Navigating the New Normal in Industrial Countries Per Jacobsson Foundation Lecture

October 10, 2010

Per Jacobsson Foundation Lecture
Mohamed A. El-Erian 1
October 10, 2010

Webcast of the lecture Webcast

I. Introduction

It is a great pleasure for me to appear in front of you today to deliver the 2010 Per Jacobsson Foundation Lecture. At the outset, please allow me to express my deep appreciation to the Board of Directors of the Foundation. Thank you very much for this great honor, for allowing me to reconnect with friends and acquaintances here in Washington, DC, and for deepening a personal tradition that started for me in 1982 when I attended my first Per Jacobsson lecture.

As someone who has had the privilege to learn and operate in many different cultures and countries, I feel particularly honored to be invited by a Foundation whose purpose is “to foster and stimulate discussion of international monetary problems, to support basic research in this field, and to disseminate the results of these activities.” At the same time, however, I must admit to you that my delight comes with a certain degree of personal discomfort.

It is intimidating to follow the outstanding people who delivered past lectures and who truly meet the Foundation’s description of “persons of the highest international qualification and eminent experience in the world of international finance and monetary cooperation.” Indeed, I have had the honor over the years to interact with many who have spoken on this special occasion. Having also worked directly with some of them—including Abdelatif Al-Hamad, Michel Camdessus, Andrew Crockett, Jacques de Larosiere, Stan Fischer, Alan Greenspan, Guillermo Ortiz, Raghu Rajan, and Larry Summers—I can tell you with a high degree of confidence that I am a negative outlier—the left tail of the distribution if you like! (And you will hear me talk a lot today about distributions and their tails.)

Given this reality, what could I possibly contribute to such a prestigious gathering?

My hope is to share with you an analysis of the global economy based on a rather eclectic approach that combines academic and policy dimensions with the daily realities of working at an investment management firm that is deeply involved in global financial markets. My presentation will be based on three, hopefully familiar, contextual hypotheses.

• First, the international monetary system suffered a “sudden stop” two years ago, 2 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, the dynamics coming out of the crisis management phase—particularly the combination of deleveraging, re-regulation, debt overhangs and structural challenges in key industrial countries—are combining with an accelerating secular re-alignment of the global economy to create what US Federal Reserve Chairman Ben Bernanke correctly called an “unusually uncertain outlook”.3

In this context, my presentation will ask a simple, yet critical question about the disappointing effectiveness of post-crisis responses by both the private and public sectors in industrial countries: Why have outcomes consistently fallen short of expectations, and what are the implications?

In responding, I will refer to three specific examples which shed light on the ongoing dynamics complicating both policy and company responses. They are consequential for more than just what is being considered when it comes appropriate policy reactions, corporate strategies, and investment positioning; they also matter for the how and why.

They speak to challenges that were inadvertently misdiagnosed while others were placed in the wrong context or subjected to excessive operational restrictions. They also shed light on the view that the world has been ill-served by the understandable, yet regrettable temptation of using short-term mean reversion as shorthand for thinking about economic and financial dislocations.

Indeed, while industrial countries did well in the crisis management phase (think in terms of “winning the war”), they have not done as well in the post-crisis phase (and thus are “losing the peace”). As a result, too many industrial countries find themselves in a rather unsettling situation where expectations involve an unusually broad range of potential outcomes and equally unusually high risks.4 Increasingly, comforting images of normally distributed (bell curve) expectations—characterized by a dominant mean and thin tails—have given way to much flatter distributions with much fatter tails.

I will argue that this change is insufficiently recognized, even though it is a direct outcome of the three generally-accepted hypotheses just cited. Indeed, an unusual aggregation problem persists today: Multiple visible structural changes on the ground are not being sufficiently aggregated into an acknowledgment of the ongoing paradigm shift and in the formulation of appropriate responses—particularly, though not exclusively, in industrial countries.

Recognition is the first part of meaningful course correction—thus the objective of this lecture. And there is much at stake for the global economy.

The longer the recognition problems persist, the greater the risk of continued “active inertia” and disappointing outcomes. The possibility of policy mistakes and business accidents will increase further; it will become harder for industrial country governments to convince their citizenry (as well as decision makers in emerging economies) to participate fully in the formulation and implementation of the required solutions; and multilateral institutions will not be able to fill the growing void at the core of the international system.

II. The Anatomy of a Global Financial Crisis

The domestic angle

Much has been written—and much more will be written—about the global financial crisis. Undoubtedly, there were many contributors. For a summary explanation, we can think in terms of multi-year balance sheet excesses and payments imbalances coinciding with the over-consumption and over-production of “innovative” financial products which were only partially understood by consumers and too lightly regulated and supervised by prudential agencies.

As we now know, these innovative financial instruments were potent in lowering barriers to entry to many markets, including important segments of the US housing market. As a result, too many households purchased homes that they could not afford, using exotic mortgages they did not fully understand; and too many small companies took on debt they could not sustain. The situation was greatly aggravated by other lapses in risk management and misaligned incentives in both the private and public sectors.

Prior to the crisis, key industrial countries had embarked upon a multi-year, serial contamination of balance sheets. At PIMCO, we called it the great age of debt and credit-entitlements when massive leverage factories operated unhindered, and often outside the direct purview of regulators and even company CEOs (and thus the came to be known as the “shadow banking system,” a term coined by my PIMCO colleague Paul McCulley).5

The initial phases of massive leverage involved the balance sheets of households and housing-related institutions. Soon, the balance sheets of banks were also contaminated. Consequently, the pinnacle of the crisis—in September-October 2008—disrupted the functioning of the international payments and settlements system.

Cascading market failures aggravated disruptive attempts at a massive and simultaneous deleveraging. The result was a sudden stop and a related, highly correlated collapse in economic activity around the world.

Governments and central banks had no choice but to step in with their own balance sheets to offset the massive deleveraging elsewhere. They did so in a bold and impressive manner, and they succeeded in avoiding a global depression.

Yet, like most things in life, this came with costs and risks. A new balance sheet was contaminated—that of the public sector. And, once again, too many were subsequently surprised when as a new set of unthinkables and improbables became realities.

The multilateral angle

The 2008-09 crisis-management involved an unprecedented degree of effective cross-border coordination. It started here in Washington, DC at the October 2008 deliberations of the G’s and of the IMFC, with the UK taking the lead. It reached its climax in April 2009 at the G-20 Summit in London.

It was global coordination at its best.6 Lecturing gave way to consultation and true collaboration. The commonality of focus and purpose was obvious to the markets, as was the alignment of narratives and interests. The design and implementation of measures were well coordinated. And, throughout this period, stubbornly hard-wired (and outmoded) concepts of global representation seemingly gave way to a greater acceptance of modern day realities.

The mix

The initial combination of effective national and global responses was highly successful in providing a floor for economies around the world. National authorities acted boldly to address cascading failures, and did so in a globally orchestrated fashion. A multi-year economic depression was averted, as was the tremendous suffering that would have been inflected on billions around the world.

Many emerging economies rebounded very quickly, in part because they had generally entered the crisis with much better initial conditions (including stronger international reserve cushions, greater policy flexibility, and smaller exposure to structured finance). In the process, they demonstrated the type of economic and financial resilience that would have been unthinkable just a few years earlier.

With the depression tail clipped, industrial country financial markets also found their footing. The sharp recovery in wealth (associated with the equity markets rebound) amplified the impact of government/central bank stimulus and the inventory cycle.7 Monthly job losses seemingly turned into accelerating gains, leading some to declare that the recovery had taken hold.

Unfortunately, such declarations proved premature, especially for the US and Europe. They also highlighted insufficient recognition of the potent mix of economic, political and social forces in play. Soon, the pace of job creation slowed, talk of a “recovery summer” faded, GDP projections were revised significantly downwards, and the risk of a double dip and/or deflation rose.

III. Post Crises Realities

Crisis management is hard, very hard. Leaders must act urgently, and with only partial information. Policy imagination and boldness are needed to overcome malfunctioning transmission mechanisms. There is often little time to create the broad social consensus that is required to support strongly the legitimacy of the policy response, let alone time to make the mid-course corrections which are inevitably required.

In the post crisis phase, societies must also deal with the unintended consequences of the crisis management period. Inevitably, policy responses are second-guessed. Fairness issues feature more prominently. And the initial policy convergence formed in the midst of the crisis gives way to fragmentation and excessive political brinksmanship. Indeed, governments are often replaced by an electorate that is seeking greater accountability for the crisis.

None of this is news for emerging economies. Yet it has come as a surprise to too many in industrial countries. Indeed, there has been a distinct resistance among many policy makers to apply “emerging markets lessons” to some of the challenges their countries are facing—despite the important insights that such an approach can, and has provided.

The recent global financial crisis has also left an important balance sheet legacy. In particular, many industrial countries did not have sufficiently sound initial conditions to accommodate the massive use of public sector balance sheets.

Related concerns about debt and deficits have added industrial country sovereign risk to an already substantive list of systemic concerns—a list that includes (still) overly-levered balance sheets elsewhere (albeit not to the same extent as before); unacceptably high and persistent unemployment; regulatory uncertainty; and political complications (namely, a situation where the economically desirable is not politically feasible, and the politically feasible is not economically desirable).

Fragilities are also evident at the global level. As countries’ circumstances evolve differently post crisis, the delegation of national authority upward to multilateral institutions and groups has become difficult once again, especially as strong and credible global governance mechanisms are still lacking.

Sustaining a high degree of global coordination (or, if you are less charitable, maintaining a high level of “correlated actions”) beyond the immediacy of a crisis is inherently hard—a reality that adds to the complexity of post crisis periods. Sadly, a once promising global response has now been replaced by inadequately coordinated national economic policies and growing frictions among countries. Moreover, with an over-simplification of the debates (e.g., “austerity now” versus “growth now”), obsession with corner solutions has tended to obfuscate the critical policy nuances in play.

It is not surprising that the impressive degree of global coordination highlighted by the April 2009 G-20 meeting did not last long. It only took a few months for that moment of extraordinary collaboration to give way to solely domestic agendas. 8 Indeed, and ironically, it is precisely the success of globally coordinated policies which has allowed countries the luxury of returning so quickly to the pursuit of overly-narrow national agendas.

IV. The Situation Today

In the course of the second and third quarters of 2010, it became clear to many that both policymakers and markets had wrongly extrapolated a cyclical bounce in industrial countries, erroneously concluding that the apparent recovery had developed secular and structural roots.

Today, policymakers in industrial countries—and especially in the UK and US, where a large bet was made on finance—find themselves facing an important set of challenges on the “bumpy journey to a new normal.”

We coined the term “new normal” at PIMCO in early 2009 in the context of cautioning against the prevailing (and dominant) market and policy view that post crisis industrial economies would revert to their most recent means.9 Instead, our research suggested that economic (as opposed to financial) normalization would be much more complex and uncertain—thus the two-part analogy of an uneven journey and a new destination.

Our use of the term was an attempt to move the discussion beyond the notion that the crisis was a mere flesh wound, easily healed with time. Instead, the crisis cut to the bone. It was the inevitable result of an extraordinary, multi-year period which was anything but normal.

Also importantly, the new normal concept was not an attempt to capture what should happen. Instead, the concept spoke to what was likely to happen given the prevailing configuration of national and global factors—some of which were inherited, and others that were the consequences of the choices being made. Put another way, the new normal postulated the world that would evolve absent a significant change in policy and business approaches.

Little did we know that, after almost a year of acute skepticism from markets and policy circles, the new normal concept would catch on so much. (And, in doing so, it now means many different things to many different people!)

Researchers—particularly Carmen Reinhart and Ken Rogoff—have produced admirable and comprehensive empirical work that supports the view of a protracted and complex recovery process.10 Others, like Warren Buffet have found elegantly simple yet powerful ways to convey this reality. Two weeks ago he noted the following: “This country had a huge, huge wound…. It takes time for wounds to heal, regardless of how good the care is.”11

The new normal challenges faced by industrial countries are the outcome of two inter-related phenomena: first, a multi-year process of massively going structurally out of balance, as illustrated by excessive consumption in industrial countries, leverage-fueled asset bubbles, inadequate risk management and incentive structures, and disruptive accelerators in the form of ill-understood financial innovations; and second, the aftermath of large balance sheet destruction, part of which remains obfuscated even today by accounting issues. Their interactions were accentuated by ongoing global re-alignments.

The symptoms of these challenges include muted economic growth in industrial countries; persistently high unemployment which is increasingly structural in nature; continuous private sector de-leveraging; large public sector deficits and debt; regulatory uncertainty; and a much greater influence of politics on economics. They also show up in the accelerated migration of growth and wealth dynamics to the emerging world.

The resulting dynamics are both unusual and unsettling for industrial societies.12 As such, they also affect the way in which society thinks about the future. Indeed, we are increasingly coming across some noteworthy changes in the pattern of both expectation formation and in behavior.

When it comes to expectation formation, the pre-dominance of regular-shaped (bell) distribution is giving way to flatter distributions with much fatter tails. These flatter and fatter distributions are a reflection of the “unusually uncertain outlook” that is part of a paradigm shift. In some cases, they are even inverted. (As an example, witness the inflationary expectations chart contained in a recent Bank of England Inflation Report.)13

We are also witnessing interesting changes in expectations about the wellbeing of children and grandchildren. It is no longer unusual to come across surveys in industrial countries that speak to concerns that future generations may struggle to attain the standards of living of the current generations. Meanwhile, the opposite trend is increasingly evident in systemically important emerging economies. There, a growing number of people now believe that their children and grandchildren will have better lives than themselves.

Behavior is also changing, with companies and households in industrial countries embarking on a greater degree of “self insurance”—again a phenomenon that is familiar to emerging economies but much less so to rich societies. For example, witness the unusual amount of cash that US companies are hoarding on their balance sheets, and note the extent to which US households are de-risking their portfolios by continuously selling equities to go into cash and bonds.

All this is happening in a society where cash has usually burnt holes in the pockets of companies and individuals. It is also taking place in the context of almost confiscatory interest rates, and massive attempts by public sector agencies to entice the private sector into taking more risk.

We will come back to the implications of all this—and they are important. In the meantime, it is imperative to better understand why this situation has occurred. To this end, it is worth thinking about three previous-unthinkables and/or improbables: the importance of debt overhangs, the degree of structural change in industrial countries, and the extent to which financial normalization can complicate (and not just facilitate) economic normalization.

These three factors shed tremendous light on the challenges that industrial countries face. They also explain why policy has been so frustratingly ineffective. And they illustrate the growing tension between economics and politics. Indeed, think of them as pointing to blind spots in policies and markets that can and should be addressed, especially as their consequences can be with us for several years.

Balance sheets matter a great deal

"It's the level, stupid, it's not the growth rates. It's the levels that matter here."

This highly insightful remark was made in August 2009 by Mervyn King, the Governor of the Bank of England. Not enough people took it to heart.

Industrial countries in general confront serious balance sheet challenges. With prospects for growth sluggish, it is far from assured that some of these countries will be able to grow their way out of their problems. In the process, they will discover the disruptive nature of “debt overhangs.”

While the parallels are only partial, Latin America’s experience of the 1980s—and the related literature on debt overhangs—may shed important light on some aspects of the challenges faced by industrial countries today.14 Indeed, it may as insightful as the much more widely used Japanese comparison.

Yes, some Latin American countries (such as Chile and Colombia) were able to grow and did not succumb to debt restructurings in the 1980s. But most were not as fortunate. The major differentiator for them was whether restructurings were undertaken in orderly or disruptive fashions. In the process, a decade’s worth of growth was sacrificed.

The dynamics of debt overhangs are particularly important to understanding the continued dislocations in peripheral Europe.

The ECB has been supporting, both directly and indirectly, the government debt issued by peripheral European countries; the EU and the IMF are providing budgetary assistance, and have indicated their willingness and ability to do more; and several peripheral European governments have embarked on strong and courageous adjustment programs. Yet market measures of risk spreads remain high, including at dangerous levels for some (e.g., Greece and Ireland).

The point is that despite all that the official sector has done, new investors are not coming in. Meanwhile, existing investors are taking advantage of the umbrella provided by the public sector to find the exit. In the process, the trio of investment, growth and employment generators is being undermined.

Under these conditions, some peripheral European economies will find it hard to limit the decline in GDP and the related rise in unemployment and socio-political pressures. Meanwhile, concerns will mount about the contamination of the ECB’s balance sheet; the risk of contagion will grow; and the revolving nature of IMF resources will be exposed to considerable risk.

Structural challenges require structural responses

Evidence of structural change is all around us For example, witness the unusually sluggish functioning of the US labor markets; the change in company and household behavior referenced earlier; and the extent to which companies are resisting policy measures aimed at pushing them to hire more people and invest more aggressively. Is it really that surprising that growth assumptions that have underpinned many policy actions in industrial countries have (repeatedly) proven too optimistic?

Such structural change should not really be that startling if you think about it. Remember, we are coming off the great age of leverage, debt and credit-entitlement. In the process, we are leaving behind a paradigm in which some countries—particularly the UK and US—inadvertently bet (heavily and erroneously) on “finance” as a natural step in the secular maturation of economies climbing up the value added curve: from agriculture, to industry, to services and, finally, to finance.15

This unusual period enabled many activities to flourish which are inherently unsustainable. In addition to buying homes they could not afford, people borrowed and drew heavily on their savings on the notion that house prices only go up. Firms invested in sectors that were on a sugar high of activity, but only because of artificial credit availability. And levered creditors (including private equity) funded companies that could only remain in business by using ever growing leverage and other creative financial engineering.

These developments, and their structural implications, were insufficiently understood. Consequently, cyclical considerations have dominated the mindset and determined the actions of too many governments. As a result, outcomes have consistently fallen short of expectations, including most critically on the employment front.16

We should worry most about jobs (and, more broadly, the functioning of labor markets) when we look to the future of industrial countries and the global economy.17 Persistently high unemployment is becoming more structural in nature, thereby eroding the skills of the labor force and putting pressure on inadequate social safety nets and already-strained government budgets. Meanwhile, labor mobility is being undermined by continual problems in the housing sector.

The impact of all this reaches well beyond the unemployed. It also makes those who are employed more cautious, aggravating the problem of deficient aggregate demand.18

Rather than question the limited effectiveness of the cyclical approaches, the response by too many has been just to advocate doing more of the same. This pattern, while regrettable, should not come as a great surprise. Behavioral economics details the reasons why people and institutions fall hostage to active inertia. It has to do with issues such as inappropriate framing, outmoded internal commitments, and an overly-restrictive comfort zone. 19Indeed, the biggest risk faced by societies undergoing paradigm shifts is not an inability to recognize the change. Instead, it is recognizing the change yet reacting with the familiar rather than the effective.

Unsurprisingly, industrial countries find themselves having to address unresolved and serious challenges.20 In the process, the international payments imbalances of years past have returned, further complicating an already fragile global configuration—one that increasingly faces mounting protectionist risks.

Failures to recognize structural challenges are not limited to the national level. As emerging countries continue to grow robustly, the composition of the global economy is shifting (whether you use activity or wealth measures). It is an ongoing evolution that must be better understood. This can only happen if greater open-mindedness were to dominate policy circles and markets, in both industrial and developing economies.21

Financial normalization far outpaces economic normalization and, critically, does not spill over to help Main Street quickly enough

The challenges faced by Main Streets in industrial countries, including the feeling of insecurity brought on by unemployment and excess indebtedness, contrast with the seemingly remarkable recovery on Wall Street—a recovery that took too many policymakers by surprise and aggravated an already complicated socio-political situation.

Note that the word “seemingly.” Indeed, while some policymakers were taken aback by the speed and magnitude of the recovery, as well as the banks’ return to bad old habits, these developments were predictable given the policy measures put in place. After all, overcoming bank losses was a target of a policy approach aimed at recapitalizing the banking system, including through the use of higher retained earnings.

Consider the yield curve, the most potent generator of enormous, low-risk earnings for banks. The engineering of a very steep curve turned deposit-taking institutions into large profit generators.

For two years now, banks have been paying very low short-dated interest rates on deposits and using the proceeds to roll down a steep Treasury yield curve. This powerful profits engine magnified the impact of all the guarantees that were put in place to help banks raise additional funds and monetize liquid investments.

In the absence of a durable windfall taxation of the artificial surge in earnings, banks passed on part of their revenues in the form of compensation and bonuses.22 Understandably, this reignited anger toward institutions that were deemed by many politicians and citizens to be responsible for the global financial crisis. It highlighted, once again, an outcome that is unacceptable in democratic society: the privatization of massive gains and the socialization of enormous losses.

Meanwhile, the spill over of Wall Street’s normalization to the real economy remains limited, accentuating the big divides that are evident—not just between Main Street and Wall Street, but also between small companies and large companies, between poor and rich households, and between different generations. Traditional transmission mechanisms are proving less potent, due primarily to balance sheet issue but also to the continued de-risking and slimming down of the banking system.

Not much is likely to change on this count in the years ahead. Regulatory reform will evolve from design to implementation. In the process, the speed limit on Wall Street will be lowered and enforcement will be strengthened. Moreover, the extent of the de facto subsidization of banks will decline as the guaranteed debt matures (a definite) and the yield curve flattens (a probability).

In sum

The three cases illustrate influences evident elsewhere when assessing the post-crisis reactions of institutions in industrial countries, whether they are in the public or private sector: We have had too many instances of inadequate responses to debt overhangs and structural change, and there is still too little understanding of the functioning of the financial services sector. The longer this situation persists, the greater the difficulties that industrial countries will experience in reducing joblessness, sustaining high growth, strengthening safety nets, and overcoming sovereign risk concerns.

It is also important to remember that this is not just a national concern. The global dimensions are also consequential and should not be underestimated.

Today’s system of open trade and globalized finance faces significant challenges. We have already witnessed erosion in the pro-market, open economy anchor for the global economy; bilateral payments agreements have surged; and currency tensions are evident.

While you cannot replace something with nothing, the world still faces the risk of further erosion in a hitherto unifying framework, together with a move to a more fragmented one. In such a world, regionalism goes from being a means (namely, a stepping stone to multilateralism) to an end in itself (a partial replacement).

It does not help that all of this comes at a time when the global economy needs extra adaptability and agility. As noted earlier, it is seeking to accommodate a gradual multi-year migration of growth and wealth dynamics from industrial to emerging countries, and doing so in the context of continued resistance by some who wish to hold onto historical entitlements rather than acknowledge and embrace modern-day realities.23

V. Looking Forward

The analysis suggests that the global economy is again at a critical juncture.

Having averted a crisis-induced depression, industrial countries are now losing the recovery momentum. If they are not careful, they risk slipping into a lost decade of low growth, high unemployment and welfare destruction. In addition to its direct adverse effects on global growth and trade, such a slippage would complicate the challenge that key emerging economies face internally in managing their development breakout phase.

To minimize these risks, industrial country societies must go beyond thinking of what to do; they must also consider the how and why. Absent such a shift, active inertia will continue to dominate; instrument innovation will become even more elusive; and the private sector will continue to respond through higher self insurance and greater deleveraging.

Income distribution issues (and other compositional aspects) will also require more urgent attention—within current generations, as well as between current and future generations. And the political system would find it even more difficult to coalesce around a holistic response, aggravating polarization and prompting additional piecemeal and reactive policy measures.

The onus is on national governments to minimize these risks.

Industrial countries face the hardest challenges, requiring bold steps by policymakers, companies and households.24 Systemically-important emerging economies are also part of the solution to what ails the global economy. Structural reforms are key to sustaining higher consumption by an emerging middle class that, in several cases, saves a remarkably high fraction of its income to offset deficiencies elsewhere.

Yes, most of the heavy lifting must be done at the national level. Having said that, multilateral institutions can (and should) play a much more important role. This aspect is the focus of the final part of this lecture.

Those interested in a better global outlook should look to credible and well functioning institutions to play a greater role in informing and influencing the design and implementation of globally consistent and reinforcing national policies.

My thinking in this regard is educated by the 15 years I spent here in Washington at the IMF, and the time I have closely followed the institution since then.

The average quality of the staff is remarkable. The institution is capable of producing path-breaking analytical insights—and not just in regular publications (such as the World Economic Outlook and the Global Financial Stability Report) but also through single-topic research (such as the recent analysis of the influence of debt and deficits on interest rate formation in industrial countries).

The IMF is still the best place for centralizing country experiences, exchanging best practices and providing a safe forum for policy exchanges. The institution’s virtually universal membership gives it unmatched access to countries, including under members’ Article IV obligations (which translate into periodic, usually annual, checkups by IMF staff, management and the board).

Simply put, the IMF is uniquely placed to be the trusted advisor.25 It is also among those best placed to put together the pieces of the new normal and derive action plans that can be discussed, implemented and monitored. Yet the institution continues to fall short in sufficiently facilitating the required level of international coordination of policies, and in hard-wiring a meaningful peer review process that is viewed as credible, fair and effective.

Some progress has been made in recent years to address the long-standing deficiencies. Witness the retooling of staff to ensure that the traditional focus on economic issues is supplemented by a better understanding of financial markets; attempts to enhance, albeit at the margin, emerging economies’ voice and representation; the large increase in the Fund’s financial resources; and efforts to improve governance and develop a more robust internal income model.

This progress is important. Yet, unfortunately, the IMF is still not where we need it to be to fill the growing vacuum at the center of the international system. The longer this gap persists, the greater the risks for the global economy.

Then there is the even more complex issue—the nature of the IMF’s political mandate. This issue will likely involve the G-20, whether in its present form or reformed; and it will require a degree of trust and interaction between the two that is not yet visible to outsiders.

VI. Concluding Remarks

Two years ago, policymakers from around the world gathered here in Washington, DC and recognized that the world was on the verge of an economic meltdown. Together they initiated an impressive set of measures, showing a commonality of purpose, narratives, interests, and actions. The private sector also responded as companies and households took steps to navigate the sudden stop in global financial flows. The war against a global depression was won.

History books will report with admiration on the crisis management phase. Unfortunately, they will be less generous when it comes to the post-crisis period.

Having won the war, industrial country societies are in the process of losing the peace. Indeed, absent some important mid-course corrections, industrial countries confront the prospects of low growth; high unemployment that is increasingly structural in nature; welfare losses, including a growing number of citizens falling through the large gaps created by overly stretched safety nets; and a rising risk of protectionism.

This dichotomy between winning the war and losing the peace is an important one. It points to shortfalls in diagnosis, inappropriate operational constraints, and the fact that structural and balance sheets imbalances that were years in the making cannot be overcome immediately.

It also reflects an excessive intellectual reliance on shortcuts, including short-term mean reversion. Indeed, an important part of the disappointing post crisis outcomes is due to the high degree of active inertia that dominates industrial countries, including difficulties in shifting from a cyclical mindset to one that also acknowledges issues pertaining to national and global paradigm shifts and debt overhangs.

It is increasingly urgent for industrial societies to move beyond cyclical responses by also taking a longer, more secular view. Multilateral institutions can and should play a more important role in helping to navigate this critical transition. But to translate the possible into the probable, multilateral institutions must step up their efforts to deal with long-standing, well known problems—and do so by going well beyond the currently measured pace.

In closing, we should not forget the insight of the philosopher Lawrence Peter Berra. Mr. Berra, a legendary baseball player and manager—and better known by his nickname “Yogi Berra”—once said “The future ain’t what it used to be.”26 Let us all hope that the global economy responds to this reality with the required degree of courage, imagination, purpose and steadfastness that it displayed in dealing with the global financial crisis.

Thank you for your attention, and for the wonderful opportunity to be with you today.


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Kahneman, Daniel (2002), “Maps of Bounded Rationality: A Perspective on Intuitive Judgment and Choice,” Nobel Prize Lecture, Stockholm, Sweden, December 8th.

Kahneman, Daniel and Amos Tversky ed (2002), Choices, Values, and Frames, Cambridge University Press.

Krugman, P. (1988), "Market-Based Debt-Reduction Schemes", NBER Working Paper, W2587 , May.

McCulley, Paul (2007), “Teton Reflections,” Fed Watch, PIMCO, September.

Reinhart, Carmen and Vince Reinhart (2010), “After the Fall,” NBER Working Paper 16334, forthcoming in Federal Reserve Bank of Kansas City Economic Policy Symposium Volume, Macroeconomic Challenges: The Decade Ahead at Jackson Hole, Wyoming, on August 26-28, 2010.

Reinhart, Carmen M. and Kenneth Rogoff (2010), This Time it Different: Eight Centuries of Financial Folly, Princeton University Press.

Sachs, J. (1989), “The Debt Overhang of Developing Countries,” in Calvo, Findlay, Kouri and Braga de Macedo.

1 CEO and co-CIO, PIMCO. I would like to express my deep gratitude for the helpful comments provided by Andrew Balls, Libby Cantrill, Rich Clarida, Gene Colter, Bill Gross, Gayle Tzemach Lemmon, Paul McCulley, Lupin Rahman, Mike Spence, Dan Tarman, and Ramin Toloui.

2 The concept of “sudden stop” was used by Guillermo Calvo to analyze the dynamics of emerging market crises. E.g., Calvo (2003) and Calvo et al (2004). It is another illustration of the extent to which emerging market tools can shed light on the recent experience of industrial countries—something that we will come back to later.

3 Bernanke (2010).

4 E.g., Clarida (2010); and Clarida and El-Erian (2010).

5 McCulley (2007).

6 Others argue that the actions were “correlated” rather than “coordinated.”

7 Greenspan (2010) contains a good discussion of these dynamics.

8 Witness the disagreements at the July 2010 G-10 meeting, and growing worries about “currency wars.”.

9 For example, see El-Erian (2009a), El-Erian (2010a) and Gross (2010a).

10 Reinhart and Reinhart (2010) and Reinhart and Rogoff (2010).

11 CNBC interview on September 22nd at the “10,000 Small Business” event at LaGuardia Community College in New York, Buffet put it as follows. In this interview, he also noted that “The biggest thing you have going for the American economy, actually, is the regenerative capacity of American capitalism, and that doesn’t happen overnight…”

12 Think again of Chairman Bernanke’s characterization of an “unusually uncertain” outlook. See also Carney (2010).

13 Bank of England (2010). As shown in the charts, larger weights are placed on both the under and the over, as opposed to the outcome being at or close to target.

14 For example, see discussions in Krugman (1988) and Frenkel, Dooley and Wickham (1989), as well as Sachs (1989) and other papers in Calvo, Findlay, Kouri and Braga de Macedo (1989).

15 The fact that many used the term “finance” rather than “financial services” speaks loudly to the extent to which the sector grew beyond what could be sustained by the real economy.

16 El-Erian (2009b).

17 El-Erian (2009a).

18 El-Erian (2010).

19 For example, see Kahneman and Tversky (2000) and Kahneman (2002).

20 Including high unemployment in the US, recurrent sovereign debt issues in Euro-land and Japan’s inability—despite explicit efforts—to counter a currency appreciation that is compounding two decades of muted growth and deflation.

21 As an example, think of the current brinkmanship by China and the US on bilateral exchange rate issues—El-Erian (2010d).

22 Even the UK, which imposed a seemingly draconian bonus tax, was not able to meaningfully change compensation behavior of banks. Banks viewed the tax as a one-off, and chose to compensate their employees for the tax rather than change the compensation process.

23 The ongoing disagreement about IMF Board seats is just one example of this.

24 See El-Erian (2010c).

25 El-Erian (2008).

26 Berra (2010).


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