This article was originally published in the Financial Times on December 3, 2008

By Mohamed El-Erian
December 3, 2008

History books will document that the global economy experienced a sudden stop after September 15. In accentuating long-standing structural weaknesses, the manner in which Lehman Brothers failed disrupted the trust that underpins the smooth functioning of market economies. As a result, virtually every indicator of economic and financial relationships exhibits characteristics of cardiac arrest.

The situation will get worse before it gets better and it will only get better if there is a shift in thinking in both the private and public sectors: away from comforting yet unrealistic notions of a return to “business as usual” and towards the more nasty reality of a volatile journey to a different destination. The implications are far-reaching as they speak to more market accidents, disorderly sectoral realignments and additional shifts in policy.

Up to September 15, debate focused on moral hazard, or the extent to which government bail-outs encourage irresponsible behavior. The need to signal the government’s seriousness about market discipline partly drove the decision to let Lehman fail. What was less well understood was that it matters a great deal how an institution’s failure affects the capital structure.

The way Lehman failed disrupted payments and settlements. Around the world, market participants stepped back in mass from what, up to then, were standardized, routine, predictable transactions. Not surprisingly, all main indicators are now violently heading south. It is not just about consumption, investment and employment in the U.S., which will result in a 4 percent plus contraction in gross domestic product in this quarter alone. It is also about pressures on production in Brazil, China, Japan and Russia, as well as the slowdown in construction in the Gulf.

What we are witnessing goes well beyond a cyclical economic shock and a consolidation of the financial sector. We are also in the midst of a prolonged increase in precautionary behavior among entities that have suffered massive wealth destruction and face a multi-year clean-up of assets and businesses. Without further adjustments, there will be an aggravation of the negative feedback loops that have been so detrimental to global welfare.

It is time to suspend unquestioned faith in a quick return to the past and adjust to the reality of change. The shift in thinking means spending less time looking for a market bottom and more ensuring that cash and collateral management keeps pace with disruptions that are global in nature and indiscriminate in impact. It calls on policymakers to eschew simple local optimization between policy alternatives (for example, capital injections versus asset purchases) for a holistic response – including more of what we saw last week in the U.S. in the form of large coordinated multi-agency steps to compensate for dysfunctional credit markets.

In continuing with a bolder policy approach to offset chaotic economic deleveraging, governments should be clear about four principles.

First, intervention should be limited to sectors at the center of the healing process, thereby supplementing recent success in the commercial and money markets with the gradual normalization of the housing and financial sectors.

Second, wherever they can, governments should partner the private sector which, in most cases, would involve voluntary co-investments, but in some cases (such as U.S. cars) may require coordinated burden-sharing among stakeholders. Third, they should address upfront exit mechanisms. Finally, they should not let the best be the enemy of the good: crisis management inevitably results in inconsistencies that a subsequent reconciliation and reform effort must address.

Aggressive government involvement runs counter to the basic tenets of a market system. It should be minimized. But, when it is required because of massive and cascading market failures such as those of today, it should be subject to these principles. The weaker the adherence to such principles, the greater the cost to human welfare and the lower the likely effectiveness of any policy action. Coming to grips quickly with this brutal reality is crucial for safeguarding the longer-term sustainability of market mechanisms, both domestically and globally.

The writer is co-chief executive and co-chief investment officer of PIMCO, and author of When Markets Collide: Investment Strategies for the Age of Global Economic Change, winner of the 2008 FT/Goldman Sachs business book of the year award.