“To say that the last few years have been economically turbulent would be a colossal understatement,” wrote economist and businessman Mohamed El-Erian in “Not Just Another Recession: Why the Global Economy May Never Be the Same,” a recently published article in Foreign Affairs. El-Erian, — one of the world’s most influential economic thinkers, — is President of Queens College in Cambridge University, chief economic advisor at Allianz, and former CEO of PIMCO.
“Inflation has surged to its highest level in decades, and a combination of geopolitical tensions, supply chain disruptions, and rising interest rates now threatens to plunge the global economy into recession,” he added. “Yet for the most part, economists and financial analysts have treated these developments as outgrowths of the normal business cycle. But rather than one more turn of the economic wheel, the world may be experiencing major structural and secular changes that will outlast the current business cycle.”
As evidence of these changes, the article cites a series of highly unlikely economic and financial development that have taken place in the past few years. These include the strengthening of autocracies around the world, the political polarization in several liberal democracies, the increasing US turn from free trade to protectionism, and the growing tensions between China and the US.
- The shift from insufficient demand to insufficient supply. A number of major changes, —a smaller labor force, trade and investment sanctions on Russia, worsening tensions with China, —are rewiring global supply chains;
- The end of boundless liquidity from central banks. Central bank interventions to stimulate economic activity and keep interest rates artificially low were meant to be time-limited, but have now caused serious collateral damage and financial market volatility.
- The increasing fragility of financial markets. The expectation of easy money encourage individuals and professionals to engage in riskier financial activities and in less well-understood and less regulated investments.
A few weeks after his article was published, El-Erian was the guest of NY Times journalist Ezra Klein in Klein’s podcast “Three Signals We’ve Entered a New Economic Era,” where they discussed the three structural changes that El-Erian wrote about in his Foreign Affairs article.
Klein introduced the podcast by noting that “In recent years, markets have been roiled by significant shocks. … But El-Erian believes we’re also witnessing a deeper structural shift in the very nature of the global economy. Economic policymakers today are trying to bring the economy back to that of 2019, but in his view, there is no going back. We’ve entered a new era that demands a different kind of response. So I invited El-Erian on the show to help me understand the economic era he thinks we’re entering and how policymakers can respond.”
The rewiring of global supply chains
Why do you say that the first major change we’re dealing with is the shift from the belief that the big problem in the global economy was insufficient demand to now believing that it will be insufficient supply?, asked Klein.
“First and foremost, the labor market is changing,” replied El-Erian. Segments of the population have been exiting the labor force at unusually high rates making it harder for companies to find workers. This has to do not only with the continuing impact of the pandemic but also “with changing preferences about life/work balance, and critically with the lack of child care and support in general for certain segments of the population to engage into the labor force.” In addition, there’s a growing, hard problem in matching the skills of the unemployed with the jobs that companies want to hire, having to do with the evolution from an economy based on the production of physical goods to one based on technology and service industries.
Klein noted that a lot of supply chain fragility was exposed by the pandemic, so we’re trying to bring back more supply chains or at least closer to home. “What are the enduring changes here? What has snapped back, and what do you think will simply not snap back?”
Most of the pandemic effects have snapped back, answered El-Erian. When the economy suddenly stopped, shipping and container costs soared, but those have now come down.
“But there are two deeper forces at play. One is geopolitical fragmentation. It has to do with tensions, particularly China/U.S. tensions. And the friend-shoring, the near-shoring, is basically saying, for national security reasons, let’s increase the resilience of our supply chains.”
The second is what companies themselves are doing. “For a very long time, just-in-time approaches were governing how people thought of their supply chains. And for good reason. Inventory can be expensive. If you can run very efficient supply chains, there’s a tremendous amount you gain. But this focus on efficiency came at the cost of resilience.”
The negative consequences of an excessive focus on efficiency were nicely explained by University of Toronto professor Roger Martin in “The High Price of Efficiency,” an article published in January, 2019 in the Harvard Business Review. The belief that efficiency is fundamental to competitive advantage has turned management into a science, whose objective is the elimination of waste, — whether of time, materials, or capital. But, an excessive focus on efficiency can produce startlingly negative effects. To counterbalance such potential negative effects, companies should pay just as much attention to a less appreciated source of competitive advantage: resilience, “the ability to recover from difficulties — to spring back into shape after a shock,” he presciently added a year before the advent of Covid-19.
The end of boundless liquidity
The second major structural change is the end of the unusual era of boundless, easy money from central banks.
Central banks played an absolutely critical role in avoiding a multi-year depression after the 2007-2008 global financial crisis, said El-Erian. By 2010, central banks had fixed malfunctioning markets and were looking to step back. But instead, they continued to inject liquidity into the economy through a series of rounds of quantitative easing (QE) while maintaining very low interest rates. This encouraged many to take on even more leverage and debt.
“And the longer it persisted, the more two things happened. One, you conditioned markets to think of central banks as their BFF, their Best Friend Forever. That whenever there’s any turbulence in markets, they’re going to come in and just buy more.”
Two, “we started seeing misallocation of resources, and we started seeing all sorts of unintended consequences and collateral damage. This, put this whole regime on turbocharge during the pandemic, when, understandably, governments and central banks stepped in but continued providing exceptional support. Combine that with what we were talking about earlier — supply problems — and you end up with high inflation.”
“And the minute you have high inflation, you can no longer continue with the monetary policy regime we had. You have to start, normalizing monetary policy. And that’s where we are. But you’re doing that with a financial system that was conditioned to optimize a regime that it thought it would last forever.”
The increasing fragility of financial markets
The discussion then turned to the third major change: we’re entering an era of increasingly fragile financial markets.
Klein observed that financial markets went through considerable turmoil just 15 years ago during the global financial crisis as well as more recently during the pandemic. Over this period, financial markets kept reaching new heights but they also seemed fragile and almost in crisis. “So tell me what kind of fragility you’re talking about here. What about this era of threatening looming financial crisis is different?”
El-Erian explained that the global financial crisis was ultimately about the banking, payments, and settlement systems. “We understood what the problem was. We applied high capital requirements. We limited the sort of activities that banks can take. And we basically de-risked the banking system.”
But, risk didn’t just disappear. It migrated from banks to non-banks, — e.g., pension systems, real estate funds, crypto assets. “And non-banks are less well-understood by regulators, less well-regulated, and less well-supervised. … These are little fires. But the risk here is that these little fires start spreading and start becoming something bigger.”
Klein said: “I’ve wondered if crypto isn’t strangely almost an unsung hero, because it took a lot of this risky financial behavior and the incentive to engage in very risky high-reward financial behavior and pushed it all at once — a lot of it, anyway — into this weirdly self-contained market.”
El-Erian agreed that it would have been a good thing if risky financial behavior was contained because it was channeled into crypto. “But what if the irresponsible risk-taking that we see in crypto was also taking place elsewhere because it was encouraged by very low interest rates, it was encouraged by a notion that markets only go up because central banks have their back covered, and that crypto simply happened to be the structurally most fragile of those cases.” In other words, what if crypto just happened to be the canary in the coal mine.
Finally, El-Erian discussed how policymakers should respond to these major changes in the economy. “What I repeat to people is that we don’t live in an orderly world anymore. We live in a world where there are many potential outcomes, none dominate in absolute terms, and therefore, we have to do three things: have an open mind and plan for several possible outcomes and not become hostage to just one; have action plans for different outcomes so we’re not surprised; and recognize that cognitive diversity is absolutely critical if you’re going to navigate this world, … which means taking gender diversity, education diversity, culture and experience diversity much more seriously.”
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