June 27 (Bloomberg) -- Nouriel Roubini, professor of economics at New York University Stern School of Business, talked with Bloomberg's Tom Keene from New York yesterday about U.S. and global economies, the role of central banks and "systemic" risk in the U.S. financial system.

(This is not a legal transcript. Bloomberg LP cannot guarantee its accuracy.)

TOM KEENE, HOST 'BLOOMBERG ON THE ECONOMY': Professor, welcome back to the program.

NOURIEL ROUBINI, PROFESSOR OF ECONOMICS, NEW YORK UNIVERSITY STERN SCHOOL OF BUSINESS: Pleasure in here today.

KEENE: You can't talk. You just raced in here. I saw you turn off your Blackberry. I assume you were messaging someone on a caution here. A year ago, eighteen months ago you were talking about economic slowdown, a recoupling. Where are we through that cycle?

If you have a timeline of slowdown, are we half way through it? Are we just beginning? Where are we in the cycle?

ROUBINI: We are in a recession in the United States. And a year ago I said that the combination of the biggest housing bust in the last 50 years, the current credit crunch, and how low prices are going to lead to recession.

I believe we're already in a recession in the United States, and now there are significant signs of slowdown, if not contraction, in a number of other countries. One, inflation is rising throughout the world. We are in a situation of stagflation lite.

KEENE: When we're in that and we can see that and we report on it every day, say in Europe that's confronting oil where it is or other nations, let's go to these emerging markets. Is the scope and scale of China slowing down? Is it single digit where they go from 11 percent to 10 or to 9, or could it be a larger slowdown?

ROUBINI: I imagine it could be a larger slowdown because right now what's happening is that the U.S. is in a recession, Japan sure enough is going to be in a recession, a good third of Europe is going to be in a recession, U.K., Spain, Italy, Ireland, Portugal. Canada is in a recession, New Zealand is in a recession. Some of these European countries already contracting.

So, we've many major economies that are slowing down. And therefore, the trade links and the financial links that China and India and the other emerging markets cannot decouple from this U.S. and global economic slowdown.

It's going to take time. Right now inflation, with pressures because of overheating of this country is still the most important factor. But they're now facing even the other side of the problem from inflation rising, but downside risk to economic growth throughout emerging markets. So that's the worst of all worlds.

KEENE: When we see the challenges central banks face, and let's talk about the G2, G5 central banks that are out there. If they jawbone your stagflation lite, is there one compensating factor? Their external adjustment, is it foreign exchange? Is that where the adjustment ultimately gets made?

ROUBINI: Yes, but the external adjustment is a little bit of a double edged sword because take the United States. The U.S. needs a weaker dollar in order to stimulate net export as the other components of demand or the domestic are contracting. So in order to deal with the recession, we need easy monetary policy and we need a weaker dollar.

But on the other side, a weaker dollar, to get the value in rising oil and energy commodity prices, leading to higher inflation and therefore to address inflation, if its going to be a problem, the Fed is to stay on hold or even threaten raising interest rates.

So, whenever you have stagflation and negative supply side shocks, that's the hardest world for central banks, because they have to ease for growth purposes, and they have to tighten for inflation purposes. So they're in a dilemma.

KEENE: I said on TV with Matt Miller today that the thing I'm watching that's away from the headlines is euro, yen. Euro, yen has taken off again. Maybe you want to say it's a carry trade. But at the end of it, the strength of euro versus yen signals that destabilization.

And is it an idea here that with the foreign exchange tensions out there, that we need to form of government - Are we yet to a Plaza Accord environment?

ROUBINI: No, we're not yet at that point. Yes, there are major misalignment in currencies. And already today Euro, the dollar is already maybe too weak. The euro, rather the yen has strength too much. But talk is cheap. The last G7 meetings, people worried about it. Seeking maybe potential intervention and done nothing. So verbal intervention in the Forex market does not work.

And even actual intervention, as long as its theorized, meaning as long as doesn't lead to change in market condition and relative interest rates, then its also not very effective. So the only way to affect actually relative interest rates is by changing monetary policy and interest rate policy.

And paradoxically now, the ECB is threatening to raise interest rates with leading to inflation. That's going to strengthen further the euro.

KEENE: What do you make of what I've been calling the hockey stick charts? Let's call them a right angle chart. Because a central banker recently said to me, there's too many right angles out there. And there are these charts, like European inflation, that were stable, and they're a jump condition, perhaps.

Does this continue? Do we see this instability in price?

ROUBINI: Yes, there is. Because of the rising oil, energy, commodity, and food prices, there's a significant risk right now that in some economies, we're going to have a rise both in headline inflation and then through secondary channels they're going to lead to increase also in core inflation.

For the United States, however, given I'm so bearish about the economy, I expect a very severe recession. I think there are going to be three factors that are going to lead to a weakening inflationary pressures.

Slack in labor markets, unemployment going up, and therefore labor, in which costs being controlled. Slack in good markets of the manner of the supply controlling the pricing power of the firms.

And three, eventually even commodity prices are going to fall, because in a global economic slowdown, then demand for commodity falls are at the supply, and therefore, commodity price has to fall.

So, I'm less worried about inflation in the United States and even in Europe. The emerging markets have a significant inflation problem. I think that we're worrying too much in the G7 about the inflation right now.

KEENE: Within twenty seconds here, Nouriel, just so many things to talk about here. When you plug in that hardest to judge thing, the time function of those interdependencies, are we out to 2009 or do you envision this out to 2010?

ROUBINI: Well, it depends. If we're talking about economic slowdown of contraction, I see the U.S. recession not being short and shallow, V-shaped, but rather long and protracted, U-shaped, lasting twelve to eighteen months. And similarly for other countries are now entering into a recession.

KEENE: This note out by Stephen Jen out of London with Luca Bindelli, Morgan Stanley. ?High transport costs to unflatten the world.? I've heard Ken Rogoff of Harvard talk this up. And they do it in a collegial way. They're not refuting Tom Friedman's classic book. But they're just saying the rate of change here is away from a flat world.

Is it a new world with these energy costs?

ROUBINI: In many dimensions, it's going to be a new world, of course. And one of the implications of high energy costs is that transportation costs are sharply up. And what made the world flatter was this global chain of supply, where essentially we could produce a computer by outsourcing pieces in a hundred different countries, and transporting them and assembling them.

Now, because of the high transportation costs, this might change. That it's going to be another dimension of this supply side shock. And some people actually believe that this over time is going to be beneficial for U.S. manufacturing, because you're going to have to bring back home jobs and part of the production process, because it's going to be too expensive to transport the stuff from far away.

KEENE: We just had the Governor of Alabama into our world headquarters. And he said he's just loving this. That they're getting a lot of inquiries down in Alabama about investment in the United States.

What's it do for Asia? That Jen and Bindelli at Morgan Stanley put their focus on Asia. There was this model that was developed of consumption exports, goods exports. A lot of that's transportation, isn't it?

ROUBINI: Yes it is. Of course if transportation costs remain so high, Asia has to think about rethinking their essential exported growth model. And that means that demand of these countries, especially the large ones, you have to think about domestic demand.

In a country like China, 1.2 billion people. A country like India, a billion people. These are the countries that are large enough, they should have more domestic demand growth and more consumption growth.

And even the Chinese authorities are aware of it. In their own five year plan, they're realizing that exported growth model is not sustainable in the long run. You have to increase domestic spending, domestic consumption, reduce the saving rate.

But it's going to take time. And that's the adjustment process. Even in the U.S., the transformation back to U.S. production is not going to occur overnight. So the costs, in the meanwhile, are going up in the short run. And that's a negative shock.

KEENE: Right. You mentioned, and speaking of shocks, you mentioned the sterilization aspect of foreign exchange and intervention earlier. But when you look at China, with a reserve still coming in, up to Larry Goodman's 1.8 trillion, and you've written about this as well. What is the stability of China's monetary fiscal mix right now?

ROUBINI: It's a very severe problem because essentially this country followed this century, the United States exchange rate. Pegged effect is the dollar were managing very heavily.

Because of that, they've intervened. Because they've intervened, they've not fully sterilized the effects of the intervention on the money supply. That's created a credit and monetary bubble, and that's led to high and rising prices of commodities.

So, partly our monetary policy easing, and direction of policy maintain impacts to the dollar in China, their country, has implied these rising commodity and global inflation. And is now coming to haunt us back and constraining the hands of Bernanke. So that's what we're risking right now.

KEENE: You've just been traveling like crazy. And you said you were in China. What did you learn new in China this trip?

ROUBINI: Certainly they were worried about inflation, but with one caveat. Inflation, at some level, is beneficial for the farmers, because the real incomes of the farmers have been squeezed for the last few years because of the changes in the dynamics of the economy. Some inflation actually was good for the farmers. That's why they did not react so fast to the rising inflation.

The other point is that these subsidies that come from oil, fuel, and subsidies are mostly beneficial for the urban classes rather than for the real poor. That's why the government decided before they're likely to start phasing them out, and given that subsidies directly to the poor.

So, the dynamics of inflation, from a political economy, continue in China. It's more complicated than just saying inflation is bad.

KEENE: We had Edmund Phelps on the other day. And again, folks, that will be on on Sunday. Yesterday V.V. Chari, of the University of Minnesota, we talked a bit about game theory. Is there game theory between central banks?

ROUBINI: There is going on some game theory between the ECB and the Fed. The Fed started worrying about the inflation and the falling of the dollar. The signal may be tightening. And then the next day, Trichet came and said, ?I'm going to really do it.? Well the Fed didn't mean it. And therefore the dollar, after rallying for a day, started falling again.

The point is talk is cheap. Trichet's putting his money where his mouth is. He's going to tighten rates in July, and that's going to strengthen the Euro. If the Fed is worried about the dollar, they'll have to tighten. My concern is that the downside risks to growth are much more severe than the upside risks to inflation. Therefore the Fed should not tighten.

KEENE: The idea of game theory here, and the science of Mervyn King, for example, of the Bank of England, is it a new era for monetary policy? Are these central bankers, given these events since August, are they working in a new theoretical area, or is it the same tools you studied years ago in Milan?

ROUBINI: My view is a new world. It's a new world in which, for example, monetary policy is not as effective as before, because there is a whole shared financial system that is not based on the banking system. That's why the Fed aggressively eased. They created all these new facility.

And interbank spreads are still very, very wide, because of the whole set of financial institutions. They look like banks. More short, highly leveraged, lending long. The Fed cannot lend excess to the lender last resort support of the Fed.

And therefore the transmission of monetary policy is some part of all this easing has maintained interbank spreads very, very wide. So we have a problem.

KEENE: When we have this problem, and in your travels, you and I were talking on the break about differentials of spreads between the U.S. and Europe.

Are you focused, in this credit crisis, more towards Europe and their financial system - the holistic system, not in a narrow sense? Or are you focused on the U.S. more?

ROUBINI: Initially the shock came from the United States within credit crunch. But now the transmission has occurred through Europe. And the fact that the Fed has eased while the ECB has not eased means that there are tight market condition in Europe.

And this kind of demand for dollar, this shorter dollar in Europe, is a problem for interbank European markets. That's why the Fed entered in the SWAP agreements before in central banks, to essentially provide money, dollars to them, so they can lend through banks.

So paradoxically, not only we're lending now money to non-bank institutions in the U.S., they're also lending money to bank institution abroad. That's a major change in monetary policy in the U.S. We are the central banker for the world.

KEENE: When you look at this, and here we are, it's June. I'm going to assume most of the known world thought the credit crisis would be over in X number of months. And we're coming up on a one year anniversary. And the spreads haven't come down.

Isn't there just an assumption that for financial stability, you really need another tranche to bring Libor, OIS and TED spreads down? That to get a credit crisis solution, there just has to be the spreads back to normal?

ROUBINI: They have to go back to normal. They're not going to go back to normal. Because we're entering a severe recession. The credit crunch is becoming more severe. Counterparty this is becoming more severe.

Hundreds of financial institutions are going to go bankrupt. And those spreads are not depending on lack of liquidity, they're depending on counterparty risk.

So, you can lend money to the banks. They're not going to lend to non-banks. That's the fundamental problem. We've tried to use liquidity and monetary policy to resolve, tried in insolvency problems where millions of bankrupt households, banks, mortgage lenders, financial institutions, hedge funds.

We're not going to resolve this problem with money. This is a credit problem. It's a debt problem. There's a nasty deleveraging going on. Nothing's going to avoid it. We're going to go through a severe economic contraction until we reach the bottom.

KEENE: You testified, I believe it was in February, to Congress. I'm looking here for the testimony. What should be the Washington prescription given the way you've structured this?

ROUBINI: One thing that has to happen is there has to be a debt reduction for mortgages. So, for example, this Barney Frank and Chris Dodd bill is not going to resolve every problem, but its going to avoid a desultory workout of essentially the financial system.

Effectively, we're on the verge of a systemic banking crisis. Either we do the market solution without this bill. And that means that the banks are going to collapse and we're going to have to bail them out, and we're going to nationalize a good chunk of the banking system.

Or if we want to avoid that, and nationalize the banks, the only alternative is the Frank-Dodd bill, is nationalizing the mortgages.

Let's be frank. The options are very simple. Either you nationalize the banks now or you nationalize the mortgages. When you have a systemic financial crisis, there is always a government bailout.

And you have to have a government intervention to avoid the disaster happening. Every financial crisis, it's happening in the United States right now. It's an ugly option, but it's a lesser option to nationalize the mortgage market.

KEENE: Is there a way to do that where you take in all the - I call it the concrete on the balance sheets? You bring it all in to the U.S. Government in one fell swoop. And then you issue out bonds for X number of years. I mean this is not an original idea. That's been done before.

Neal Soss of Credit Suisse makes real clear that this is the tool to get it done. Is that what you would prescribe?

ROUBINI: Well, effectively part of it has already occurred. For example, the Fed has already mortgaged $500 of its $700 billion of Treasuries to be swapped for illiquid and probably toxic assets.

But it's not the job of the Fed to do a fiscal bailout. If we decide, as a nation, we have to bail out the mortgage market, that's a fiscal cost. So we'll have to pay for it.

Yes, we'll have to write down the debt. We'll have to try to subsidize the financial institutions. And that might be part of the solution. But it's a fiscal decision that has to be made by Congress, not by the Fed.

KEENE: Should the Fed retreat to a more traditional Fed function, or should they add on or codify the new duties they've done in the last four, five, six months?

ROUBINI: You cannot go back to the traditional function. Central banks were created not to smooth inflation and growth. But they were created because there were bank runs. And they were created to provide lender of last resort support, and therefore financial stability.

And what we have discovered today is that even after we've provided the lender of last resort support to banks, even after we have deposited insurance and avoided bank runs, there is a whole part of the financial system that's like banks, subject to bank runs.

Therefore, the Fed and every central bank has to worry about financial stability. There is no way back. That means also that we have to regulate non-banks like banks. Because now they're having access to this lender of last resort support.

KEENE: Nouriel Roubini, you said this on the break. And I was speaking with Yalman Onaran and Christine Harper today. And I think it was Christine that said exactly what came out of your mouth. Goldman Sachs is just a hedge fund. Should the Fed and the government be in the business of bailing out non-bank firms that are "just a hedge fund"?

ROUBINI: Unfortunately, they have to be in the business of providing liquidity support to major systemically important financial institutions. That was the lesson of Bear Stearns. That this institution was too large or too interconnected to be allowed to fail.

And therefore, when their run occurred on a non-bank financial institution, and now runs can occur because they all have essentially short term liquid liabilities. If anything, the run is even more severe when it occurs because you don't have depositors.

Then you have to do something. If you don't do something, there is (inaudible) or Lehman, or Goldman Sachs. We're going to have a systemic financial meltdown. So the lesson is, yes, you have to provide liquidity if they're illiquid, to try to avoid the run. But that means that they have to be regulated and supervised like banks.

And once you've regulated and supervised banks and non-banks like broker dealers, there is no reason why you should not regulate also hedge funds or other high deleveraged financial institutions.

These are all similar institutions, whether you call them hedge fund, commercial bank, investment bank, broker dealer. Very similar. Therefore, we have to have a whole different system of regulation supervision. They have to be regulated similarly.

KEENE: I was speaking with Henry Kaufman last week. Let's flip your words around. You mentioned too big to fail. Dr. Kaufman is worried about too small to succeed. One of his great worries is the outcome of this banking crisis, are mergers. And that we end up with too few too big platforms.

Is part of the reason we're in this crisis here, Europe, everywhere, is just these giant, giant banks that can't control risk?

ROUBINI: Yes. The bigger they become, the issue of risk management becomes much more complex in these institutions. There are siluses (ph). And you don't get a holistic approach to risk management.

So, unfortunately, many of the smaller institutions are going to go belly up. You're going to have bigger institutions. And unfortunately, these bigger institutions are too big to be allowed to fail.

So that's one of the side effects that is negative of this financial crisis. Therefore, they have to be regulated and supervised in a much more cautious way.

We've spent the last 10 years speaking about self- regulation. That means no regulation. And what market discipline, there is no market discipline. About principles rather than rules. About internal risk management that nobody cares about, because when the music play, you have to dance.

We have to go back and the pendulum swaying too much about free markets. We have to go towards the center of the sensible regulation supervision. Otherwise, we're going to have increasing currency, financial banking crisis.

KEENE: We're going to talk Charlie Pellet out of the studio, and you and I are going to go another hour. We've got one minute left, sir. When we look at John Lipsky of the IMF, and he talks about a coordinated fiscal response of nations, is that feasible?

Is it feasible in your perspective with all of your childhood travel, countries to countries, is it feasible to just think countries can get together, not like Plaza Accord and foreign exchange, but get together and do coordinated fiscal response?

ROUBINI: I don't think so. We spoke before about game theory between central bankers. The same thing has happened for fiscal policy. The interests of different countries are very different.

And the fiscal countries, that have deficit who like to stimulate more because they're going into a recession. But they cannot do it. And the countries that instead can fiscally stimulate are overheating, like China, and they don't need it.

So you have this paradox. Those who want to do fiscal stimulus cannot do it because of the budget deficits. And those who can do it don't need to do it. So we cannot have coordination.

KEENE: Nouriel Roubini, thank you so much for coming, and particularly off the airplane. Folks, Nouriel Roubini of New York University.

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#<256905.807900.1.0.82.31279.25># -0- Jun/27/2008 15:51 GMT

Last Updated: June 27, 2008 11:51 EDT