Dr. Doom says we have a long way to go

Lately I've taken to listening to Bloomberg News while in the car on my way to and from work. The radio pickin's are pretty lean in the morning around here, perhaps because fewer people are listening to terrestrial radio. The only FM stations worth my while are WFDU at 89.1 on Mondays and Wednesdays, when they play blues; WFUV at 90.7, and WKCR at 89.9, and then only if it's something like Bix Beiderbecke's birthday. But when you drive New Jersey highways in the morning, news radio trumps everything, because you know that at any moment there's a better than even chance that some idiot, probably in an SUV, is going to miscalculate while cutting someone off, and boom! There goes the 35-minute drive to work. (Note to self: Get moving and order that Garmin 265T already!) General interest news radio sets my teeth on edge, with its emphasis on celebrity news, fires, murders, and other staples of local radio. So it's become far more entertaining to put on Bloomberg News and listen to the so-called "experts" of the financial community chirp about how the tech sector is on the verge of recovery, or bemoan how reduced year-end bonuses are really going to hurt those who rely on them to pay for their boats and country club memberships.

But the one talking head that you will never hear on Bloomberg is Dr. Doom himself, Nouriel Roubini, who predicted this very debacle early in 2008 and has not yet been wrong about anything. So in case you're inclined to listen to those predicting a recovery in the second half of 2009, you might want to read the predictions of the only person who's been right:

Severe vulnerabilities remain in financial markets: a credit crunch that will get worse before it gets any better; deleveraging that continues as hedge funds and other leveraged players are forced to sell assets into illiquid and distressed markets, thus leading to cascading falls in asset prices, margin calls, and further deleveraging; other financial institutions going bust; a few emerging-market economies entering a full-blown financial crisis, and some at risk of defaulting on their sovereign debt.

Certainly, the United States will experience its worst recession in decades. The formerly mainstream notion that the U.S. contraction would be short and shallow—a V-shaped recession with a quick recovery like the ones in 1990–91 and 2001—is out the window. Instead, the U.S. contraction will be U-shaped: long, deep, and lasting about 24 months. It could end up being even longer, an L-shaped, multiyear stagnation, like the one Japan suffered in the 1990s.

As the U.S. economy shrinks, the entire global economy will go into recession. In Europe, Canada, Japan, and the other advanced economies, it will be severe. Nor will emerging-market economies—linked to the developed world by trade in goods, finance, and currency—escape real pain.

What constitutes a “recession” will depend on the country in question. For China, a hard landing would mean annual growth falls from 12 to 6 percent. China must grow by 10 percent or more each year to bring 12 to 15 million poor rural farmers into the modern world. For other emerging markets, such as Brazil or South Korea, growth below 3 percent would represent a hard landing. The most vulnerable countries, such as Ecuador, Hungary, Latvia, Pakistan, or Ukraine may experience an outright financial crisis and will require massive external financing to avoid a meltdown.

For the wealthiest countries, a debilitating combination of economic stagnation and deflation might happen as markets for goods go slack because aggregate demand falls. Given how sharply production capacity has risen due to overinvestment in China and other emerging markets, this drop in demand would likely lead to lower inflation. Meanwhile, job losses would mount and unemployment rates would rise, putting downward pressure on wages. Weakening commodity markets—where prices have already fallen sharply since their summer peak and will fall further in a global recession—would lead to still lower inflation. Indeed, by early 2009, inflation in the advanced economies could fall toward the 1 percent level, too close to deflation for comfort.

This scenario is dangerous for many reasons. A number of central banks will be close enough to setting interest rates of zero that their economies fall into a triple whammy: a liquidity trap, a deflation trap, and debt deflation. In a liquidity trap, the banks lose their ability to stimulate the economy because they cannot set nominal interest rates below zero. In a deflation trap, falling prices mean that real interest rates are relatively high, choking off consumption and investment. This leads to a vicious circle wherein incomes and jobs are falling, with demand dropping still further. Finally, in debt deflation, the real value of nominal debts rises as prices fall—bad news for countries such as the United States and Japan that have high ratios of debt to GDP.