds and other leveraged players are forced to sell assets into illiquid and distressed markets, leading to further cascading falls in prices, other insolvent financial institutions going bust and a few emerging market economies entering a full-blown financial crisis.
The worst is not behind us: 2009 will be a painful year of a global recession, deflation and bankruptcies. Only very aggressive and co-ordinated policy actions will ensure the global economy recovers in 2010 rather than facing protracted stagnation and deflation.