"Sorry to break to the news, but the financial crisis is not over, à la CIT. You’ve got plenty more writeoffs of bad paper to come," Roach told CNBC.
"75 percent of the world’s economies today are still contracting and the biggest piece on the demand side of the global economy is the American consumer, who is dead in the water," he added.
The markets' reaction to the "anemic character of the recovery" is pretty euphoric, and it actually is a manifestation of the excess liquidity poured into the system by monetary authorities, according to Roach.
"Liquidity is seeking return and right now these markets are priced for a recovery that’s going to end up disappointing," he said.
Despite better-than-expected earnings from some companies, those pricing in vigorous results "are going to be in for a rude awakening," Roach said.
"Where’s the demand? As I go around the world, especially in Asia, I don’t see any follow-through on the demand front," he added.
"Talk of green shoots is a "really simplistic way of looking at the world," according to Roach.
"These green shoots are not going to go up to the sky, so my advice is pick a different metaphor," he said.
Last month, Roach gave a lecture at the Rafael del Pino Foundation in Madrid, on post-crisis policy imperatives, and he said he foresees the macro environment over the next several years as likely to be characterized by a "persistent fragility, punctuated by periodic setbacks."
Download a copy of "Leadership Imperatives for a Post-Crisis World."
Dr. Roach said this crisis didn’t have to happen.
"I categorically reject the "inevitability excuse" — the notion that the world has once again been engulfed by the proverbial 100-year tsunami. This all too convenient justification is nothing more than a cop-out by those who were asleep at the switch during the Era of Excess," he said.
Yes, cycles of fear and greed date back to the inception of markets, he said. And those powerful animal spirits were very much at work this time, as well. "But I take strong issue with the apologists who claim little could have been done to avoid the devastating repercussions of the so-called subprime crisis. Instead, there is compelling reason to hold the stewards of the financial system — those in Washington as well as those on Wall Street — accountable for much of the blame," he added.
Roach outlined how starting in the late 1990s, the US economy went through an ominous transformation. Income-short consumers discovered the miracle drug of a new source of purchasing power — the seemingly open-ended wealth creation of ever-frothy asset markets. First equities, then residential property, American households drew on asset appreciation to consume well beyond their means. He said real private sector compensation — the broadest measure of the economy’s endogenous income flows — currently stands only about 13% above its early 2002 levels in inflation-adjusted terms. Yet personal consumption surged to a record 72% of real GDP in early 2007 — a spending binge without precedent in US history, or for that matter in the long history of any leading economy in the modern era
Wealth creation closed the gap — driven especially in recent years by the self-reinforcing feedbacks between housing and credit bubbles. Courtesy of new "breakthroughs" in mortgage finance — breakthroughs, in retrospect, that were more destructive than constructive — homeowners tapped the seemingly open-ended home equity till as never before. Net equity extraction from residential property surged from about 3% of disposable personal income in 2000 to nearly 9% in 2006. This provided newfound support to spending and saving that allowed households to more than compensate for the extraordinary shortfall of labor income generation. The result was not only the consumption binge noted above, but also a profound shortfall of income-based saving. The personal saving rate slid into negative territory in late 2005 for the first time since the 1930s.
Lacking in income-based saving, the US imported surplus saving from abroad in order to keep growing. But it had to run massive external deficits in order to attract the capital — sufficient to push the current-account deficit up to a record 6.5% of US GDP by the third quarter of 2006. Roach said the impact of that development was global in scope — deficits must always be matched by surpluses elsewhere in the world. Courtesy of America’s gaping external shortfall, global imbalances — the absolute sum of the world’s current account deficits and surpluses — soared to 6% of world GDP in 2006, nearly triple the 2% reading of a decade earlier. Joined at the hip, asset bubbles and global imbalances stretched the macro fabric of the global economy as never before.
Roach said in retrospect, there can be little doubt of the profusion of bubbles that developed over the past decade — equities, residential property, credit, and many other risky assets. The Fed mistakenly dismissed all of these developments, harboring the illusion that it could clean up any mess afterwards. The extent of today’s devastating mess is clear repudiation of that hands-off approach.
“You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others,” said Representative Henry A. Waxman of California, chairman of the House Committee on Oversight and Government Reform, in October 2008, to Alan Greenspan. “Do you feel that your ideology pushed you to make decisions that you wish you had not made?”
Greenspan conceded: “Yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact.”
Stephen Roach says monetary policy will need to shift away from the Greenspan-Bernanke reactive post-bubble cleanup approach toward pre-emptive bubble avoidance. He says it may be tricky to judge when an asset class is in danger of forming a bubble.
Roach advocates that Congress should add financial stability to the Fed's existing mandates of price stability and full employment.
He says there would be no room in a new financial stability mandate for the ideological excuses of bubble denialists. Alan Greenspan, for example, argued that equities were surging because of a New Economy; that housing forms local not national bubbles; and that the credit explosion was a by-product of the American genius of financial innovation. In retrospect, while there was a kernel of truth to all of those observations, they should not have been decisive in shaping Fed policy. Under a financial stability mandate, the US central bank would have no such leeway. It will, instead, need to replace ideological convictions with common sense. When investors and speculators buy assets in anticipation of future price increases — precisely the case in each of the bubbles of the past decade — the Fed will need to err on the side of caution and presume that a bubble is forming that could pose a threat to financial stability.
Slides of the Madrid presentation
