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Mohamed A. El-Erian
IntroductionI am extremely honored to be with you today to deliver the Bagehot Lecture. At the outset, please allow me to convey my deep appreciation to colleagues at The Economist, a publication that I first started reading at school when I was just 15 years old (and I have not stopped since).My objective today is ambitious and, some would say, unrealistic. By drawing on research and many discussions at PIMCO, I hope to set out a simple approach to analyze a fluid and complex world. The world is undoubtedly fluid. You need only consider the seemingly endless list of prior unthinkables that have become facts (see Chart 1 for a partial illustration); and it is a list that keeps growing. Indeed, some could well argue that this fluidity, and the complexity that underpins it, renders the very notion of a simplified analysis both undesirable and not feasible. Yet left unanswered, this complexity can also lead to damaging intellectual and operational paralysis.
Having spent a lot of time discussing and analyzing the issue, we believe that a handful of major forces may be extremely useful in shedding light on most, albeit not all, of what is happening in the global economy today. They involve a mix of historical and scenario analyses. They also provide useful insights for what is likely to lie ahead.A SnapshotThe Economist is rightly admired for many things: from insightful articles to opinionated editorials; from operationally oriented coverage to out-of-the-box pieces; and from intelligent global overviews to detailed regional/sectoral surveys.I also look forward to something else every Thursday evening when downloading my new Economist on my tablet – the magazine’s covers. Rarely do they fail in being both imaginative and impactful. Now, I have no aspiration to even coming close to replicating one of these wonderful covers. Having said that, I could not help wondering what a possible cover for this presentation would look like. How does one best capture the major influences on the global economy, and what they mean for companies, governments, households and investors? Perhaps it could look something like Chart 2 – that is to say, a global economy that is led today by bold central bankers, particularly in Europe and the U.S. They are venturing ever deeper into unfamiliar territory, in the context of a murky landscape and with partial and declining visibility. And they are not alone.
Central bankers are pulling along politicians and other policymakers who seem to spend way too much time bickering and dithering, and less time being visionary leaders.Then there are the reluctant citizens. Many are bewildered and confused, and their reactions range from apprehension to resistance and outright rejection. The two big questions are, first, how stable is this collective and, second, where will it end up? It will not take you long to recognize that this is a potentially unstable situation. There is a lot of pulling, pushing and shoving going on here. After all, the extent of mutual trust is not very high, and neither is the ability of any single group to smoothly impose its will and direction on others. Obviously, the less cooperative the collective, the greater the scope for instability and disorder. Indeed, many of The Economist’s covers in the recent past have alerted us to the downside risks – at the national, regional and global levels (Chart 3).
Yet it is also important to remember that the risks are not one-sided. There are also upside possibilities, albeit less imposing than the set of downside risks. Whether it is driven by idle capital and sidelined cash or a series of significant innovations, better policy cooperation could unleash forces that shape a completely different outlook – the sudden emergence of sunshine, if you like.This is the multi-year reality that companies, governments and households face today – that of an “unusually uncertain” ii baseline, asymmetrical two-sided risks, and the accompanying possibility of tipping points, multiple equilibria and path dependency. iii To better understand all this, and to do so in an operationally oriented manner, let us briefly consider each of the cast of characters, including how they may interact going forward. Any discussion of today’s global economy needs to acknowledge up front the bold and unusual policy activism of western central banks – particularly when it comes to the Bank of England, European Central Bank (ECB) and the U.S. Federal Reserve. We will focus here on the latter two. For the ECB, the latest – and most dramatic – phase of unusual policy activism started on July 26 of this year, when President Mario Draghi announced at a London conference that “within our mandate, the ECB is ready to do whatever it takes to preserve the euro.” And to leave no doubt in anyone’s mind about his seriousness, he added “and believe me, it will be enough.” His remarks culminated in the September 6 decision by the ECB’s governing council. The Bank now stands ready to buy “unlimited” amounts of government bonds issued by struggling and systemically important peripheral countries (e.g., Italy and Spain). The focus will be on securities with up to three-year maturity, at least initially; and the purchase program will be subject to light policy conditionality (especially when compared to that imposed by the Troika on the program countries – Greece, Ireland and Portugal).The key to this latest phase of policy activism is the attempt to remove convertibility risk and the threat of further financial fragmentation; and to do so by striking that delicate balance between massive financing (what debtor countries emphasize as key to a sustainable solution of the eurozone crisis) and appropriate policy conditionality (what creditor countries stress). The closer the ECB gets to striking this balance, the more progress is made toward aligning incentives within the eurozone. And this is a prerequisite for being able to solve simultaneously the trio of proper debt mutualization; policy reforms that provide for sustainable high growth, job creation and the safe deleveraging of over-indebted segments; and acceptability by national democracies (Chart 4). iv
This formulation is important in explaining something else – why the ECB’s actions, while significant and necessary, are not sufficient. Acting on its own, the ECB can only buy time. It cannot deliver the much-desired growth and financial sustainability outcomes; nor can it ensure the convergence of national democracies to a harmonized forward-looking regional narrative.Yes, the ECB actions reduced the tail risk of disorderly eurozone fragmentation (defined as a chaotic return to national currencies by a significant group of countries, including one or more of the big four – France, Germany, Italy and Spain).Yes, the central bank engineered a decline from explosive levels in the yields and spreads on peripheral government bonds, thereby also slowing deposit outflows and capital flights. Yet, acting on its own, it cannot address long-standing competitiveness problems that plague several countries; nor can it deal with their crippling debt overhangs, malfunctioning labor markets, antiquated pension systems, etc.… And it finds it hard to galvanize greater political integration. As such, it does not have the direct ability to restore growth, employment and debt sustainability. Going back to the illustrative cover, the ECB has managed for now to maintain the integrity of the collective of people. It is providing more time for politicians and other policymakers to sort out their issues and step up to their responsibilities. It has also countered individuals’ inclination to step away, including by withdrawing their funds out of banks in peripheral economies and depositing them in Germany, Switzerland and the U.S. instead. But, critically, it has not secured a sustainably safe place for the collective.Simply put, the ECB is impacting the journey but, acting on its own, it cannot deliver the destination. This reality also applies to the U.S., albeit in a less dramatic fashion. Here too, the central bank has assumed the bulk of the policy burden while other government entities sit on the sidelines. And here too it has been venturing ever deeper into policy experimentation.On September 13, the U.S. Federal Reserve did a lot more than (i) extend to mid-2015 the forward guidance applicable to rock-bottom policy interest rates and (ii) commit to open-ended purchases of securities (or “QE3”). Importantly, it also indicated that it would keep its foot on the reflationary accelerator well into the recovery. In the process, it signaled what we believe is an understandable reordering of the two components of its dual mandate: placing employment above inflation in what we labeled the “reverse Volcker moment.” v The Fed has done so with full awareness that it does not possess a set of first best policy tools. Indeed, Chairman Ben Bernanke has been quite open about the “costs and risks of unconventional monetary policy” (what we have referred to as collateral damage and unintended consequences). He just believes that they are more than offset by the expected benefits.Given the trio of imperfect policy measures, weak transmission mechanisms and the lagging reaction of other policymaking entities, we should expect these central banks to remain unusually active and imaginative. Indeed, under current leaderships, we should have little doubt about their willingness to do even more. And companies, households and investors should incorporate this in their assessment of the outlook. But they should not automatically and fully map willingness to policy effectiveness.The longer central banks are left carrying the bulk of the policy burden, the more likely that the intended benefits of their actions will be countered – first partially and then fully – by collateral damage and unintended consequences. And with time, these could go from being qualifiers to baseline strategies, to becoming major influences.Have no doubt, the costs and risks are real and mounting. vi They range from distortions to the normal functioning of markets to the implosion of some sectors that provide financial services to segments of society (e.g., through money market accounts, life insurance and pension provision). For some countries, public sector moral hazard is also becoming an issue, as is the risk of inflation down the road. No one knows where the limits to balance sheet expansion lie. But, already, many are rightly wondering about damaging consequences for household and financial sector behavior of central banks’ sustaining such a large artificial wedge between market valuations (high) and underlying fundamentals (depressed).What about politicians and other government entities?Many of these concerns would be alleviated if other policymakers, and their political bosses, were to step up to their responsibilities. Without their active and enlightened involvement, there is virtually no chance of resolving quickly the fundamental problems undermining too many western economies: too little growth; too high a joblessness rate, especially among the young and the long-term unemployed; too much debt in the wrong places; too much income and wealth inequality; and too great a political polarization (Chart 5).
Listening to what most economists believe is needed to solve this, game theorists would quickly tell you that the solution lies in better incentivizing a “cooperative game.” Otherwise, it is virtually impossible to attain the critical mass of policy simultaneity – that is to say, concurrent and coordinated progress among a set of self-reinforcing measures. For this to happen, we need greater trust among key stakeholders and their elected representatives, as well as mechanisms to encourage significant mutual assurances and proper verification processes. And none of this will happen without agreement on how to allocate the losses incurred by nations that fell victim to a multi-year period of overleverage, excessive indebtedness and unrealistic credit entitlements. Otherwise, it will take the west several more years to overcome alternate – and often polarized – views of the past and present.In Europe, it is about consolidating and building on the progress of recent months – by ensuring that the better policy design is now accompanied by steadfast implementation. This is particularly true for the “four legs” of stronger regional underpinnings: namely, complementing monetary union with much greater banking, fiscal and political integration. Without that, ECB intervention will continue to (inadvertently) fund the exiting of private capital, as opposed to crowding in the private investment and credit that are so critical to invigorating private sector activity. In the U.S., it is about overcoming impediments to the reform of housing and housing finance, improving the function of the labor market, and constructing a more robust credit intermediation network. It also involves finding that delicate balance between medium-term fiscal reforms (which, by necessity, speaks to both revenues and expenditures) and immediate stimulus. Finally, it is about strengthening social safety nets that were not conceived for prolonged periods of economic sluggishness and persistently high unemployment (including among the young).And for the multilateral system, it is about a much higher degree of forward-looking policy coordination, which also involves giving systemically important emerging economies greater say in global economic governance. Otherwise, the resolution of persistent payment imbalances will remain elusive or, perhaps even worse, impart an even greater recessionary bias to the global economy.This brings us to the third group in the collective – the set of increasingly reluctant and doubtful citizens. The longer the economic malaise continues, the harder it is to convince citizens to trust and follow their elected representatives. Self-insurance becomes more prevalent; society polarizes, as do political parties; the blame game intensifies; and some countries experience a resurgence of nationalist sentiments (vis-a-vis other countries, and within communities and minorities). This type of potential popular rejection is already quite visible in Greece, for example; and it has economic, financial, political and social dimensions. Economic activity implodes. Individuals disengage from the formal financial system. They lose faith in the integrity of the political system. And social unrest spreads. The longer all this persists, the harder it is for government leaders to design a reform program, let alone implement it in a sustainable fashion.The Baseline Whichever way you analyze it, it will take time for the west to decisively overcome its current malaise. Indeed, our forecasts point to a rather sluggish growth outlook for the global economy over the next 12 months. We anticipate the U.S. to grow by around 1.5%–2%, thereby prolonging a period of historically insufficient growth (Chart 6). We project Europe to contract by 1%–1.5%, with quite pronounced differences among countries. We also expect that emerging economies will slow, with China soft landing at 6.5%–7.0% annualized growth.
Add in other systematically important economies around the world, and this speaks to a global economy that is yet to achieve “escape velocity.” Indeed, global growth could remain uncomfortably close to “stall speed.” At the same time, the convergence gap between advanced and emerging economies would continue to narrow.Most multinational companies are well-placed to handle such a world. They have made enormous progress in strengthening their balance sheets, controlling their cost structures and generating positive cash flows. But don’t look for them to deploy in a big way their large cash holdings into new plants, equipment and jobs. Yes, the cash is earning a negative real yield. But for many CEOs, this is better than committing to long-term expenses in such a fluid and uncertain world. Moreover, business leaders are under enormous pressure to return cash to shareholders – a trend that is picking up steam. The outlook is more concerning for many governments. Such low growth will make it difficult for them to overcome excessive indebtedness. And the type of financial repression being pursued in Europe and the U.S. (involving the de facto taxation of creditors and subsidization of debtors) is inevitably slow-acting when it comes to recapitalizing vulnerable balance sheets. The result will be a further step down on the ladder of sovereign credit quality. Households will face particularly sharp segmentation. The subset of those with good jobs, education and globally oriented talents will continue to prosper. Others (indeed, too many others) risk languishing among the ranks of the long-term unemployed, the young struggling to establish themselves in the labor force, and those in low-paying occupations. The result will be a further worsening of already pronounced inequalities in income and wealth. The longer all this persists, the greater the risk that – for the first time in a very long time in western countries – our children’s generation may end up worse off than ours. vii Two-Sided (Asymmetrical) TailsNo analysis of today’s global economy would be even close to complete without a discussion of the two-sided tails – i.e., factors that could tip the world into a much worse situation (the left tail) and those that could tip it into a much better place (the right tail).The (fatter) left tail is dominated by five topics (Chart 7). The first two – the possibility of Spain not enabling continued ECB support and Greece succumbing to another debt restructuring and possible eurozone exit – are closely linked to the rising degree of popular rejection in Europe and, ultimately, loss of policy control. This is particularly the case for Greece where societal change could come in a disorderly fashion “from below” (via popular unrest), rather than being the result of “top down” political leadership.
The third risk has to do with the U.S. and its fiscal cliff. Were it to materialize, this self-created challenge would unambiguously push the country into recession, with widespread adverse consequences. This is not our baseline. We believe that, following the November elections, there is a 60%–70% probability that politicians will iterate to a “mini bargain” involving around 1.5% of GDP (via a more orderly fiscal contraction), rather than a disorderly contraction of some 4% of GDP. viii Then there is China. Many are rightly concerned about the twin challenges of reacting to slowing global demand and navigating the inherently tricky “middle income transition.” And as Michael Spence has noted, only five countries have navigated this transition at high speed; and none were as large and complex as China.Finally, geopolitical risk remains high in Middle Eastern countries – and especially Iran – where, to use Tom Friedman’s characterization, instability risks “explosion” rather than “implosion” when it comes to regional network effects. Given the extent of these risks, it is understandable that economists tend to focus on left tail analysis; and they should, given the Pascal’s Wager nature of the potential payoffs. But this should not preclude us totally from recognizing the components of the right tail.Here, it is about the possible deployment of idle capital and cash balances. A critical mass of policy reform and political coherence – or modern-day “Sputnik moments” – could easily unleash them. It is also about a series of productivity-enhancing changes. This includes some that significantly lower input costs (e.g., shale gas) and others that provide for much greater connectivity (technological innovation). There are many illustrations. For example, digitalization is allowing for more responsive input management, including the application by farmers of fertilizers. It is also providing for much more effective inventory management and more efficient access to market. Indeed, we should never underestimate the potential for developmental leap-frogging associated with individual innovations. Imagine what a combination of them could do. In SumWhat we are ultimately talking about is an “unusually uncertain” distribution of potential baseline outcomes, as well as unusually shaped tails. This inevitably undermines the robustness of lots of conventional wisdom, as well as a range of historical contracts and entitlements. It also challenges the agility of institutions in both the public and private sectors.Behavioralists would tell you that, in the face of such an unsettling situation, economic agents face a high risk of paralysis; alternatively, they could slip into “active inertia” (i.e., actions are taken but they boil down to simply doing more of the ineffective same). What is needed in today’s world is different. Drawing from the work of Don Sull, it is about the right mix of absorption and agility; ix that is to say, a mix that enables economic agents both to respond to opportunities and to be able to afford their unintended mistakes. And it will only work for societies and regions as a whole if there is much greater recognition of the need for shared responsibilities and cooperative outcomes.It is tempting to turn one’s back on this difficult challenge. Yet doing so would encumber our children’s generation with sputtering growth engines, structural unemployment, overwhelming indebtedness, extreme inequalities and dysfunctional politics. In turn, they would find it very hard to maintain their living standards, let alone improve on them. This should not be so. And through education and action-oriented advocacy, it need not be so.Thank you very much.
Reproduced with permission of The Economist. Date of broadcast 24 October 2012.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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