A Conversation with Mohamed A. El-Erian
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.