PIMCO’s Former CEO Mohamed El-Erian On The ‘Delusion Of Liquidity’ by [email protected]

Top global financier Mohamed El-Erian is warning that the central banks’ unprecedented moves in recent years to keep the world economy stable through aggressively accommodative policies have numbed the markets to experiencing true risk and so there is a “delusion of liquidity.” In his new book, The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse, the chief economic advisor of Allianz and former PIMCO CEO says global leaders missed an opportunity to rebuild the world’s financial systems to make it more resistant to future financial meltdowns.

Mohamed El-Erian believes that as a result of the central banks’ policies post-crisis, investors have borrowed returns from the future, are likely to face more volatility and experience unstable correlations. With the markets out of whack, that means investors must change as well. For one, diversified asset allocations cannot be counted on to bring in returns and mitigate risks as well as they have done in the past, he says.

[email protected] recently spoke with El-Erian to discuss his views on the global markets and monetary policy as well as their implications for investors. An edited transcript of the conversation follows.

[email protected]: In the book, you write that society sometimes needs a Sputnik moment: a shock to the system that forces change. Was the 2008 financial crisis a missed opportunity, a lost Sputnik moment?

[drizzle]Mohamed El-Erian: It was a semi-Sputnik moment. What wasn’t lost is the realization that you cannot rely on finance as indication of growth, that finance had gotten too big and had taken on too much risk. I think that message has been internalized and the banking system today is a lot safer than it’s been during my lifetime.

The reason why it’s not a complete Sputnik moment is because the other side of this is not just what you shrink, but what you build, [and that] wasn’t completed…. The sense of crisis went away too quickly. Because of that, the political response started to be less and less effective.

[email protected]: Yet there was a window of opportunity?

Mohamed El-Erian: The biggest window of opportunity was April 2009, the G20 London meeting. [In] October [2008,] officials from over 180 countries gathered at the annual meetings of the IMF and World Bank in Washington, D.C. They realized that the problems they were facing at home were very similar to everybody else in the room, that it wasn’t just about them, that this was a global crisis and required a global response. And that global response came in April 2009 in the G20 meeting.

But rather than be a launching pad for doing even better, that became the end of the process. Collaboration and thinking about the structural issues facing the global economy gave way to very nationalistic, insular views. And then ultimately gave way to central banks trying to do it all on their own.

“The biggest risk I worry about is what I call the delusion of liquidity.”

[email protected]: What kind of reforms might have been enacted at that moment?

Mohamed El-Erian: The major reform would have been a growth pact among the systemically important countries that would have had elements of better infrastructure and a better way to manage international trade, because people realized that they were very dependent on each other. The second element had to do with global governance.

What I argue in the book is the need to give the IMF — as the most credible multilateral institution — greater credibility and effectiveness, which means reforming its governance to reflect the world of today and tomorrow, not the world of 40 or 50 years ago. The third element was a process that allows for continuous consultation and course correction. That could have been done if the sense of crisis hadn’t evaporated so quickly. You really had the minds focused at that time in a major way.

[email protected]: While the stimulus measures put in place after 2008 saved us from economic collapse and bought us time, you argue that we’ve become hooked on those interventions and substituted financial engineering for proper drivers of growth. What are the main drivers of growth, and what is necessary to set them in motion?

Mohamed El-Erian: It’s important to understand what was done and what was not done. I think of this in [terms of] a very simple hospital analogy. The U.S. economy and the global economy [from September to December] of 2008 was in the intensive care unit. It came very close to a multi-year depression that would have damaged not just the livelihood of the current generation, but future generations. And the ER doctors did a great job in avoiding what would have been a major disaster.

The patient then got out of the ICU and went into the hospital. At that point, doctors there were supposed to look at the structural impediments to this patient’s wellbeing. Didn’t turn up. The other doctors continued to give pain killers. And the patient was discharged with a prescription for pain killers.

This patient now is out of the hospital: That is the good news especially given the terrible state the patient was in, in the ICU. But this patient is structurally impaired. The best this patient can do is walk. She or he cannot run. Moreover, the patient relies on pain killers and has become hooked on the pain killers.

“My concern is that we have lots of people who believe that there’s a lot more liquidity than actually would be available if the market paradigm changes.”

So that’s what has happened. The pain killers are the injection of liquidity that are being provided by central banks around the world. And the structural impediments have to do with insufficient infrastructure, insufficient labor retooling, too many pockets of excessive indebtedness, a corporate tax system that is riddled with anti-growth exemptions and insufficient global policy coordination.

We need two things to happen: the structural impediments must be addressed, and as that happens, you’re going to be able to reduce the dosage of pain killers and make sure that the patient doesn’t fall victim to the collateral damage associated with prolonged reliance on pain killers. That is the handoff that’s required.

[email protected]: You also write about a morphing and a migration of risk as it moves away from what you call the “diminished middle” of the financial system and toward non-banking institutions. Is it just the reforms that have shrunk that middle, or is it a hangover from the crisis, or both?

Mohamed El-Erian: There are two things. One is that the regulators have focused on de-risking the banking system, and that has happened in two major ways: Require a lot more capital [and] limit some of the risky activities in which banks have ventured into. The first is very much a regulatory shrinkage, by making it hold more capital and do less risky stuff. The second is [dependent on the] markets. Markets tend to punish banks quite severely if they end up taking too much risk.

So you have a regulatory influence and you have a market influence that is de-risking and shrinking the middle and moving the banks towards the utilities market [model] where they are much more regulated and there’s a much greater definition of

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