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Remarks to the NBER-Sloan Conference on the European Crisis
By Mohamed El-Erian
August 1, 2012

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Good afternoon.

Please allow me to start my remarks by expressing my appreciation to Kristin Forbes, Pierre-Olivier Gourinchas and Jim Poterba. Thank you for organizing this important seminar at a pivotal time for Europe and, by implications, for the global economy; and thank you for inviting me to participate. I am thrilled to be here.

I recognize that, especially at the end of a very stimulating day of panels and discussions, it is very hard to say something that is both new and interesting. So rather than join much more able colleagues here today in their comprehensive analyses of the European crisis and possible solutions, I will focus on how we judge the intersection of economic knowledge and policy issues. And I will do so based on work and discussions that have taken place at PIMCO over the last few years, and that have involved colleagues from around the world.

We believe that this intersection – between what economists and policymakers know – is a critical one to get right, and not only for a long-term investor like PIMCO. You see, unless there is a strong economic anchor, policymakers (and their political bosses) will lack the conviction and foundation needed to take difficult decisions and explain them well to citizens. So it is crucial for both sides to know what is known – and also to recognize, to the extent possible, the known unknowns. 

We approach the issue from the perspective of our daily challenge – investment managers who, like others in this field, face the necessity of positioning portfolios for what have become highly macro-driven markets. And with you today, I will try to differentiate between: (i) areas where economics has informed and influenced the policy debate, (ii) where policymakers have failed to sufficiently internalize existing research findings, and (iii) where greater research is urgently needed.

The greater the success we have as a community in understanding and analyzing the implications of these three, the more likely that actual and desired policymaking will converge. In the process, we will increase the collective ability to strengthen the institutional underpinnings, understand the technical forces and, most importantly, counter the enormous human cost of crises suffered by current and future generations.
* * *
Certain things are already clear from today’s discussions, which have drawn on a rich body of economic research. Europe is in the midst of a consequential historic phase. Its challenges are part of a broader western reality dominated by the foursome of too little growth (overall and in key countries), too much debt in the wrong places, too extreme a political polarization, and increasing policy ineffectiveness.
With this foursome, it is not surprising that Europe repeatedly finds itself in the grips of adverse feedback loops – be it between bad economics and bad politics, or between weak banks and deteriorating sovereign creditworthiness.
It is also not surprising that European citizens are confronted virtually every week with confusing developments, many of which would have been deemed unthinkable not so long ago – be it the horribly high unemployment (especially among the young) and a de facto debt default in one eurozone member to seeing so many (almost half) of the members of this special club in Europe slip below a single A sovereign credit rating.
Most importantly, despite multiple summits and an almost permanent crisis management mode, Europe still has insufficient clarity on the critical prerequisites for promoting and maintaining high growth and job creation.
It is in this context that economists have succeeded in illustrating why, at its roots, the eurozone crisis is fundamentally about incomplete design issues accentuating major operational/governance/institutional challenges and flaws – especially in the context of the West’s multi-year private sector deleveraging that follows the period of excessive leverage and credit entitlement that culminated in the 2008 global financial crisis.
Correctly, we heard a lot today about the need to supplement European monetary union with fiscal union, banking union and greater political integration. Proper emphasis was also placed on correcting institutional failures in both the private and public sectors.
Judging from the most recent summit of European leaders, it is encouraging that these issues are on the policy agenda, or nearly there. As they progress on the design and implementation fronts, European leaders will need to overcome two difficult challenges: first, and using the words of my PIMCO colleague Andy Bosomworth, the requirement to simultaneously solve for the trio of mutualization, conditionality and national democracies; and second, how to address the needs of the 17 members of the eurozone in a manner that is consistent with the integrity of the 27-country European Union.
This also speaks to another consensus in this room – the view that policy measures have, until now, been too little, too late. The process has been excessively constrained and repeatedly incomplete. As such, outcomes have consistently undershot policymakers’ own expectations.
At every stage, there has been an inadequate balance struck between reactive and proactive measures, tactical and strategic, sequential and simultaneous, and nationalism and regionalism. In the process, the credibility of the European policymaking process itself, and its institutions, has suffered.
Not surprisingly, both the list of required measures and the degree of implementation difficulty have grown as the crisis has migrated from the outer core of the eurozone toward its core. Concurrently, the adverse global implications have increased. And, to make things worse, the inadequacies of the governance and operational modalities at the multilateral level have undermined an important set of checks and balances, further weakening much-needed circuit breakers. 
It is as if national and multilateral policymakers had totally ignored the rich economic literature on both crisis prevention and crisis management. Yes, much of it materialized in the context of the disruptions in emerging economies during the 1980s, 1990s and early 2000s. Yet a crisis is a crisis. And the forces of inter-connectiveness, technical contagion and non-linearities do not distinguish between country groupings that, increasingly, have less information and analytical content.
Policymakers also under-appreciated the economic literature on the complicating role of private capital flows during crises, including bank deposits.
In Europe, two flows have dominated: intra-zone, from the periphery to the inner core (notably Germany); and from the eurozone to the rest of the world (most notably Switzerland and the United States). Both have disrupted the functioning of markets while taking financial fragmentation to a level once deemed highly unlikely, if not impossible.
There are good technical reasons for such flows and, again, this is well covered in the literature on emerging country crises. Yet they were inadequately understood by European policymakers, especially in the first couple of years of their crisis. And the result has been high and volatile sovereign yields and spreads. These have served to (i) shift to the left the demand curve for peripheral sovereign debt, (ii) transfer the burden from private creditors to tax payers, (iii) increase the influence of short-term capital relative to long-term investors, and (iv) amplify vulnerability to periodic sudden stops. 
This also speaks to why it has taken officials so long to understand the complexities surrounding the fallacy of composition at the level of the eurozone. Of course politics played an important role. But we also suspect that there has been insufficient understanding of the dynamics of multiple equilbria, path dependency, sudden stops and debt overhangs.
Again we are reminded here of the reaction I got back in the beginning of 2010 when suggesting that European policymakers should study carefully the economic literature on emerging country crises. This suggestion was dismissed on the basis that European countries are advanced and, as such, there was little to learn from the experience of emerging economies.
It should come as no surprise that certain European economies, led by Greece, are facing an unusual mix of economic, financial, political and social rejection. Already, citizens have voted out almost two-thirds of incumbent governments. Two countries opted for technocratic leaders who were appointed rather than elected. Meanwhile, rejectionist parties have emerged and gained traction.
* * *
For all these reasons, today’s European politicians still lack a commonly-shared analysis – and not only for what should be done (and how the adjustment burden should be shared), but also for why the eurozone is where it is. And for economists, this translates into a further set of policy limitations.
Under such conditions of widespread and multi-faceted rejection, we do not know how the constrained optimization will be (and should be) solved. And some findings from the theory of second best take us to places that politicians do not even wish to discuss, let alone address. As such, the gap between feasibility and desirability is significant.
At PIMCO, we believe that Europe is experiencing a consequential change in the distribution of expected outcomes. With the current situation becoming highly unstable and untenable, this is no longer about the conventional bell-shaped distribution characterized by a dominant mean and thin tails. It is a much flatter distribution, with much fatter tails. It may even have gone bimodal. With that, the list of known unknowns grows rapidly – not only for investment management firms, but also for policymakers. (For those interested in the implications for investment management, please visit the research notes posted by my colleagues on
Should this indeed be the case, then today’s economic research could shed more light on the implications. For example, we would suggest that the economic profession needs deeper analysis of (and this is just a subset):


  • the network effects when the probability of the two modes of the expected outcome distribution is similar and yet the outcomes are radically different:
  • the extent to which economic agents (individuals and firms) opt for self-insurance, including willingness to pay what are historically expensive premia;
  • how certain segments of the financial services industry will navigate ultra-low German and U.S. interest rates, including the highly challenged segments that provide long-duration services to many in the form of pensions and life insurance;
  • the functioning of global financial system in the context of fewer “safe assets,” particularly as the balance between interest rate and credit risks shifts unfavorably for a growing number of Western sovereigns;
  • the aftermath of unusual central bank activism; and
  • the operational implications for such “routine” issues as the design of benchmarks, margin requirements guidelines, counterparty risk, etc.


Yes, there are lots of known unknowns (and we suspect quite a few unknown unknowns, too). And there is an even bigger issue – one that, we believe, the economic profession needs to think about quickly as it is particularly complicated and under-researched.
Europe is not the only systemic economic region that is threatened today by the foursome mentioned earlier (too little growth, too much debt, too great a political polarization, and increasingly ineffective policy tools). The U.S. has these elements too, though thankfully to a lesser degree than Europe.
Now Europe and the U.S. are, of course, the two largest economic areas in the world; and they are the ones with the most intense interlinkages. Emerging economies, while possessing stronger initial conditions as a whole, will not be able to compensate fully and sustainably. And, in any case, they, too, are also slowing for both domestic and international reasons.
Potentially, this unusual configuration has huge implications for the functioning of a global economic and monetary system that is usefully characterized as built on the notion of concentric circles.
With the inner circles (occupied by the U.S. and Europe) acting as the anchor for the system and providing a range of global public goods, the stability of the whole construct is weakened by today’s circumstances. If the strength and stability of the center continue to erode, it is not clear whether relative or absolute dynamics would prevail. And we do not know which institutional setup is best tailored to deal with such complexities.
* * *
In conclusion, we suspect that Europe would be in a better place today had its policymakers and their political bosses spent more time and effort internalizing existing economic research, including that on emerging country crises. Indeed, as vividly illustrated by earlier panels and discussions, economics can still shed light on the dramatic challenges facing the eurozone, as well as on the elements of a sustainable solution. But there are also a few questions that warrant a lot more research.

This is a very important and exciting time to be an economist. Many of you in this room are uniquely placed to advance the frontier of knowledge on issues that are of immense relevance to both current and future generations. We wish you great success.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.





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