Stephen’s Posterous

From Alan Greenspan, former chairman of the Federal Reserve and president of Greenspan Associates LLC.

Global economic policymakers are currently confronted with their most daunting challenge since the 1930s. There is considerable fear in the marketplace that the unprecedented set of stimulus programmes and efforts to recapitalise banks with sovereign credits will fall short of success. It is thus useful to contemplate alternatives to that distressing outcome.

Over the past two centuries, global capitalism has experienced similar crises and, up until now, has always recovered and proceeded to achieve ever higher levels of material prosperity. What would today’s world look like if, instead of the vast government policy efforts to stem the onset of crisis, we had allowed market mechanisms and automatic stabilisers, currently built into most of our economies, to function without any additional assistance?

Counterfactual scenarios are highly problematic to say the least. But there are intriguing possibilities that offer comfort that, if all else fails, the global economy is not on a track towards years of stagnation or worse.

In one credible scenario, behind the unprecedented loss of wealth during the last year and a half, lie the seeds of recovery. Stock markets across the globe have to be close to a turning point. Even if a stock market recovery is quite modest, as I suspect it will be, the turnround may well have large (and positive) economic consequences.

For a few months before the August 2007 disruption, the crisis was wholly financial. The world’s non-financial sector balance sheets and cash flows were in good shape. But the contagion from the crisis in finance took hold in the autumn of 2007. Global stock prices peaked at the end of October and then progressively declined for nearly a year into the Lehman crisis. Global losses in publicly traded corporate equities up to that point were $16,000bn (€12,000bn, £11,000bn).

Losses more than doubled in the 10 weeks following the Lehman default, bringing cumulative global losses to almost $35,000bn, a decline in stock market value of more than 50 per cent and an effective doubling of the degree of corporate leverage. Added to that are thousands of billions of dollars of losses of equity in homes and losses of non-listed corporate and unincorporated businesses that could easily bring the aggregate equity loss to well over $40,000bn, a staggering two-thirds of last year’s global gross domestic product.

This combined loss has been critically important in the disabling of global finance because equity capital serves as the fundamental support for all corporate and mortgage debt and their derivatives. These assets are the collateral that powers global intermediation, the process that directs a nation’s saving into the types of productive investment that fosters growth.

I find it useful to think of the world economy’s equity capital in the context of the global consolidated balance sheet. All debt (public and private) and derivatives cancel out, leaving intellectual and physical assets at market value on the left-hand side of the balance sheet and the market value of equity on the right-hand side.

Changes in equity values result in equal changes on both sides of the balance sheet. Debt and derivatives are best seen as a grossing up, reflecting the degree of intermediation or leverage.

The consolidated global equity is also, by construction, the sum of the separate but additive equities of all individual corporations, other businesses, households and governments. At some point, global stock prices will bottom out and rise. A rise in global private sector equity will tend to raise the net worth (at market prices) of virtually all business entities.

In a bull market, the vast majority of stock prices rise. Newly created equity tends to be arbitraged across global businesses. In the current environment, new equity will open up frozen markets and provide capital across the globe to companies in general, and banks in particular. Greater equity, after addressing the shortage of bank net worth, will support more bank lending than currently available, enhance the market value of collateral (debt as well as equity), and could reopen moribund debt markets.

In short, liquidity should re-emerge and solvency fears recede. Restoration of normal global lending could be as effective a stimulus as any fiscal programme of which I am aware.

Widespread capital gains will add equity to balance sheets, but aside from increasing liquidity and decreasing insolvency, they do not in themselves raise economic activity. The fact that claims on business entities are, in effect, purchasing power, does. Most automotive dealers, for example, being compensated for the inconvenience, would presumably accept shares of stock as payment for a car.

We see this process more generally in the so-called wealth effect, where the creation of capital gains augments spending and gross domestic product, whereas capital losses lower spending.

We too often think of fluctuations in stock prices in terms of “paper” profits and losses that are somehow not connected to the real world. But the evaporation of the value of those “paper claims” over the past 18 months has had a profoundly deflationary impact on global economic activity. Failures of intermediation have hobbled many economies over the decades, most conspicuously Japan in the 1990s.

The household wealth effect on personal consumption expenditures has been documented, but stock prices have a statistically highly significant impact on private capital investment as well. Such analyses suggest that much of the recent decline in global economic activity can be associated directly or indirectly with declining equity values.

Of course, it is not simple to disentangle the complex sequence of cause and effect between change in the market value of assets and economic activity. If stock prices were wholly reflective of changes in economic variables, movements in asset prices could be modelled as endogenous and given little attention. But they are not.

A significant part of stock price dynamics is driven by the innate human propensity to swing intermittently between euphoria and fear, which, while heavily influenced by economic events, nonetheless has a partial life of its own. In my experience, such episodes are often not mere forecasts of future business activity, but a key cause of it.

Stock prices are governed through most of the business cycle by profit expectations and economic activity. They appear, however, to become increasingly independent of that activity at turning points. It is this property that makes them a leading indicator, which is the conclusion of most business cycle analysts.

The substitution of sovereign credit for private credit has helped to fend off some of the extremes of the solvency crisis. However, when we look back on this period, I very much suspect that the force that will be seen to have been most instrumental to global economic recovery will be a partial reversal of the $35,000bn global loss in corporate equity values that has so devastated financial intermediation. A recovery of the equity market, driven largely by a receding of fear, may well be a seminal turning point of the crisis.

The key issue is when. Certainly by any historical measure, world stock prices are cheap, even after the recent run-up. But as history also counsels, they may or may not get a lot cheaper before they decisively return to more normal levels. What is undeniable is that stock market prices today are being suppressed by a degree of fear not experienced since the early 20th century (1907 and 1932 come to mind).

But history tells us that there is a limit to how deep, and for how long, fear can paralyse market participants. The pace of economic deterioration cannot persist indefinitely.

It is the rate of decline of product, labour and financial markets that generates much of the uncertainty that, in turn, fuels fear. To an employed person, it is the rate of job cuts, more than the level of unemployment, that fosters job insecurity and the economic responses that go with it. The current pace of deterioration is bound to slow and with it there should come a lessening of the level of fear.

One cause of fear is uncertainty. This uncertainty is reflected in the spread of corporate bond yields over US treasuries. The spread has historically exhibited consistent upside and downside limits clearly indicated by data going back to the 1870s. Today we are at an outer extreme of historic credit risk.

As the level of fear recedes, stock market values will rise. Even if we recover only half of the $35,000bn global equity losses, the quantity of newly created equity value and the additional debt it can support are important sources of funding for banks. As almost everyone is beginning to recognise, restoring a viable degree of financial intermediation is the key to recovery. Failure to do so will significantly reduce any positive impact from a fiscal stimulus.

Source.

From Alan Greenspan, former chairman of the Federal Reserve and president of Greenspan Associates LLC.

The extraordinary risk-management discipline that developed out of the writings of the University of Chicago’s Harry Markowitz in the 1950s produced insights that won several Nobel prizes in economics. It was widely embraced not only by academia but also by a large majority of financial professionals and global regulators.

But in August 2007, the risk-management structure cracked. All the sophisticated mathematics and computer wizardry essentially rested on one central premise: that the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring their firms’ capital and risk positions.

For generations, that premise appeared incontestable but, in the summer of 2007, it failed. It is clear that the levels of complexity to which market practitioners, at the height of their euphoria, carried risk-management techniques and risk-product design were too much for even the most sophisticated market players to handle prudently.

Even with the breakdown of self-regulation, the financial system would have held together had the second bulwark against crisis – our regulatory system – functioned effectively. But, under crisis pressure, it too failed. Only a year earlier, the Federal Deposit Insurance Corporation had noted that “more than 99 per cent of all insured institutions met or exceeded the requirements of the highest regulatory capital standards”.

US banks are extensively regulated and, even though our largest 10 to 15 banking institutions have had permanently assigned on-site examiners to oversee daily operations, many of these banks still took on toxic assets that brought them to their knees.

The UK’s heavily praised Financial Services Authority was unable to anticipate and prevent the bank run that threatened Northern Rock. The Basel Committee, representing regulatory authorities from the world’s major financial systems, promulgated a set of capital rules that failed to foresee the need that arose in August 2007 for large capital buffers.

The important lesson is that bank regulators cannot fully or accurately forecast whether, for example, subprime mortgages will turn toxic, or a particular tranche of a collateralised debt obligation will default, or even if the financial system will seize up. A large fraction of such difficult forecasts will invariably be proved wrong.

What, in my experience, supervision and examination can do is set and enforce capital and collateral requirements and other rules that are preventative and do not require anticipating an uncertain future. It can, and has, put limits or prohibitions on certain types of bank lending, for example, in commercial real estate.

But it is incumbent on advocates of new regulations that they improve the ability of financial institutions to direct a nation’s savings into the most productive capital investments – those that enhance living standards. Much regulation fails that test and is often costly and counterproductive. Regulation should enhance the effectiveness of competitive markets, not impede them. Competition, not protectionism, is the source of capitalism’s great success over the generations.

New regulatory challenges arise because of the recently proven fact that some financial institutions have become too big to fail as their failure would raise systemic concerns. This status gives them a highly market-distorting special competitive advantage in pricing their debt and equities.

The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage. In any event, we need not rush to reform. Private markets are now imposing far greater restraint than would any of the current sets of regulatory proposals.

Free-market capitalism has emerged from the battle of ideas as the most effective means to maximise material wellbeing, but it has also been periodically derailed by asset-price bubbles and rare but devastating economic collapse that engenders widespread misery.

Bubbles seem to require prolonged periods of prosperity, damped inflation and low long-term interest rates. Euphoria-driven bubbles do not arise in inflation-racked or unsuccessful economies. I do not recall bubbles emerging in the former Soviet Union.

History also demonstrates that underpriced risk – the hallmark of bubbles – can persist for years. I feared “irrational exuberance” in 1996, but the dotcom bubble proceeded to inflate for another four years.

Similarly, I opined in a federal open market committee meeting in 2002 that “it’s hard to escape the conclusion that ... our extraordinary housing boom ... finan­ced by very large increases in mortgage debt, cannot continue indefinitely into the future”. The housing bubble did continue to inflate into 2006.

It has rarely been a problem of judging when risk is historically underpriced. Credit spreads are reliable guides. Anticipating the onset of crisis, however, appears out of our forecasting reach. Financial crises are defined by a sharp discontinuity of asset prices.

But that requires that the crisis be largely unanticipated by market participants. For, were it otherwise, financial arbitrage would have diverted it. Earlier this decade, for example, it was widely expected that the next crisis would be triggered by the large and persistent US current-account deficit precipitating a collapse of the US dollar.

The dollar accordingly came under heavy selling pressure. The rise in the euro-dollar exchange rate from, say, 1.10 in the spring of 2003 to 1.30 at the end of 2004 appears to have arbitraged away the presumed dollar trigger of the “next” crisis. Instead, arguably, it was the excess securitisation of US subprime mortgages that unexpectedly set off the current solvency crisis.

Once a bubble emerges out of an exceptionally positive economic environment, an inbred propensity of human nature fosters speculative fever that builds on itself, seeking new unexplored, leveraged areas of profit. Mortgage-backed securities were sliced into collateralised debt obligations and then into CDOs squared. Speculative fever creates new avenues of excess until the house of cards collapses. What causes it finally to fall? Reality.

An event shocks markets when it contradicts conventional wisdom of how the financial world is supposed to work. The uncertainty leads to a dramatic disengagement by the financial community that almost always requires sales and, hence, lower prices of goods and assets. We can model the euphoria and the fear stage of the business cycle. Their parameters are quite different. We have never successfully modelled the transition from euphoria to fear.

I do not question that central banks can defuse any bubble. But it has been my experience that unless monetary policy crushes economic activity and, for example, breaks the back of rising profits or rents, policy actions to abort bubbles will fail. I know of no instance where incremental monetary policy has defused a bubble.

I believe that recent risk spreads suggest that markets require perhaps 13 or 14 per cent capital (up from 10 per cent) before US banks are likely to lend freely again. Thus, before we probe too deeply into what type of new regulatory structure is appropriate, we have to find ways to restore our now-broken system of financial intermediation.

Restoring the US banking system is a key requirement of global rebalancing. The US Treasury’s purchase of $250bn (€185bn, £173bn) of preferred stock of US commercial banks under the troubled asset relief programme (subsequent to the Lehman Brothers default) was measurably successful in reducing the risk of US bank insolvency.

But, starting in mid-January 2009, without further investments from the US Treasury, the improvement has stalled. The restoration of normal bank lending by banks will require a very large capital infusion from private or public sources. Analysis of the US consolidated bank balance sheet suggests a potential loss of at least $1,000bn out of the more than $12,000bn of US commercial bank assets at original book value.

Through the end of 2008, approximately $500bn had been written off, leaving an additional $500bn yet to be recognised. But funding the latter $500bn will not be enough to foster normal lending if investors in the liabilities of banks require, as I suspect, an additional 3-4 percentage points of cushion in their equity capital-to-asset ratios.

The overall need appears to be north of $850bn. Some is being replenished by increased bank cash flow. A turnround of global equity prices could deliver a far larger part of those needs. Still, a deep hole must be filled, probably with sovereign US Treasury credits. It is too soon to evaluate the US Treasury’s most recent public-private initiatives. Hopefully, they will succeed in removing much of the heavy burden of illiquid bank assets.

Mr. Greenspan is the author of The Age of Turbulence: Adventures in a New World. 

Source.

Stephen Roach, Chairman of Morgan Stanley Asia and the bank’s former chief economist, answers questions.

How should capitalism evolve to create a sustainable economy and limit the occurrence of boom and busts and asset bubbles, while at the same time creating opportunities and incentives for innovation and wealth creation?

Stephen Roach: The demise of capitalism is greatly exaggerated. As the free-enterprise system survived the Great Depression of the 1930s, I have little doubt it will reinvent itself and endure the current crisis. Yet we can and must do much better in making market-based capitalism a safer, more stable and sustainable system. There has been a major systemic failure of the model that has held the world together since the 1930s.

Governance, or the lack thereof both within the private sector as well as by those charged with regulation and oversight proved to be the weak link in the chain. As a first priority, that shortcoming now needs to be addressed head on.

In one key respect, that is already happening: Wall Street is being turned inside out right before our eyes. But the new post-crisis regime must also include a revamped code of governance not just regulatory streamlining and reform but also the hardwiring of financial stability into the policy mandates of central banks.

Independent central banks that operate apolitically and free of ideology could well be the most important stewards of a post-crisis capitalism. But they can’t do it alone. Only through better discipline and more effective governance of regulators, rating agencies, and the political oversight function, can the invisible hand of Adam Smith start to work its magic once again.

How should global imbalances, the savings glut in the U.S. funded by China and Japan, be addressed?

SR: The theory is simple: spenders need to start saving and savers need to start spending. Easier said than done, of course. Execution is the problem for a world that simply doesn’t seem to have the appetite, i.e., political will, for the heavy lifting of global rebalancing.

Significantly, powerful market forces have already sparked the early stages of an endogenous rebalancing. In the US, the simultaneous bursting of property, equity, and credit bubbles is forcing households to shift from asset-based saving strategies back to income-based saving strategies. The ageing of 77 million US baby boomers, the first of whom started retiring last year, underscores the urgency of this adjustment, as a large generation of Americans now comes face to face with the imperatives of retirement security.

In China, a massive external demand shock has brought its export-led growth strategy into serious question. If a multi-year compression in US consumer spending growth leads to a protracted slowing in the growth of China’s external markets, Chinese policymakers will have no other choice than to accelerate the transition to a more balanced, and increasingly consumer-led, growth.

Critical in this regard is for China finally to put in place policies that will expand its social safety net, especially social security, private pensions, unemployment insurance, and public support to education and healthcare.

The United States is adding to its already great national debt to fight the recession. Should the US enact laws now, which state that we will raise taxes and cut spending in the future to guarantee that we will stand behind our national debt and prevent catastrophe, e.g. increased interest rates if our debt is considered worthless or has reduced credit worthiness?

SR: The good news is that the coming explosion of federal debt starts from a relatively low base, just 40 per cent of GDP at the end of 2008. The bad news is that open-ended deficit spending seems likely to take the debt-to-GDP ratio toward 60 per cent by 2013 and to over 100 per cent by 2022.

The real problem is the lack of a credible exit strategy from fiscal and monetary stimulus, alike. Post bubble economies are very fragile and not easy to wean from the life support of fiscal and monetary accommodation. Just ask Japan. Twenty years after the bursting of its big bubbles, public sector debt-to-GDP is nearly 150 per cent and the Bank of Japan’s zero interest rate policy is celebrating its 10th anniversary.

While I am not worried about a debt default of the United States government, I am very sympathetic to your suggestion that we codify an exit strategy to the massive fiscal expansion now under way. Toward that end, I believe that the Congress and the White House should collectively declare a formal fiscal emergency and empower a bi-partisan task force to develop new guidelines for federal budgetary control.

Washington did this once before in an effort to contain the runaway budget deficits of the Reagan era, deficits that now look like child’s play when compared with what lies ahead. The automatic spending caps and sequestration mechanisms prescribed by the Gramm-Rudman-Hollings Balanced Budget and Emergency Deficit Control Act of 1985 succeeded in taking some of the optionality out of the fiscal debate.

This problem is too big and the long-term stakes are too high for fiscal sustainability to be entrusted to the oft-politicised whims of the year-by-year discretionary budgeting process.

Given the balance sheet repair needed by the Western consumers, do you see Asia growing at all over the next two years? And more specifically, is there any way that China can juice its economy now that global demand has evaporated?

SR: In light of prospects for a multi-year compression of US consumer demand growth, together with persistent sluggishness of private consumption in Europe, Japan, and elsewhere in the developed world, there can be no mistaking the challenges faced by export-led Developing Asia.

Those challenges are all the more acute in light of Asia’s sharply increased dependence on exports. Over the past decade-plus, the export share of Developing Asia’s GDP went from about 36 per cent in 1997-98 to fully 47 per cent by 2007. This strategy worked brilliantly while global trade was booming. But now that this boom has gone bust, Asia has been hit extremely hard leaving it with no choice other than to come up with a new growth strategy.

The answer for Asia is obvious, to embark on the heavy lifting of structural rebalancing and stimulate internal private consumption. Nowhere is that more evident than in China, where the private consumption share has fallen to a record low of about 36 per cent of its GDP.

In the meantime, Developing Asia will still grow, driven by ongoing infrastructure-led investment and less than optimal growth in personal consumption. I suspect the growth rate for the region over the next few years will average only around 5 per cent about half the pre-crisis norms and not strong enough to prevent unemployment from rising further. For a region that has long worried about social instability, this is a disconcerting outcome, to say the least. It underscores the critical imperatives of Asian rebalancing.

What is the likelihood of Anglo-Saxon-style capitalism morphing toward a more state-involved Chinese approach, along with more draconian penalties for moral lapses?

SR: Your point is provocative and well taken, but I just can’t get on board this ideological spin to the twists and turns of a post-crisis capitalism. The history of capitalism is very much a continuum of tough tests. Yet in the end, it is a system with strong survival instincts, one that periodically reinvents itself. Financial panics, periodic recessions, and even the Great Depression are all part of the stress testing that has long shaped the rough and tumble evolution of market-based capitalism.

Notwithstanding the claims of a sensationalist media, the scale of state-directed intervention in America’s privately-held corporations remains relatively small.

According to US Commerce Department statistics, the value added by banks, securities firms, and other financial intermediaries collectively accounted for 6.2 per cent of the private sector’s gross domestic product in 2007; the insurance sector made up another 2.8 per cent, whereas the share going to motor vehicles manufacturers was just 0.8 per cent.

Private employment shares of these newly protected industries are even smaller, 5.3 per cent for finance and insurance and just 0.7 per cent for motor vehicles.

These figures provide an outside estimate of the US government’s recent intervention share of around 6-10 per cent in the private economy. That means, of course, that more than 90 per cent of the private sector in the United States is still operating largely as a free-enterprise system. That is not exactly consistent with the widely popularised image of a bail-out nation that has been offered up to depict a US economy in chaos and a market-based system on the brink of collapse.

Still, there is good reason to be concerned about the implications of these recent interventions. Emergency government investments in privately-held companies, capital injections as well as backstop financing, have become an all-too-frequent outgrowth of what started out as a mere sub-prime crisis. At the same time, compensation caps, home mortgage foreclosure mitigation efforts, and politically-engineered consumer lending programs all smack of a quasi-socialisation of American finance.

Add to that, Washington’s new-found aggression on trade policy, “buy America” government procurement policies, along with Chinese currency bashing and it seems as if the US strain of capitalism is being turned inside out. The US body politic is rushing headlong toward a very slippery slope!

The intro asks what is to be done to restore ”faith” in the free market. Is anyone using reason to re-examine free-market ideology itself, or considering the possibility that free markets might be less lethal if they were a little less free?

SR: The current mess is deeply rooted in an ideological approach to economic governance, namely, America’s recent penchant for market libertarianism. Alan Greenspan, the high priest of this approach, framed most of the Federal Reserve’s critical policy choices in the context of this ideology.

As seen through this lens, asset bubbles were not judged to represent a dangerous build-up of speculative excesses instead, they were repeatedly perceived by Greenspan as outgrowths of America’s thriving free enterprise system. The equity bubble of the late 1990s was justified by the breathtaking acclaim accorded to IT-enabled, productivity-led advances of a New Economy.

Property bubbles were presumed to be local, not national,  especially in an era of rising homeownership at the lower or subprime end of the income distribution. And the credit bubble, together with the risk bubble it spawned, was offered as testament to the genius of financial innovation and American creativity. Market libertarians simply looked the other way as the US lurched recklessly from bubble to bubble.

Bubbles, of course, are always based on a shred of truth. But the post-bubble wreckage of the US economy begs for a very different interpretation than that which became conventional wisdom over the past decade. So, too, does the Fed’s blatant abrogation of its regulatory responsibilities during the Greenspan years.

Nowhere was that more apparent than in the central bank’s failure to make the distinction between financial engineering and financial innovation. Far from playing the widely popularised role as the ultimate shock absorber, the originate and distribute hallmark of the derivatives explosion became a lethal transmission mechanism of cross-border and cross-product shocks.

Ideology blinded America’s central bank, as well as its political overseers, to the imperatives of discipline. That same ideology let an unregulated and increasingly unstable free-enterprise system veer unnecessarily out of control. I don’t think that markets have to be any less free, as you suggest.

We just need to be more vigilant in attending to their potential for instability and in recognising the repercussions such destabilising adjustments can have on increasingly asset-dependent real economies. Market risk must be taken far more seriously by the Authorities in the future.

Some form of regulation is undoubtedly needed, but it can sometimes be counter-productive, merely adding layers of costs and giving more business to corporate lawyers and auditors. Sarbanes-Oxley is a perfect example of this form of regulation. In light of such issues, what in your opinion is the ideal form of regulation, and do you foresee a return to Glass-Steagall?

SR: While I agree that misplaced regulation can be counter-productive, I also believe that our system of self-regulation failed miserably in an increasingly complex and globalised economy. An important corollary of this failure is the dangerous and destabilising implications of bubble-dependent economic growth.

We must be very careful, however, in rushing to judgment in designing a new regulatory approach in this post-bubble era. The search for scapegoats can become an obsession; in effect, a lightning rod for national angst. But scapegoating can play an even more destructive role as it can bias and eventually undermine the re-regulatory fix that invariably follows any crisis.

Therein lies one of the greatest potential pitfalls in the post-crisis backlash of 2009. Wall Street has been singled out as the villain in this crisis. On one level, this is understandable. Financial service firms did make many serious and regretful mistakes from faulty risk management models and perverse incentive systems to misguided business strategies and momentum-driven capital deployment. But they were hardly alone.

The modern US financial system has long been under the purview of an institutionalised network of checks and balances controlled by regulators, a politically-independent central bank, and congressional oversight. Rating agencies were empowered as the arbiters of risk assessment. Yet every single one of those safeguards failed to temper the systemic problems that were building for years in the Era of Excess.

The task ahead is to pick up the pieces, learn the lessons of this crisis, and take actions to insure these types of problems never occur again. The post-crisis fix can succeed only if it is grounded in the premise of shared responsibility. A targeted politicised fix is not a solution to a systemic problem. Fix the system that gave rise to the crisis not just the banks that have defined ground zero of a wrenching credit crunch.

It is hard to know where the re-regulatory fix will end up. I would not be surprised if new Glass-Steagall-like regulations were enacted in order to shield the credit intermediation function from riskier activities. Moreover, a much broader umbrella is likely, covering banks and non-bank financial institutions, alike.

In the face of government picking winners and losers both of businesses and individuals have we had a free market in reality during the last 40 years? Isn’t it correct to state that what we have had is a hybrid economic system that depended on government manipulation of the financial system to exist?

SR: To the contrary. During the Era of Excess, market libertarians were in charge, embracing a regime of self-regulation and unbridled free-market capitalism. Led by Alan Greenspan, there was very little of the manipulation you seem to believe in.

Those days appear to be over at least for the time being. With many of the once proud icons of Corporate America now on the skids, emergency government intervention has become the norm in this crisis. That is closer to the hybrid system that you seem to be alluding to. As I noted above, the real trick will be to wean the patient from the life support measures of such interventions without triggering a relapse.

To what extent might governments try to influence the business strategies of the financial institutions, which agreed to state aid?

SR: That is a little close to home. The words “might” and “try” should be stricken as this train has already left the station. The feeding frenzy of US Congressional bonus bashing has taken on a life of its own with extreme “clawback” legislation having already passed the House of Representatives and now working its way through the Senate.

If signed into law, these draconian measures would severely impact talent retention, as well as the willingness of any financial institution to accept government “assistance” in the future. Your choice of the word “influence” is a massive understatement of the destructive intent of America’s increasingly vengeful body politic.

Personally, I am sickened by the hypocrisy of the blame game that has been spawned by this wrenching crisis, a politically inspired witch-hunt that has now singled out Wall Street as the villain in this mess. While our industry is hardly blameless for developments that gave rise to the so-called sub-prime crisis, it is dead wrong to lay it all on Wall Street.

Yes, we made many serious mistakes from faulty risk management models and perverse incentive systems to misguided business strategies and momentum-driven capital deployment. I personally have great regret for these errors, honest mistakes that were made by a few but with implications for far too many.

But the verdict must be rendered in context. Governance of the modern US financial system has long been relegated to an institutionalised network of checks and balances, controlled by regulators, a politically-independent central bank, and congressional oversight. Rating agencies were empowered as the arbiters of risk assessment.

Yet every single one of those safeguards failed to temper the systemic problems that were building for years in the Era of Excess. In short, the system failed. And in this new era of responsibility, as President Obama calls it, all of us must accept shared responsibility for that, from Wall Street to Washington to Main Street.

America’s politicians, the stewards of a system that went to excess, apparently can’t stomach the possibility that they, too, played an important role in shaping the endgame. They prefer, instead, to opt for the blame game, in particular, singling out Wall Street as the major culprit in this devastating crisis.

Focusing on the fall guy deflects attention away from the tough choices that ultimately must be made by elected leaders to avoid the repetition of a crisis like this in the future. Never mind the hypocrisy. It is as if the people’s representatives were innocent passengers on a runaway train.

The blame game is the darkest side of any crisis. The search for scapegoats often becomes an obsession, in effect, a lightning rod for national angst. And it brings out the very worst in an otherwise great nation. Accountability is, indeed, a critical issue in any post-crisis debate. But it must be adjudicated objectively and fairly.

Capitalism is failed in the form it is in and will fail again. If the only target of a system is to accumulate wealth for the minority, it is a worthless system. What do think about the ideas of Mahammad Yunus and his Grameen Bank?

SR: I stand by what I said above. The failure is not capitalism but the system of governance or should I say, the non-governance of self-regulation, that was put in place to manage the capitalist system. Fix that, and capitalism will be fine.

No one could reasonably have expected the boards of directors of major financial institutions to foresee the devastation caused by the financial crisis, but was it not reasonable to expect them to be much more effective in forcing their chief executives to protect against the demise of their banks? If not, what real value can boards play in a governance system if they cannot be relied on to do the right thing when it is most critical?

SR: It is premature to judge the most critical failures in the system of corporate governance that guided financial institutions into the eye of this storm. Was it directors, senior managements, risk managers, credit departments, incentive systems or a lethal interplay between all of the above?

Or was it a siloed decision making process and a related failure to communicate effectively across these different constituencies? Getting to the bottom of these concerns is an urgent matter for every financial services firm.

But there is a very human piece to this sad tale, as well. Call it greed, blind greed, for that matter. Like it or not, booms, artificial or real, distort incentives. Booms also warp values and blind us to downside risks. And denial, that most powerful of human defenses, leads us to dismiss the tough questions that might draw the staying power of a boom into question.

In the now-ended boom, there was everything to gain from keeping the magic alive. And much to lose by drawing it all into question. But it wasn’t just Boards of Directors that failed. It was the American body politic – from Wall Street to Main Street to Washington that was consumed by the hopes and dreams of a bubble-induced boom.

As long as the music kept playing, went the painfully accurate metaphor, no one wanted to stop dancing. We even found heroes to worship: Alan Greenspan, anointed as the Maestro, knighted by the Queen, lionised by US Congress, and yet derelict in his responsibilities as a tough and disciplined central banker was the champion of the Era of Excess.

In the end, the ultimate seduction came from the appearance of unbridled wealth accumulation, soaring stock prices, surging home values, and the ultimate in retirement security. But it wasn’t just us. The rest of the world was delighted to go along for the ride, especially export-led developing economies whose newfound prosperity was built on selling anything and everything to over-extended American consumers. Literally, no one, not even you guys in Shanghai, Peter, wanted this party to end.

If the core reason for the current financial crisis was the failure of the American consumer to save, how will policies designed to simulate spending massively at a time when the consumers’ financial position is even more precarious be conducive to the long term change in behaviour needed to really solve this crisis?

SR: There is enormous push-back to my pro-saving prescription for a saving-short US economy. “America needs to spend,” is the increasingly desperate cry of the born-again Keynesians steeped in fear of the dreaded “Paradox of Thrift.” Greg, you have your finger on one of the biggest issues of this crisis: do we want to go back to the failed macro of bubble-and debt-driven consumption that got us into this mess, or do we have the guts to try and break the mold of years of excess?

The answer is clear to me: the US needs to shift its growth dynamic away from excess consumption and de-minimus saving toward enhanced saving and increased investment. The surplus savers of the world need to do the opposite. To do this, we need to rethink our views on the “paradox of thrift”, viewing this phenomenon in the context of an open global economy rather than something as seen through the lens of a closed domestic economy.

I am not suggesting that the world boost its saving rate. What I am suggesting is a critical shift in the mix of global saving with the US doing more of it and Asia doing less of it. As Developing Asia moves to more of a consumption-driven economy, its currencies should also appreciate, allowing the US dollar to work its way lower and helping American boost its export competitiveness.

If the Obama Administration delivers on other aspects of its competitiveness agenda, namely, infrastructure, educational and healthcare reforms, and energy independence, the excesses of bubble-dependent consumption growth should give way to increasing support from export-led growth.

If, however, the US backtracks and goes back to the well for another dose of excess consumption growth, imbalances will only build again, culminating in an even more treacherous endgame. The ever-expedient quick fix must be avoided at all costs. It is a recipe for disaster.

What would be the very first sign that you will be looking for to tell you that this crisis has come to an end and recovery should begin soon? Do you think there will be a long gap between the end of this crisis and the start of recovery?

SR: I wish it were that easy, one magical indicator turns and the end would finally be in sight. This is a lethal and very complex crisis, with many moving parts. The first stage was the credit market contagion that started with the bursting of the subprime bubble in the summer of 2007 and then spread like wildfire in a cross-product contagion that engulfed the remainder of the capital markets.

Moreover, courtesy of the “originate and distribute” technology of the derivatives explosion, toxic instruments found their way all over the world. This interplay between cross-product and cross-border contagion has created a crisis of truly epic proportions.

The second stage of this crisis is the impact of the capital markets contagion on the real side of asset-dependent economies. The asset-dependent American consumer has been first to tumble. But quick to follow has been export-led economies elsewhere in the world – especially in Asia, Europe, and now Latin America. The decoupling dream was just that – actually a bad dream, bordering on a nightmare.

The third stage of this crisis involves the adverse feedback loop between a deteriorating real business cycle and the loan quality of the same financial institutions that bore the brunt of the credit market contagion in the first stage. That stage is now unfolding with a vengeance. Unfortunately, these stages tend to feed on each other – creating the true vicious circle that is exceedingly difficult to break.

Politicians, policymakers, media pundits, and many business leaders have argued for quite some time that this is mainly a crisis of confidence. If only we all just started smiling more and spinning the good news, then the vicious circle would magically turn virtuous and the worst would be over. As I said, I wish it were that easy.

What will be the global consequences of the Fed’s decision to buy US government bonds and bad bank debt on such a massive scale? Will we see hyper-inflation in the US, and will the creditor nations in Asia now want to stop lending them money? What strategic opportunities/risks do you see as a result of this situation?

SR: For a world in recession, the immediate impact of Helicopter Ben’s unconventional monetary easing is not nearly as problematic as you seem to imply. Given the slack in the global economy, together with its still massive imbalances, it is highly unlikely that inflation will spontaneously ignite or that the world will stage a buying protest against dollar-denominated assets.

Keep in mind that trend growth in the world economy has been about 3.7 per cent per annum over the past 35 years. That means if global GDP contracts by over 1 per cent this year as many, myself included, now suspect, such an outcome will open up about a five percentage point gap relative to the global economy’s longer-term growth potential. Given the multi-year sluggishness I envision, I suspect that the global output gap will expand further in the years immediately ahead, possibly peaking at around 7 per cent to 10 per cent of world GDP.

Such a huge global output gap implies a lingering risk of deflation rather than the immediate risk of an outbreak of inflation. If, however, the gap starts to narrow and the Authorities have been unable to develop effective and credible exit strategies for their massive monetary and fiscal stimulus campaigns, then there will be good reason to worry about inflation. Those worries are distant, however, at least three years, and maybe even five years out in time.

In the meantime, I doubt if the export-dependent surplus savers in Asia would stop lending capital to the US. If they did, their currencies would appreciate, undermining their export competitiveness and thereby threatening a key source of their economic growth.

However, if Asia is successful in migrating to more of a consumption-dependent growth strategy, it will start to absorb its surplus saving and have less capital to send to the US. And then, Asians can truly afford to be far more demanding in seeking better terms on dollar-denominated assets. Doesn’t sound very symbiotic to me.

If banks are too big to fail,  too important to our economy, are they not also too important to be owned and managed by capitalists alone? How can we have smart and well-paid bankers and traders make the right decisions for the long-run benefit of their organisations, and not just churn and burn for short-term bonuses?

SR: Having worked for one firm on Wall Street for over 26 years, I am obviously biased in attempting to answer this critical question. But I believe very strongly that financial institutions are too important to be turned back into state-owned public utilities. In an era of globalisation and interdependent markets, financial intermediation and capital allocation have taken on new dimensions of complexity and risk. These are critically important functions in any economy’s quest for prosperity.

Alas, as we have painfully learned, that quest can cut both ways. That provides one of the most important lessons for the financial services industry, the need to redress the asymmetries of reward and compensation. Remuneration, in my view, can no longer be paid out on a point-of-sale basis. It must be aligned with the longer-term risk-adjusted returns of individuals and their companies. Only then, can we avoid the distorted incentives that encouraged short-term payouts from bubble-driven momentum in trading and banking activities.

Of course, in the Era of Excess, we ended up with a very different system. The profusion of bubbles distorted everything, from the financial system to the real economy. If we do a better job in containing the excesses of asset and credit bubbles in the future, I think we will go a long way in establishing a stable and secure market structure that will force the financial services industry to adopt a more reasonable and equitable system of incentives and rewards.

This critical adjustment can not be taken for granted. The trick will come in aligning a new financial system with the industry’s contribution to broader measures of national prosperity. That is a very contentious point.

Former Fed chairman Paul Volcker put it all too well in an April 2008 speech to The Economic Club of New York when he said, “It is hard to argue that the new (financial) system has brought exceptional benefits to the economy generally. Economic growth and productivity over the last 25 years has been comparable to that of the 1950s and 60s, but in the earlier years the prosperity was more widely shared.” Volcker concluded that. “The bright new financial system, for all its talented participants, for all its rich rewards, has failed the test of the market place.”

If the next financial system fails the Volcker-like test of the market place, its rewards, or lack thereof, should be aligned with its failed returns. If, however, the outcome is more favorable, remuneration to its workforce, and presumably to its shareholders, should follow. This is the crux of the challenge for our industry and for those charged with its governance. It is an especially critical challenge for the central bank, an institution, which owes its very existence to the crises of yesteryear.

The role of the central bank is, in fact, testament to one of capitalism’s most important covenants, that finance cannot be entrusted to self-regulation. That is the most painful flaw of the Greenspan era. Never again should we let ideology guide central banking and its regulatory responsibilities.

Central banks need new mandates that explicitly tie their policy targets to the requirement of containing the excesses of asset bubbles and the severe economic distortions they spawn. Then, and only then, can the new financial system be on much sounder footing than the old one. But that’s not to say that we in the industry shouldn’t take a long and hard look in the mirror before we embark on our own Herculean task of attempting to rebuild a failed financial system.

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From Alan Greenspan, former chairman of the Federal Reserve and president of Greenspan Associates LLC.

We are in the midst of a global crisis that will unquestionably rank as the most virulent since the 1930s. It will eventually subside and pass into history. But how the interacting and reinforcing causes and effects of this severe contraction are interpreted will shape the reconfiguration of our currently disabled global financial system.

There are at least two broad and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today's financial mess.

The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.

This should not come as a surprise. After all, the prices of long-lived assets have always been determined by discounting the flow of income (or imputed services) by interest rates of the same maturities as the life of the asset. No one, to my knowledge, employs overnight interest rates, such as the fed-funds rate, to determine the capitalization rate of real estate, whether it be an office building or a single-family residence.

The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier, in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.

U.S. mortgage rates' linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.

As I noted on this page [Opinion, Wall Street Journal] in December 2007, the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition.

The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.

That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble.

The U.S. price bubble was at, or below, the median according to the International Monetary Fund. By 2006, long-term interest rates and the home mortgage rates driven by them, for all developed and the main developing economies, had declined to single digits, I believe for the first time ever. I would have thought that the weight of such evidence would lead to wide support for this as a global explanation of the current crisis.

However, starting in mid-2007, history began to be rewritten, in large part by my good friend and former colleague, Stanford University Professor John Taylor, with whom I have rarely disagreed. Yet writing in these pages last month, Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his "Taylor Rule," "it would have prevented this housing boom and bust. " This notion has been cited and repeated so often that it has taken on the aura of conventional wisdom.

Aside from the inappropriate use of short-term rates to explain the value of long-term assets, his statistical indictment of Federal Reserve policy in the period 2003-2005 fails to address the aforementioned extraordinary structural developments in the global economy. His statistical analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.

Moreover, while I believe the "Taylor Rule" is a useful first approximation to the path of monetary policy, its parameters and predictions derive from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the sole basis for successful policy analysis or advice, with or without the benefit of hindsight.

Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have prevented the housing bubble. All things considered, I personally prefer Milton Friedman's performance appraisal of the Federal Reserve.

In evaluating the period of 1987 to 2005, he wrote on this page [Opinion, Wall Street Journal] in early 2006: "There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind."

How much does it matter whether the bubble was caused by inappropriate monetary policy, over which policy makers have control, or broader global forces over which their control is limited? A great deal. If it is monetary policy that is at fault, then that can be corrected in the future, at least in principle. If, however, we are dealing with global forces beyond the control of domestic monetary policy makers, as I strongly suspect is the case, then we are facing a broader issue.

Global market competition and integration in goods, services and finance have brought unprecedented gains in material well being. But the growth path of highly competitive markets is cyclical. And on rare occasions it can break down, with consequences such as those we are currently experiencing.

It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.

However, the appropriate policy response is not to bridle financial intermediation with heavy regulation. That would stifle important advances in finance that enhance standards of living. Remember, prior to the crisis, the U.S. economy exhibited an impressive degree of productivity advance. To achieve that with a modest level of combined domestic and borrowed foreign savings, our current account deficit, was a measure of our financial system's precrisis success.

The solutions for the financial-market failures revealed by the crisis are higher capital requirements and a wider prosecution of fraud, not increased micromanagement by government entities.

Any new regulations should improve the ability of financial institutions to effectively direct a nation's savings into the most productive capital investments. Much regulation fails that test, and is often costly and counterproductive. Adequate capital and collateral requirements can address the weaknesses that the crisis has unearthed. Such requirements will not be overly intrusive, and thus will not interfere unduly in private-sector business decisions.

If we are to retain a dynamic world economy capable of producing prosperity and future sustainable growth, we cannot rely on governments to intermediate saving and investment flows.

Our challenge in the months ahead will be to install a regulatory regime that will ensure responsible risk management on the part of financial institutions, while encouraging them to continue taking the risks necessary and inherent in any successful market economy.

Mr. Greenspan is the author of The Age of Turbulence: Adventures in a New World.

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With the Dow Jones Industrial Average below 7,000 at 6,763, the US stock market is well below its early 1995 level, adjusted for changes in nominal GDP. That suggests it’s cheap, if growth prospects are as good as they were back then. The risk, however, is that too much fiscal and budgetary stimulus will bring on growth-stultifying inflation.

On December 5, 1996, the Standard and Poor’s 500 Index closed at 744.38. That evening, Fed Chairman Alan Greenspan decried the market’s “irrational exuberance”. At its March 2, 2009, close of 700.82 S&P 500, the market is clearly exuberant no more.

It is not, however, exceptionally low. Greenspan announced a new easier monetary policy to Congress on February 23, 1995, the day the Dow Jones average, which had been generally rising since 1990, first reached 4,000. Adjusting for the 95% increase in nominal GDP since that time would give an equivalent Dow level today of around 7,800. That suggests that current levels are only somewhat below their long term trend, and that the 1996-2007 period represented a lengthy bubble.

Standard and Poor’s currently projects 2009 earnings on the S&P of $48.10. Over the 20-year period to 2008 the index traded at an average of 19.4 times earnings. That would give a current value of 933.14. That 20-year period however includes the 12-year bubble; taking a longer-term average of around 15 times earnings gives a valuation of 721.5, again, just slightly above the current level.

So, based on 1995 stock prices and long-term earnings considerations the market is just below a middling valuation. However, that assumes US growth and earnings prospects are as good today as they were in 1995, or over the long-term average. That’s where doubts creep in.

If the exceptional monetary stimulus since September produces inflation, which needs to be squeezed out, or the unprecedentedly large budget deficits in fiscal years 2009 and 2010 “crowd out” private investment, then growth and earnings prospects for the next few years would be below average.

In that event, the market as it stands today would be overvalued. Bailouts and stimulus can thus produce long-term uncertainty as well as short-term uplift.

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Nouriel Roubini is always dressed in black-and-white.

I have known him for nearly two years, and have seen him in a variety of situations, en route to class at New York University's Stern Business School, where he's a professor; over a glass of wine in his boyish loft in Manhattan's Tribeca; at an academic conference, seated sagely on the dais; at a bohemian party in Greenwich Village, and he always, always wears a black suit with a white linen shirt.

And so, in black-and-white he was, earlier this week, when he rushed into the office of Roubini Global Economics, his consulting firm in downtown Manhattan, and offered a breathless apology to this correspondent, who'd been waiting for half an hour. "Really sorry I'm late! Charlie Rose taped for way longer than he said he would."

Mr. Roubini -- a month short of 50 -- is in huge media demand, the nearest thing to a rock-star among the economists who hold our fate in their hands these days. The peculiar thing, of course, is that he's in demand because he specializes in predictions of gloom. (He has earned himself the sobriquet of "Doctor Doom.") In person, though, he's anything but a downer.

The man has instant impact on public debate. An idea he floated only last week -- that our "zombie banks" be temporarily nationalized, aired first on Forbes.com, where he writes a weekly column. It has evolved, in the space of just a few days, from radical solution to almost received wisdom.

Last Sunday on ABC, George Stephanopoulos asked Lindsey Graham, the conservative Republican senator, what he thought about all this talk of bank nationalization. Mr. Graham said that he wouldn't take the idea off the table. And on Wednesday, Alan Greenspan told the Financial Times that "it may be necessary to temporarily nationalize some banks in order to facilitate a swift and orderly restructuring."

Mr. Roubini tells me that bank nationalization "is something the partisans would have regarded as anathema a few weeks ago. But when I and others put it in the context of the Swedish approach [of the 1990s], i.e. you take banks over, you clean them up, and you sell them in rapid order to the private sector, it's clear that it's temporary. No one's in favor of a permanent government takeover of the financial system."

There's another reason why the concept should appeal to (fiscal) conservatives, he explains. "The idea that government will fork out trillions of dollars to try to rescue financial institutions, and throw more money after bad dollars, is not appealing because then the fiscal cost is much larger. So rather than being seen as something Bolshevik, nationalization is seen as pragmatic. Paradoxically, the proposal is more market-friendly than the alternative of zombie banks."

In any case, Republicans must now temper their reactions, he says. "The kind of government interference in the economy that we saw in the last year of Bush was unprecedented. The central bank -- supposed to be the lender of the last resort -- became the lender of first and only resort! With our recapitalizing of financial institutions, and massive government intervention in the markets, we've already crossed a significant bridge."

So, will the highest level of government be receptive to the bank-nationalization idea? "I think it will," Mr. Roubini says, unhesitatingly. "People like Graham and Greenspan have already given their explicit blessing. This gives Obama cover." And how long will it be before the administration goes in formally for nationalization? "I think that we're going to see the policy adopted in the next few months . . . in six months or so."

That long? I ask. "Six months from now," he replies, "even firms that today look solvent are going to look insolvent. Most of the major banks -- almost all of them -- are going to look insolvent. In which case, if you take them all over all at once, you cause less damage than if you would if you took over a couple now, and created so much confusion and panic and nervousness.

"Between guarantees, liquidity support, and capitalization, the government has provided between $7 trillion to $9 trillion of help to the financial system. De facto, the government is already controlling a good chunk of the banking system. The question is: Do you want to move to the de jure step."

Yet another reason why bank nationalization is a good idea, Mr. Roubini continues, is that "we started with banks that were too big to fail, but what has happened, in the process, is that these banks have become even-bigger-to-fail. J.P. Morgan took over Bear Stearns and WaMu. BofA took over Countrywide and then Merrill. Wells Fargo took over Wachovia. It doesn't work! You can't take two zombie banks, put them together, and make a strong bank. It's like having two drunks trying to keep each other standing.

"So if you took over a big bank, and you split the assets in three or four pieces, maybe you create three or four regional or national banks, and they're stronger! Nationalization -- or 'temporary receivership,' if you like, if the N-word is a political liability -- is an occasion to undo the sort of consolidation that has created an even bigger systemic problem. And the only way to do it is by essentially taking them over and breaking them up."

Here, I ask Mr. Roubini whether he has been more right -- more prescient -- in his reading of the economic downturn than all the other famous bears in America. After all, judging by the attention paid to him in the press, it is hard not to conclude that he is the leading guru of the current recession, or "near-depression," as he often calls it. My question, remarkably, induces in him some diffidence. "I don't want to personalize the analysis, you know . . . because, first of all, there were many people who got many of the elements right.

"People like [Robert] Shiller were very worried about the housing bubble. People like Steve Roach were worried about an economy based on asset bubbles leading to consumption bubbles that were unsustainable. People like Ken Rogoff talked about global imbalances in the current account deficit not being sustainable. Nassim Taleb has been worrying for a while about 'fat tail' events . . . . So lots of people signaled concern about things. I was one of those who put the dots together and thus gave a more fleshed-out picture."

To Mr. Roubini, the most interesting question isn't the one of who got it right. Instead, he asks why we "over and over again, get into these periods of irrational exuberance, when not only is there an asset bubble and a credit bubble, but people believe these are sustainable over a long time -- Wall Street, policy makers, rating agencies, academics, journalists . . . ."

What exactly is Nouriel Roubini's economic philosophy? "I believe in market economics," he says, with some emphasis. "But to paraphrase Churchill -- who said this about democracy and political regimes -- a market economy might be the worst economic regime available, apart from the alternatives.

"I believe that people react to incentives, that incentives matter, and that prices reflect the way things should be allocated. But I also believe that market economies sometimes have market failures, and when these occur, there's a role for prudential -- not excessive -- regulation of the financial system. The two things that Greenspan got totally wrong were his beliefs that, one, markets self-regulate, and two, that there's no market failure."

How could Mr. Greenspan have been so naïve, I ask, hoping to get a rise. "Well," says Mr. Roubini, "at some level it's good to have a framework to think about the world, in which you emphasize the role of incentives and market economics . . . fair enough! But I think it led to an excessive ideological belief that there are no market failures, and no issues of distortions on incentives.

Also, central banks were created to provide financial stability. Greenspan forgot this, and that was a mistake. I think there were ideological blinders, taking Ayn Rand's view of the world to an extreme.

"Again, I don't want to personalize things, but the last decade was one of self-regulation. But in the financial markets, without proper institutional rules, there's the law of the jungle -- because there's greed! There's nothing wrong with greed, per se. It's not that people are more greedy now than they were 20 years ago. But greed has to be tempered, first, by fear of losses. So if you bail people out, there's less fear. And second, by prudential regulation and supervision to avoid certain excesses."

How does Mr. Roubini think the media has covered the financial crisis? "The problem," he says, after first stating to me that he intends "no offense!" "is that in the bubble years, everyone becomes a cheerleader, including the media. This is the time when journalists should be asking tough questions, and I think there was a failure there.

The Masters of the Universe were always on the cover, or the front page -- the hedge-fund guys, the imperial CEO, private equity. I wish there had been more financial and business journalists, in the good years, who'd said, 'Wait a moment, if this man, or this firm, is making a 100% return a year, how do they do it? Is it because they're smarter than everybody else . . . or because they're taking so much risk they'll be bankrupt two years down the line?'

"And I think, in the bubble years, no one asked the hard questions. A good journalist has to be one who, in good times, challenges the conventional wisdom. If you don't do that, you fail in one of your duties."

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