PIMCO’s Former CEO Mohamed El-Erian On The ‘Delusion Of Liquidity’ by Knowledge@Wharton
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.
Knowledge@Wharton 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.
Knowledge@Wharton: 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?
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.
Knowledge@Wharton: 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.”
Knowledge@Wharton: 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.
Knowledge@Wharton: 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.
Knowledge@Wharton: 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 what they can do.
If you were to assess the banking system in terms of risk, there’s a lot less risk. But with that comes a cost, which is they are financing less of the real economy. And that is the trade-off. The pendulum swings [and] right now when the pendulum is swinging towards greater regulation, it tends to overshoot, then within a few years we’re going to start coming back the other way, and I suspect at some point it will overshoot in the other way. And that’s really the history of regulation because you’re trying to find the right balance between soundness and efficiency.
… It’s a very, very difficult balance to strike.
Knowledge@Wharton: What can be done about that new migrated risk, how to give it, as you discuss in the book, escape valves?
Mohamed El-Erian: The biggest risk I worry about is what I call the delusion of liquidity. As a consequence of shrinking the core … when conventional wisdom changes, when the paradigm changes and people look to reposition themselves, they suddenly realize there isn’t enough counter-cyclical risk. There aren’t enough people willing to be on the other side to trade.
“Markets have believed for quite a while that central banks are their BFFs, their best friends forever, that … will step in and repress volatility.”
So you have one of two choices, both of which are unpleasant. One is you don’t reposition, or two, you reposition at a huge cost. We go through periods where markets seem fine, and then the minute there is a change in the paradigm, suddenly some of the most basic transactions can’t get done. And that is a scary element because we get technical disruptions if people can’t get done what they get done. They start doing other things.
We’ve had a few [liquidity] scares. When in May, June 2013 Chairman Bernanke uttered the word “taper” — that he would taper the support of the central bank — markets went into six weeks of a tantrum, it’s called a taper tantrum, where market functioning was put on distress.
Earlier this year, when concern mounted about China, we saw also market distress. We’ve also seen some products including a high yield mutual fund that would have ventured into very exotic areas that had over-promised liquidity. So it had promised its investors daily liquidity. But the underlying market didn’t provide daily liquidity, so it had to close. It had to put up gates and basically tell its investors, you can’t redeem your shares in the mutual fund. And that’s a really scary element. So 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.
Knowledge@Wharton: In the book you refer several times to the economist Hyman Minsky, whose financial instability hypothesis posited decades-long credit cycles ending with the bursting of a credit bubble, followed by needed reforms and the start of a new cycle. Did the interventions of central banks prevent that cycle from bottoming out?
Mohamed El-Erian: The main argument is stability breeds instability. And taken to an extreme, instability changes behaviors that ensure stability follows. So you have two views. You have the view of, let the cycle work. Let’s purge the system of its excesses and then it resets at a more sustainable level.
I have some sympathy with this argument, but not complete sympathy. And the reason why is you can not control the purging of the system that easily. And there are a lot of innocent victims. So I go back to the example I used, which is would you let your child put her or his arm in the fire? Undoubtedly they will learn. Undoubtedly. But how many parents are willing to do that? Why? Because they realize the consequences. What if the arm is burnt really badly? What if I somehow handicapped a child in the future?
So while I have some sympathy with letting markets do it all, I worry that there are so many unintended consequences of that and so many innocent victims that you’ve got to take a more qualified view of this.
“The first thing investors have to realize is that we’ve already borrowed returns from the future.”
Knowledge@Wharton: What is that credit cycle going to look like in this era of unprecedented central bank intervention?
Mohamed El-Erian: Banks will provide less credit than they have in the past. You have the emergence of non-bank providers of financial services. You have peer-to-peer lending as an example of that. You will also have risk that used to reside in the banking system migrate to the non-banks. And that’s where the danger lies. And most importantly, you will have what we’ve had for the last few years, which are financial asset prices that are decoupled from fundamentals.
And you’re going to have a lot of improbables, negative interest rates being the biggest example — this notion that for a third of government debt around the world, the lender not only lends her or his money, but pays for the privilege of lending his or her own money. So you’re also going to have a lot of improbables occur because the system is highly influenced by the experimental policies of central banks.
Knowledge@Wharton: Nassim Nicholas Taleb has written that long-term stability requires short-term instability, and that artificially repressing volatility can often backfire. You write that we should expect increased volatility in the market. Is that a side effect of this repression of volatility that we’ve seen in the last few years?
Mohamed El-Erian: Yes. And I have a lot of sympathy with Taleb’s work, which is that by giving people too much insurance they stop thinking in terms of the range of scenarios that are possible, and they are really ill prepared not just for when a black swan hits, but [also when] the grey swan hits. [According to Taleb, a black swan is an unusual event that is extremely tough to predict while a grey swan can be somewhat anticipated but considered unlikely to happen.]
And this [is Taleb’s] argument: [Even if there is] moral hazard, if you’ve got my back covered, why should I be careful? And I think that markets have believed for quite a while that central banks are their BFFs — their best friends forever — and that the central banks will step in and repress volatility. That is why you have the illusion of liquidity because central banks have been there. And I think that is dangerous.
Now the fault of all this [does not lie with] central banks; the fault is that central banks haven’t been able to hand off [the shift to genuine economic growth]. So I go back to how many doctors would stop treating a patient even though they don’t have the right medicine? Central banks are like doctors. They are not in the business of creating crises, they’re in the business of avoiding and solving crises. Central banks will not step away easily, even though they know that they haven’t got the right medication.
“Only a small group of us is going to understand that this is a bimodal distribution. We’ll understand that we need to do things differently.”
Knowledge@Wharton: How should investors think about navigating this stretch of increasing volatility?
Mohamed El-Erian: Think of the three most important inputs to an investment’s asset allocation…. One, what do you expect returns [of each asset class] to be? Two, how much volatility do you think each asset class will go through? The more volatility, the more likely you are to do something silly at the wrong time…. Third is the correlation between various asset classes — how are they all correlated? Will they all go up and down together or do I have [to do] certain risk mitigation? These are the three building blocks of any portfolio.
What has happened? First, as I mentioned earlier, central banks have basically brought future returns to the present by decoupling asset prices from fundamentals. So the first thing investors have to realize is that we’ve already borrowed returns from the future. The second thing … is that we are coming from a period where volatility has been artificially suppressed and we’re entering a period where there will be greater volatility. And thirdly, because of central bank involvement, correlations have broken down.
One of the nice realities of the last five years is you would have made money pretty well anywhere. You would have made money had you invested in government bonds or you invested in equities. And that shouldn’t happen. These things should be negatively correlated.
So for the investor, if they sit back and say, wait a minute, so you’re telling me we’ve borrowed returns from the future, you’re telling me we’re likely to see changed volatility regimes, and you’re telling me that correlations are unstable? These are three very big hypotheses.
If you believe these, which I do, then two things result immediately that question conventional wisdom. The first one is that a diversified asset allocation can do it all for you. It can produce returns, it can mitigate risk. It can’t. So either you revise down your expectation of returns or you recognize that you’re taking a lot more risk. The second thing you realize is that cash is not a dead asset. In most strategic asset allocations, cash plays no role whatsoever. It’s a dead asset. … It’s not.
In a world where you’re facing this T junction, you need three things. You need resilience. You need agility. And you need optionality. And I go through them in the book — resilience, agility, and optionality. The only thing that gives you these three things is cash. So suddenly cash becomes a part of the strategic asset allocation, which again is putting conventional wisdom on its head. So if you believe in the hypotheses of this book, you will start doing things differently in terms of how you invest.
Knowledge@Wharton: You say we’re approaching a tipping point where the range of possible outcomes will be “bimodal” and will resemble a barbell [weighting at two ends] more than a bell curve. How are we going to have to alter our approach to take this into account?
Mohamed El-Erian: This is where the link to behavioral science is very important. In general, we do not make good decisions when facing bimodal distributions. That’s our reality. We are wired to do really well in bell-shaped, normal distributions. Why? Because that’s the world we live in most of the time and it’s an incredibly confident world. There’s a high probability of a certain outcome. There are tails, but they’re thin. We know how to deal with that world.
If I suddenly come and tell you, as an example, your flight is at 2 o’clock in the afternoon. You know what to do. Is there a chance that the flight will be cancelled? Yes, there is. Is there a chance that the plane is completely empty and you get to stretch out and you get treated really well? Yes. But you don’t plan on either of these things. You plan that your flight is going to be taking off at 2 and it’s going to be a full flight.
Now suppose I tell you that’s not the distribution you face. The distribution you face is either the flight will take off at 8 am or the flight will take off at 8 pm. What does the behavioral science tell us about this? One group of us will not even see it. We’d have a complete blind spot. It’s something outside anything we can recognize. A second group will see it and then reframe it. Married couples do this all the time. You hear something and then you reframe it. So they’ll say something like, “Wow, so you mean it’s either 8 am or 8 pm? I don’t quite understand this. What’s the midpoint between the two? 2 p.m. I’ll turn up for a 2 p.m. flight.”
A third group, and I talk about this in the book, will go into active inertia, and will realize that something has to be done differently. … But the structural forces are so strong that they end up doing exactly the same thing. And very successful companies have fallen into that trap. I talk about IBM and its approach to the PC revolution. It was by far the most powerful technological brand. It had a very large research and development budget. And yet it couldn’t adapt quickly enough.
Only a small group of us is going to understand that this is a bimodal distribution. We’ll understand that we need to do things differently. We need to actively think about our blind spots. We need to actively think about our unconscious biases and our conscious biases. We need to actively go into scenario analysis. And we need to develop this resilience, optionality and agility.
At the end of the book, I [use the] example from the [historic 1974 Muhammad Ali-George Foreman boxing match in Zaire.] The Ali camp recognized that they weren’t facing normal distribution [or a normalized situation that would result in a typical outcome]. Normal distribution [would dictate that they use a strategy of putting] Ali in the ring and hope he can survive 12 to 15 rounds. And maybe you win by points.
When they saw what Foreman was, they realized it was bimodal — very high probability that not only would he get knocked out, but it could have even been life threatening. And there’s a very small probability that [Ali] could win. But the likelihood of him surviving the full 15 rounds was the least likely outcome. And then they got themselves out of their normal distribution to do it bimodal and they started trying to move the modes accordingly. [Ali won by knockout within eight rounds in the ‘The Rumble in the Jungle’ bout.]
And that’s a bit of what we have to do if we want to navigate the next few years.