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.
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.
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
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
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
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
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
Policymakers also under-appreciated the economic literature on the
complicating role of private capital flows during crises, including bank
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
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
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 pimco.com.)
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
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.
material contains the opinions of the author but not necessarily those
of PIMCO and such opinions are subject to change without notice. This
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permission. ©2012, PIMCO.