Mohamed El-Erian's Bagehot Lecture From Buttonwood

By Mohamed El-Erian  OCT 24, 2012 4:45 PM

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.


[Editor's note: Mohamed El-Erian delivered the "Bagehot Lecture" at the Buttonwood gathering in New York hosted by The Economist today. The following are excerpts from his talk.]

The world is undoubtedly fluid. You need only consider the seemingly endless list of prior unthinkables that have become facts; and it is a list that keeps growing. [Editor's note: The list includes France and US losing AAA rating, eurozone economy defaults, and Switzerland pegs its currency.] 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.

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 [which is being] led by bold central bankers, particularly in Europe and the US. 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. 

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” baseline, asymmetrical two-sided risks, and the accompanying possibility of tipping points, multiple equilibria and path dependency.

For the European Central Bank, 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). 

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. Simply put, the ECB is impacting the journey but, acting on its own, it cannot deliver the destination. 

This reality also applies to the US, 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 US 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.”

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.

In the US, 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.

No 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 [Spain, Greece, US fiscal cliff, China slowdown, geopolitics]. 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 US 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.

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.

What 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.

What is needed in today’s world is different. Drawing from the work of Don Sull, [author of The Upside of Turbulence: Seizing Opportunity in an Uncertain World]; it is about the right mix of absorption and agility; 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.
No positions in stocks mentioned.