Navigating the New Normal in Industrial Countries Per Jacobsson Foundation Lecture

IMF News, October 10, 2010

Source details

Canonical URL: Navigating the New Normal in Industrial Countries Per Jacobsson Foundation Lecture

Other formats

Bibliographic details

Published: October 10, 2010

I. Introduction — framing and hypotheses

Lecture delivered October 10, 2010.
Author: Mohamed A. El-Erian, CEO and co-CIO, PIMCO.
Three contextual hypotheses:
- First: the international monetary system suffered a “sudden stop” two years ago, the adverse impact of which is still being felt today by millions, if not billions, of people around the world.
- Second: the causes of the crisis were many years in the making and included balance sheet excesses, risk management failures at virtually every level of society, antiquated infrastructures, and outmoded governance and incentive systems in both the pubic and private sector.
- Third: post-crisis dynamics—particularly deleveraging, re-regulation, debt overhangs and structural challenges in key industrial countries—combine with an accelerating secular re-alignment of the global economy to create an “unusually uncertain outlook.”3
Central question posed: Why have outcomes consistently fallen short of expectations in the post-crisis phase, and what are the implications?

II. Anatomy of the global financial crisis — domestic, multilateral, and the mix

Domestic findings:
- Multi-year balance sheet excesses, payments imbalances, over-consumption and over-production of “innovative” financial products.
- Shadow banking system contributed to contagion and leverage growth (term attributed to Paul McCulley).5
- Pinnacle of crisis: September-October 2008 disrupted international payments and settlements.
- Massive deleveraging led to a sudden stop and a highly correlated collapse in economic activity.
- Governments and central banks used public sector balance sheets to offset private deleveraging, avoiding global depression but contaminating public balance sheets.
Multilateral angle:
- 2008-09 crisis management involved unprecedented cross-border coordination, beginning in Washington in October 2008 and culminating at the April 2009 G-20 Summit in London.
- Some argue the actions were “correlated” rather than “coordinated.”6
The mix and outcomes:
- Initial policy responses provided a floor and avoided multi-year depression.
- Many emerging economies rebounded quickly due to stronger initial conditions and policy flexibility.
- Industrial country recoveries proved fragile: job creation slowed, GDP projections were revised downwards, and risks of double dip and/or deflation rose.7

III. Post-crisis realities — balance sheets, structural change, and financial normalization

Key substantive findings:
- Crisis management succeeded in the short run (“won the war”) but post-crisis performance has been disappointing (“losing the peace”).
- Policy convergence during the crisis gave way to fragmentation and political brinksmanship in the post-crisis phase.
- Long-standing fragilities: overly-levered balance sheets, persistently high unemployment, regulatory uncertainty, and political constraints where the economically desirable may be politically infeasible.
- Sustaining global coordination beyond crisis immediacy is inherently difficult; the April 2009 global cooperation did not last.8
Three illustrative, inter-related blind spots:

1. Debt overhangs matter:

“It's the level, stupid, it's not the growth rates. It's the levels that matter here.” — Mervyn King (August 2009).
Debt overhangs risk undermining investment, growth and employment, especially in peripheral Europe (examples: Greece and Ireland).
Despite ECB, EU and IMF support, new investors are not coming in; existing investors may seek exits under official umbrellas, raising contagion and IMF resource risks.

2. Structural change requires structural responses:

Evidence: sluggish US labor markets; corporate and household behavioral shifts; firms resisting policies aimed at hiring and investment.
Persistently high unemployment is becoming more structural, eroding skills, straining safety nets, and depressing aggregate demand.16,17,18
Active inertia and behavioral commitments lead to repeating familiar policy actions rather than effective paradigm-shift responses.19

3. Financial normalization outpaces economic normalization:

Wall Street recovered more quickly than Main Street; banking profits benefited from a steep yield curve and guarantees, partly monetized through compensation and bonuses.22
Spillovers to the real economy remain limited; traditional transmission mechanisms are impaired by balance sheet constraints and continued de-risking.
Regulatory reform will lower the speed limit on Wall Street as guarantees mature and the yield curve flattens.

Aggregate implication:
- Too many inadequate responses to debt overhangs and structural change, plus insufficient understanding of financial sector functioning, threaten joblessness reduction, growth, safety nets, and sovereign risk containment.

IV. The situation today — the “new normal” and its manifestations

Term “new normal” coined at PIMCO in early 2009 to caution against mean reversion assumptions; concept emphasizes an uneven journey and a new destination rather than a return to pre-crisis means.9
Drivers of the new normal:
- Multi-year structural imbalances (excessive consumption, leverage-fueled asset bubbles, inadequate risk management, disruptive financial innovations).
- Aftermath of large balance sheet destruction; some effects obfuscated by accounting.
- Accelerating migration of growth and wealth dynamics to the emerging world.
Observable symptoms:
- Muted economic growth in industrial countries.
- Persistently high and increasingly structural unemployment.
- Continuous private sector deleveraging; large public deficits and debt.
- Regulatory uncertainty and greater politicization of economic decisions.
- Changed expectation formation: bell-curve expectations give way to flatter distributions with fatter tails; some distributions even inverted (e.g., inflation expectations in Bank of England Inflation Report).13
- Behavioral shifts: increased “self insurance” by companies and households (e.g., unusual corporate cash hoarding in the US; households selling equities for cash and bonds).
- Diverging intergenerational expectations: rising pessimism about children’s wellbeing in some industrial countries versus optimism in several emerging economies.
Risks to global architecture:
- Erosion of pro-market, open-economy anchoring; surge in bilateral payments agreements and currency tensions.
- Move toward regionalism as an end rather than a stepping stone to multilateralism.

V. Looking forward — policy priorities and institutional roles

Macro-level risk:
- Industrial countries risk slipping into a lost decade of low growth, high unemployment and welfare destruction without mid-course corrections.
- Such a slippage would harm global growth and trade and complicate emerging economies’ development management.
Policy and behavioral recommendations (implied and explicit):
- National governments must focus not only on what to do, but also on how and why—addressing active inertia and designing instruments suited to structural shifts.
- Address income distribution and compositional aspects urgently—within and across generations—to reduce political polarization and piecemeal reactive policies.
- Pursue structural reforms to sustain higher consumption in emerging economies and to offset global deficiencies.
- Recognize that most heavy lifting occurs at the national level but systemically-important emerging economies are part of the solution.
Role for multilateral institutions, especially the IMF:
- The IMF is uniquely placed to centralize country experiences, exchange best practices, and provide a safe forum under Article IV obligations.
- The IMF’s strengths: high-quality staff, capacity for path-breaking analytical insights, and near-universal membership.
- Current IMF shortfalls: insufficient facilitation of international policy coordination and absence of a hard-wired, credible peer review process.
- Progress noted: retooling staff to include financial market expertise; marginally enhanced emerging economy voice and representation; large increase in Fund financial resources; governance and internal income model improvements.
- To be more effective, the IMF must step up efforts—going well beyond current measured pace—and resolve questions about its political mandate, likely involving the G-20.24,25

VI. Concluding remarks — diagnosis and urgency

Summary diagnosis:
- Crisis management was largely successful; post-crisis policy and market responses have been less effective, producing a risk of “losing the peace.”
- Shortfalls stem from misdiagnoses, inappropriate operational constraints, reliance on short-term mean reversion, and active inertia.
Urgent imperatives:
- Industrial societies must move beyond cyclical responses to adopt longer, secular perspectives that address debt overhangs and structural shifts.
- Multilateral institutions should play a stronger, faster role in informing, coordinating and monitoring globally consistent national policies.
Closing thought:
- Quotation: “The future ain’t what it used to be.”26 — Yogi Berra
- Call for courage, imagination, purpose and steadfastness to translate the possible into the probable.

Italicized source: Mohamed A. El-Erian, Per Jacobsson Foundation Lecture, “Navigating the New Normal in Industrial Countries,” October 10, 2010, IMF news article.