Mohamed A. El-Erian is one of the best known and most highly respected investment managers in the world. He is senior economic adviser to Allianz, and was formerly CEO and co-CIO (with Bill Gross) of PIMCO. From 2006 to 2007 he was president of Harvard Management Company. Dr. El-Erian was educated at Cambridge University and received his doctorate from Oxford University. His most recent book, The Only Game in Town, was published in January.
We spoke with Dr. El-Erian on February 16.
Larry: I’ve read your book, The Only Game in Town, which is principally about the Federal Reserve and other central banks. I had an overriding question while reading it: how did we, meaning the American people, let the Fed get so powerful? According to the Fed’s own website, the Fed was originally established to prevent banking panics, yet its mandate grew over time to include price stability and full employment and now seems to involve stewardship of the entire economy. What happened, and is this good?
El-Erian: We didn’t let the Fed get more powerful, nor did the Fed go for a power grab. What happened is that we inadvertently limited our policy responses and created a huge vacuum, and the Fed felt that, in order to buy time for the system, it had a moral and ethical obligation to step in.
Larry: Where did we limit our policy responses? What did we do that was wrong?
El-Erian: It’s what we didn’t do. We made three basic mistakes. In the run-up to the global financial crisis, we overinvested in the financial services sector as an engine of growth. We wrongly believed as a society that finance was the next level of capitalism. You can see this in the way that countries were competing to become the global financial center; even smaller countries such as Switzerland, Ireland, Iceland and Dubai opted to grow their financial system to sizes bigger than their GDP. And regulators believed that they could reduce their oversight and regulation of the financial sector because, after all, it was the next level of sophisticated capitalism. So we stopped investing in industries that create growth, and we excessively embraced the financial sector. In fact, we changed its name from financial services to just “finance” – again the notion that it is a stand-alone. So, that was the first mistake.
The second mistake we made was that, when we were coming out of the financial crisis, we didn’t understand that it was much more than a cyclical shock. Importantly, it was also structural and secular and, as such, it required a different mindset. Policymakers focused too much on the notion that Western economies operate only in cyclical space and that secular and structural issues were the domain of emerging economies. They didn’t understand that we were also facing structural headwinds, so we got an insufficient policy response.
The third mistake was the over-reliance on central banks. And, awaiting a policy handoff that hasn’t materialized as yet – to a more comprehensive policy response that deals with the real impediments to growth and genuine financial stability – these institutions had no choice but to venture ever deeper into experimental policy terrain and to stay there a lot longer than they anticipated. As such, the benefits of their policy interventions have come with heightened risks of collateral damage and unintended consequences.
Larry: Let me reflect for a moment on the idea of overinvesting in finance. In retrospect, of course we did, but in a market economy each industry, or each corporation, sees it as their job to grow as big as they can. So, in the 1950s we probably overinvested in cars, and then in the 1990s we overinvested in technology and telecom. I don’t think finance is any different. People in financial services companies want big profits and big bonuses, so who is going to stop them from trying to expand?
El-Erian: You’re absolutely right. Capitalism has a tendency of going too far on certain activities. The only difference – and this is an important difference – is that overinvesting in cars doesn’t mean that you risk the payments and settlement system of an economy, whereas finance is an integral part of the payments and settlement system. I think of finance as being the oil in your car. If it breaks down, then no matter how good your engine is, no matter how good your brakes are, you simply are not going to be able to drive the car. Other sectors are different; you can still drive a car if your bumper falls off. Finance, unfortunately or fortunately, speaks to the payments and settlement system, which is a necessity. And what happened in 2008 is that the payments and settlement system was threatened.
Larry: I agree. I think of finance as a type of infrastructure, and it has to function. As John Stuart Mill said about money, it is only important when it doesn’t function. Can you elaborate a little on the third mistake we made?
El-Erian: While central banks stepped in to fill a void, they did so based on the understanding that there would be a policy hand-off.
Fed chairman Ben Bernanke’s speech in August 2010 at Jackson Hole, Wyoming, really identified the moment when the Fed started using unconventional policies to pursue broad economic objectives, as opposed to pursuing market normalization. He said that it’s about “benefits, costs and risks.” It was understood that, the longer the Fed remains unconventional, the lower the benefits and the greater the costs and risks. I don’t think anybody imagined, at that point, that the Fed wouldn’t be able to make the handoff from unconventional monetary policy to a much broader policy response. So the third mistake was the absence of a hand-off, and that speaks to political issues.
Larry: Advisor Perspectives operates an online community that has about 10,000 financial advisors as members. One of those members asks, “You’ve always maintained that the Federal Reserve is basically a one-tool pony. It only possesses the ability to manage interest rates. However, deliberately or not, it has taken on the public mantle of savior of the economy without revealing to the world how limited its toolbox really is. Do you feel that Janet Yellen, who is now Fed chair, should start to more assertively shift the responsibility for growing the economy to the fiscal side?” After all, hasn’t the Fed, almost by definition, reached the limit of what it can do by lowering interest rates? As this member asks, “Don't we need a movement advocating for Congress to fund something like an infrastructure bank to lend to private businesses, who would in turn hire tens of thousands of Americans to rebuild our country” and, in this member’s view, “create a new, vital wave of consumer demand?”
El-Erian: That’s a really good question. The answer to the first part is that the Fed, the ECB, the Bank of Japan, the Banque de France and the Bank of England have gone out of their way to stress that they cannot be the only game in town. If you look just last week at Fed chair Janet Yellen’s testimony, she basically told Congress that you need to do all these things; we, the Fed, can’t deliver these things. So I think the central banks have gone out of their way to convey the notion that they cannot be the only game in town.
In fact, Larry, the title of my book comes from a central banker. In November 2014, the outgoing governor of the central bank of France reminded a conference in Paris that central banks were the only game in town and they didn’t like it. So I think the central banks have gone out of their way to state that – but it has fallen on deaf ears both in the political process and in markets.
The political system is not in a position right now to deliver the policy responses that are needed. Therefore, it is more than happy to delegate this responsibility to central banks. This is, of course, an excessive burden for central banks. Moreover, markets care less about the ultimate economic destination and more about the influence that central banks have on asset prices. And, for a very long time, central banks have been able to decouple asset prices from the underlying fundamentals. So I would respond to the member that the problem has not been that central banks are not saying the truth. It is about people not listening.
Turning to the question of an infrastructure bank, we definitely need a policy response that includes greater investment in infrastructure. With interest rates so low, and, in the case of Europe, negative, it is absurd that we’re not seeing initiatives, including private-public partnerships, to fill obvious infrastructure needs that enable and empower a lot more private sector activity. But I would stress that infrastructure is just one element of a multi-part solution.
Larry: But, as a taxpayer and a citizen, I want to express the other side: we have $18 trillion in explicit debt at the federal level, God knows how much at state and local levels, plus unfunded pension liabilities and other entitlement liabilities. From that perspective, I don’t want to spend one penny that can’t be paid for out of current taxation. I just don’t see how we can ask the people to go into debt even further to fund a benefit that may or may not materialize.
El-Erian: I sympathize with that view, but with one qualifier. The level of debt sustainability is rightly expressed as a fraction with a numerator and a denominator. The numerator speaks to the dollar amount of debt and the cost of debt servicing. But there is also a denominator, the amount of income available for servicing the debt, that defines how burdensome that debt is.
Larry: I see where you are going: if we had 4% real growth, the debt would become insignificant over time. But there is a real concern that slow growth may not be a result of bad policy, but of an underlying slowing in technological change. If that is the case, there may be nothing you can do to get 4% growth. I don’t believe that. I think there’s plenty you can do. But many people do believe it.
El-Erian: And I would say to them, do you know what? You are right in saying that there are demographic and structural headwinds to growth. But that doesn’t mean we shouldn’t be enabling and empowering private sector activity, particularly given how we have underinvested in infrastructure.
Larry: After about six years of near zero interest rates, and now talk about negative rates, it’s worth asking what the benefits of low rates are in the first place. Isn’t lowering interest rates stimulative only when there are business projects or consumer purchases that are not being done because the rates are too high? Is there any evidence that the rates are too high – in other words, that such forgone projects or consumer purchases exist? Or, is the desire for low or negative rates based on belief in a model, specifically a Keynesian model of aggregate demand, that needs to be tested further and could be wrong?
El-Erian: First, let me tell you what should happen according to people who are pursuing this policy, and then what I think will happen. Note, first, that nominal policy interest rates are now negative in Europe and in Japan, and that around 30% of the stock of government debt around the world is trading at negative yields. This tells you that there is something strange with where we are today.
The theory is that by taking interest rates to a very low -- if not negative -- level, investors get pushed into higher risk-taking activities, and companies get pushed to deploy the cash that they hold on their balance sheet. As investors take more risk, they push up the stock market. You and I look at our 401(k) statements, we feel that we are richer and we spend more. This is called the “wealth effect.” Meanwhile, companies see that we are spending more, and the companies themselves are being pushed to deploy their cash, so they invest more. Consumption and investment go up, and that promotes economic growth. That is the theory.
In addition, if you can get your interest rates to be very low or negative and others don’t follow, you can also weaken your currency. And, the next thing you know, you also promote exports. That is the theory; in practice, it has not worked that way to the extent that central bankers expected.
It does not work for good reasons: companies and households are smarter than that. They want to see genuine growth, not financial engineering. And, increasingly now, people doubt the effectiveness of central banks.
So, for example, when the Bank of Japan took interest rates negative a few weeks ago, it probably didn’t anticipate that the currency would strengthen as opposed to weaken or that the stock market would go down as opposed to go up. Yet that is what happened. So, beyond a certain point, lowering interest rates is not just pushing on a string, or unproductive; it can end up being counter-productive. That is why I call it a journey to the end of the road that we were on. That’s why I call it the T-junction. We cannot continue like this for much longer before either something gives in a bad way or we transition to a better world.
Larry: What is a T-junction?
El-Erian: It is a British term for the place where a road terminates in another road so that you cannot go forward, only left or right. You have to choose, and the consequences of turning left or right are very different.
My book makes two points about the T-junction. First, I indicate why humans are bad at making good decisions when facing a T-junction; we have lots of science on this. Second, the book argues that there are three characteristics that investors should put front and center when confronting a T-junction. These are resilience, optionality and agility.
Larry: Regarding the global financial crisis, an APViewpoint member writes, “Without central bank intervention I suspect we would have endured a deeper but shorter period of pain, ultimately leaving us in a stronger position than what we are in now. The damage from the intervention still lingers after seven years, including direct bailouts and a massive risk transfer, in the form of mortgage-backed securities, from the banks to the Fed. While market prices are not conclusive evidence, stock prices [of our] financial services companies are saying something.” How do you respond to this?
El-Erian: First, counterfactuals are really difficult, so I don’t know whether, after the initial shock, the system would have reset quickly. What I do know is that the initial shock would have been massive, that had central banks not intervened in 2008 and the first half of 2009, we would have been in a multi-year global depression. I am pretty confident about that.
What I don’t know is whether, once we went through the shock of a global multi-year depression, the system would have reset quickly and if we would have come out as your reader suggests. But I can tell you that very few people will take that risk. Let me give you a parenting analogy. If you let your kid put her hand in the fire, she will not do it again, but how many parents actually allow their kids to burn themselves?
So the intellectual appeal to the idea of having a prolonged and severe crisis so the system will reset is just like the intellectual appeal of your kid learning not to play with fire once she burns herself. Very few people will want to take that risk.
Larry: That’s a fair response. You have to go all the way back to 1921 [to find a] depression that did not provoke a policy response. The results were good, but when 1929 came along, the collapse went way beyond any tolerable limit, and I believe it was correct to have a policy response. No one knew where the bottom would be.
This discussion transitions nicely to the hottest topic of our young century, inequality. Your book indicates that you are deeply concerned about it. Yet there is a very strong thread in growth and development economics saying that inequality in a single country like the United States is an unintended and unavoidable by-product of greater equality among countries. Global inequality was greatest around 1950. At that time the First World was already rich, but China and India had lower incomes than they did 500 years earlier. And around 1950, not coincidentally, U.S. inequality was at a minimum, so we remember it nostalgically as a period of social harmony. But this makes sense only if you care about people in the United States only. Economic growth outside the First World has benefited billions of people while increasing inequality within countries. How, if at all, do these circumstances affect your view of inequality?
El-Erian: There are many aspects to this question. One is that global inequality has come down; that is correct. And, essentially, it is because the developing countries have grown faster than the advanced economies. In the 1990s and most of the 2000s, we had a growing global GDP and we were reducing poverty at the same time because a lot of the poverty was concentrated in the developing world and particularly in China and India.
On top of that, most countries were getting more unequal. So we had less international inequality and more national inequality. Part of that change was structural in nature. Some of it was actually a good thing because inequality is also associated with incentives to work harder.
But then we went too far. Not only did we have structural engines of inequality such as changes in technology, but we made things worse in two ways. One, we relied excessively on central banks. Remember our discussion that central banks can only achieve their objectives by affecting the prices of financial assets. Who owns financial assets but the rich? So we relied on a policy that worsened inequality.
The second problem we created for ourselves was freezing budget policy, fiscal policy. For six years, Congress didn’t approve an active annual budget. So we are at a stage where inequality goes from helping the capitalist system to harming it because it goes to far. Inequality harms capitalism in two ways: the demand effect and the opportunity effect.
Larry: What are these?
El-Erian: The demand effect is very simple. When the rich get the vast majority of an increase in income and wealth, which is what has happened over the last few years, they spend less of it. They have a lower marginal propensity to consume. Therefore, you aggravate the economic situation by having insufficient aggregate demand.
Second, you start worrying about inequality of opportunity. In this country we are very proud of having relatively equal opportunity. But, beyond a certain degree of inequality in wealth distribution, that equality of opportunity deteriorates. That is, I think, where we are today. So, in addition to the structural issues you point out, we’ve made things worse.
Larry: Isn’t technology the real source of this inequality? Technology has made it tougher on almost everyone who has an IQ below the median, including those in developing countries. Now that sophisticated machines are available, there just aren’t that many jobs for low-skilled people. That is a problem that we are not going to solve through policy adjustments. I just don’t know what’s going to happen. Can you comment?
El-Erian: Martin Ford has written a very important book on this topic, Rise of the Robots: Technology and the Threat of a Jobless Future. He makes your point and says that, with machine learning, it is going to get even worse.
Larry: Yes, it will, at least for the time being while workers adjust by developing new skills – if they can. I am not sure that everyone can. We cannot all be above average.
El-Erian: Okay, so you agree with him, but his policy recommendations are something that, I suspect, you will find rather upsetting.
Larry: To wrap up, how should an individual investor saving for retirement and holding a 60/40 index portfolio of global equities and bonds modify her portfolio to account for the concerns that you raise in your book about liquidity, inequality, stagnation and the inability of central banks to bear the whole burden of rescuing the economy? What should investors take away from your book in terms of their portfolio construction?
El-Erian: First you have to decide whether you buy into the central hypothesis of my book, which is that the path that we are on right now – one characterized by low, stable growth and the ability of central banks to repress financial volatility – is in the process of ending. The book identifies ten of the underlying contradictions that make this path harder to sustain.
In addition, it should come as no surprise to anybody that market volatility has gone up. Nor should it come as a surprise that improbables are becoming realities. Same for this ridiculous blame game between equity markets and oil markets.
It should also come as no surprise that the narrative about low oil prices has changed. It used to be viewed as a blessing, but it’s now being viewed as a curse. All of these anomalies are simply confirmation that we are coming to the end of the road that we have been on.
The second part of the hypothesis of this book is that there is nothing predestined about what comes next. It depends on choices that are made. I talk about the T-junction, this notion that the road you are on ends, but there are two very different roads out of it, or a bimodal distribution of outcomes if you prefer statistical language.
Larry: And if you buy into this two-part hypothesis, then what?
El-Erian: It’s a big “if.” A lot of people buy into the first part but then say that everything is going to fall apart. And there are many people who don’t even buy into the first part – they believe we can just continue as we are by depending on central banks. So I want to stress that, if investors buy into my two-part hypothesis, they should realize that what lies ahead is higher financial volatility. Prices will overshoot on the way up. They will overshoot on the way down.
Second, there will be much less liquidity available for repositioning your portfolios. Third, correlations will break down so that portfolio diversification will be less powerful in mitigating risk. Fourth, once in a while a whole segment of the financial markets will become unhinged. Three of these segments – oil, high-yield bonds and emerging market currencies – are already there.
If this is your outlook, you have to ask yourself certain questions, including some that run counter to conventional wisdom. For example, when you said 60/40, conventional wisdom is that you decide how much to put in equities, put the rest in fixed income and don’t hold cash. Cash is a dead asset in that approach. But in the world that I am talking about, the world of the bimodal distribution, cash has a strategic place in your portfolio, turning conventional wisdom upside down when it comes to asset allocation. Do you know why?
Larry: Because cash is an option to buy something else later, at more favorable prices. It is not a dead asset.
El-Erian: Correct. And the resilience to be able to withstand market volatility is also important.
The second piece of conventional wisdom that gets turned upside down is the advice to be a long-term investor and forget about all these short-term fluctuations.
On the contrary, the short-term fluctuations actually will give you more insights as to how we’re going to come out of the T-junction. So pay attention to them because you are going to get information from them. The information may or may not have strategic consequences. But don’t dismiss them as noise. They are actually signals in the system. And you may need to get more tactical.
Larry: Thank you. I really appreciate your generosity with your time.
El-Erian: My great pleasure. Thank you very much.
Read more articles by Laurence B. Siegel
