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Economists Examine Potential for Longer Recession

June 15, 2010 at 12:00 AM EDT
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As part of his ongoing series of reports making sense of economic news, Paul Solman checks back in with two economists who remain pessimistic about the chances of an economic recovery to discuss recent market volatility and the possibility of a double dip recession.
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GWEN IFILL: Now: what two economists who warned of the coming financial crisis are worried about today.

It’s part of “NewsHour” economics correspondent Paul Solman’s ongoing reporting Making Sense of financial news.

PAUL SOLMAN: October 2006, here on the “NewsHour,” Nassim Taleb warned of the fragility of markets well before the crash, before his cautionary book, “The Black Swan.”

As I understand it, your central insight is that people underestimate the likelihood of rare events.

NASSIM TALEB, author, “The Black Swan”: Exactly. And my idea is twofold, number one, that rare events happen more often, and, two, that, when they happen, they’re far more devastating than we can imagine.

PAUL SOLMAN: A few weeks later, economist Nouriel Roubini took us on a pessimistic real estate tour.

NOURIEL ROUBINI, NYU Stern School of Business: Many people had no equity in their homes. Essentially, they had zero down payments, and now prices are falling, so they have negative equity. There will be lots of delinquencies, a lot of foreclosures.

PAUL SOLMAN: So, on the occasion of their new books, Roubini’s “Crisis Economics,” and a revised of Taleb’s “Black Swan,” we brought our doubty doomsters together recently at New York’s Museum of American Finance to look back and ahead.

First, what was the reaction to their Cassandra turns on the “NewsHour”?

NASSIM TALEB: I had a lot of criticisms, because that was the first time I was voicing my opinion on national TV. And, so, I got a lot of hate mail at the time and a lot of criticism because my position contradicted the prevailing belief that the world moved into a permanent state of low risk, high growth, great productivity, and happy days.

PAUL SOLMAN: Did you get hate mail at the time?

NOURIEL ROUBINI: Not hate mail. Later on, I got hate mail. But people listened carefully, but they were highly skeptical.

PAUL SOLMAN: But the real skeptics were Rubio and Taleb, skeptical of the traditional economic model of markets.

NASSIM TALEB: I’m only coming to that — to the game from the standpoint of fat tails, fat tails meaning the contribution of the rare event to everything.

PAUL SOLMAN: OK, a bit of explanation.

Fat tails refers to the two tail ends of the bell curve, the tails of the so-called normal distribution, which is used to depict human height, for example, height on the horizontal, number of people on the vertical.

So, most folks are average height, and there are fewer and fewer, as you work your way to teeny-tiny on the left tail of the curve to terrifically tall on the right. Markets were also imagined as a normal curve, most days, no real change, a small one-day loss happening maybe twice a week, same for a small one-day gain, a big loss maybe once a year, same for a big gain, a one-day crash, or jackpot, every million years or so.

That’s why the tails are so thin. The extreme market-moving event is graphed as almost never happening at all. But small-likelihood events with huge impact happen a lot, says Taleb. The tails are way fatter than assumed.

NASSIM TALEB: The exception matters a lot. In economic life, it matters a lot.

PAUL SOLMAN: And, historically, it often has mattered.

NOURIEL ROUBINI: The trouble is that the average trader on Wall Street, he or she is so young, he doesn’t even remember the recession of 2001, let alone the previous one.

And people are intellectually lazy. They think that, you know, normal times always with us to stay. But, as Nassim has pointed out, things that should be happening once every hundred years are becoming much more frequent, much more virulent. And the economic costs, the financial costs, the job losses, the income losses, the fiscal costs of bailing out financial system are becoming larger and larger.

PAUL SOLMAN: Case in point, the European debt crisis now roiling the markets and, say Taleb and Rubio, threatening the U.S. as well.

NASSIM TALEB: The risks of debt are monstrous. And now we’re facing a future with even more debt. The only — you know, the only hope I had was that someone would do to us what the rest of the world, Europe and the IMF, are doing to Greece.

No democratically elected government would take the right measure, would go through chemotherapy, would put its population through chemotherapy, which we need to do.

PAUL SOLMAN: So, has the tumor grown?

NOURIEL ROUBINI: There is now massive re-leveraging of the public sector. The U.S. today is having a budget deficit of $0.5 Trillion this year. That’s 11 percent of U.S. GDP. That’s not very far to the 13 percent of Greece. And U.S. is much bigger than Greece.

NASSIM TALEB: The U.S., we’re facing $6 trillion in the next 10 years in the rosiest of scenarios. You agree?

NOURIEL ROUBINI: And the bond market vigilantes have already woken up in Greece, in Portugal, in Spain, U.K., in Ireland and Iceland. But, soon enough, they are going to wake up in the United States.

PAUL SOLMAN: You mean people who are loaning money to governments, buying their bonds, but who might demand higher interest rates because they say, I’m not sure you’re going to be able to pay me back?

NOURIEL ROUBINI: Yes, exactly.

NASSIM TALEB: The governments have transformed private debt into public debt. Now, that’s not something very commendable, because your grandchildren — and I know you have grandchildren — your grandchildren and their children will bear the price. This is immoral.

PAUL SOLMAN: So, what you’re basically saying is, there were bad private promises of the past, mortgage-backed securities and all that kind of stuff; governments came in and made public promises, and thereby redeemed the private promises, and now we should be worried about the credibility of the public promises?

NOURIEL ROUBINI: Exactly.

NASSIM TALEB: Yes.

NOURIEL ROUBINI: Is never a free lunch. And, eventually, either you raise taxes or cut spending, or, otherwise, there are only two options, outright default or a capital levy through monetizing and I think an inflation tax.

PAUL SOLMAN: An inflation tax meaning there will be inflation, which is in effect a tax on your income?

NOURIEL ROUBINI: The real value of the public debt is going to be destroyed by the rise in inflation.

PAUL SOLMAN: And we will all be poorer.

NOURIEL ROUBINI: And that’s like a tax. And everybody — everybody who is a holder of public debt is going to have a loss.

PAUL SOLMAN: So, with unemployment close to 10 percent here, higher elsewhere, doesn’t cutting off stimulus now, taxing people more and so forth, threaten to — to end the upturn?

NOURIEL ROUBINI: Well, the economy is starting to recover. And if we raise taxes and cut spending, in the short run, there might be a slowdown in growth.

But, if we don’t do it, the spreads on government debt are going to rise in a way that’s going to crowd out the recovery and lead to a double dip. So, once that the bottoming of the (INAUDIBLE) that occurred and the recovery is starting, it’s time to take away the stimulus. If we make a mistake of postponing it and keep on running larger deficits, we end up in — maybe with the kind of financial disaster that Nassim is worried about.

PAUL SOLMAN: The kind of financial disaster that Europe is worried about at this very moment.