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Mohamed El-Erian's Bagehot Lecture From Buttonwood


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.

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.
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