In a speech to the IMF in September 2006, NYU Economics Professor Nouriel Roubini predicted that the United States was likely to face a "once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence, and ultimately, a deep recession," according to The New York Times.

Roubini was dubbed "Dr. Doom" for his dire outlook. But IMF economist Prakash Loungani said that in hindsight, Roubini should have been called a prophet. (Some critics are now saying Dr. Doom didn't see the market recovery coming.)

Roubini's new book is Crisis Economics: A Crash Course in the Future of Finance, which he co-authored with Stephen Mihm. In this first of two articles, Motley Fool Money Radio Show host Chris Hill talks with Roubini about the EU bailout, white swans, and financial reform.

Chris Hill: We're right on the heels of the EU approving a trillion-dollar bailout to help stabilize the euro and Greece. What is your take on the plan and the future of the EU?

Nouriel Roubini: As I discuss in my book, this is no surprise because many crises that start from excessive amounts of debt and leverage in the private sector eventually lead to solving that problem because many of the private losses are then socialized. So we're now facing the next stage of this global financial crisis, where the problem is spreading from the private sector to the public sector. So that's happening already in Europe, but even in the United States we have a budget deficit of a trillion dollars or more.

I'm worried that this particular trillion-dollar rescue package in Europe is not going to work because even if there is money on the table, first of all, it's conditional on this country making lots of sacrifices. Then you have to ask yourself, "Can you reduce the budget deficit by 10% of the GDP by cutting spending or raising revenue in places like Greece or other European countries?"

Politically, it's going to be very hard. Two, if you raise taxes and cut spending, you're going to have more recession in the short run. Can a country accept year after year of a recession in order to achieve stabilization of the deficit? That's highly unlikely. Three, these countries were facing an issue of competitiveness because they were already losing market share to China/Asia a decade ago, as their exports were labor-intensive. And then they had the decade where wages were growing more than productivity.

And the final nail in the coffin was appreciation of their currency for the last few years. So, they need to restore fiscal stability, they need to restore competitiveness, they need to restore economic growth. I think it's going to be very, very hard for them to do that. That's why I'm still bearish, in spite of this trillion-dollar rescue package.

White swan events
Chris Hill: What surprised you the most when you were writing your book?

Nouriel Roubini: What surprised me the most was that when you look, historically, you see a pattern of crisis occurring with similar pattern -- asset bubbles, leverage, risk taking, and so on, and we seem like we're never learning from history.

There is nothing particularly new about the most recent financial crisis, as we discuss in our book. We refer to them as being "white swan events" to compare them with the idea of a black swan event that has been popularized by my friend Nassim Taleb. It's not just a random outcome of a distribution with a fat tail of a financial crisis. It's the result of a buildup of macro financial policy vulnerabilities -- asset bubbles, booms that are followed by leveraging up of the private sector and the public sector -- and eventually, the bust and the crash come. So in some sense, they are white swans in the sense of being predictable, but it seems like people never learn from experience.

Chris Hill: You write that crises are predictable. Why didn't more people predict this crisis?

Nouriel Roubini: What happens in every crisis is in the period of time of the bubble and the irrational exuberance and euphoria, everybody is in a denial mode. Consumers could spend more than their income by using their homes at the ATM machines. Politicians were happy because the economy was doing well and they were being re-elected. The financial sector on Wall Street was very happy because they were doing billions and billions of profit. So, everybody was in a denial mode, because when there is a bubble, there is euphoria and people lose track of reality.

Fixing the financial system
Chris Hill: You write that the financial crisis was less of a function of subprime mortgages and more about a subprime financial system. It's obviously a big topic here in Washington, D.C. What do you think are two or three things that need to be done to fix the financial system?

Nouriel Roubini: The three most important ones are to deal with the "too big to fail" problem by breaking up financial institutions that are too big. So if they're too big to fail, in my view, they're too big. Using a resolution regime or capital charge is not going to work.

Two, we need to give the incentive to traders and bankers not to take excessive risk and that means to change the system of compensation by having a bonus model with clawbacks of those bonuses in case, over time, those risk investments turn out to have led to losses rather than profit.

Three, I think we have to go back to the kind of restrictions we had under Glass-Steagall -- of separating investment banking from commercial banking. The Volcker rule goes in that direction by restricting bank holding companies from doing prop trading, private equity and hedge fund activities, but in my view, it doesn't go far enough. I would go back to the restrictions we had under Glass-Steagall. So those are the three most important things that need to be done.

Check on Monday for part 2 of our interview with Nouriel Roubini, in which we ask him about some of his not-so-successful predictions and get his thoughts on the next financial crisis, gold prices, Geithner, and Gaga. For the podcast, check out the Motley Fool Money Radio Show.

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