Seven Questions: Mohamed El-Erian on the New Global Economy

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Foreign Policy: Is the credit crisis under control?

Mohamed El-Erian: Not yet. We are getting closer to a time when the endogenous financial part of the crisis will be behind us because of two factors: One is a recognition by the financial institutions of losses, and second, a previously unthinkable policy reaction looking to reliquefy the financial system and cut off the fat tail.

FP: You wrote in the Financial Times in March that U.S. policymakers ought to study the experience of emerging economies. Can you explain a little bit what you mean by this?

ME: I think the United States finds itself in the unusual position of being a manager for a crisis that originated within the U.S. The U.S. normally has witnessed crisis management in other countries, but this time the crisis has erupted at home. Crisis management involves a certain mind-set. And that mind-set is one of making sure that you act early, making sure that you act in a coordinated fashion domestically and internationally, and be willing to live with the fact that there is no perfect policy responsethat once you get to crisis-management world, every policy response entails collateral damage, and the issue is how you minimize that.

FP: The U.S. Federal Reserve has been extremely active. Whats your assessment of the way Fed Chairman Ben Bernanke and the Treasury have handled this crisis?

ME: I think that theyve done well in terms of effort, given the situation theyve found themselves in. In particularand this is a much broader comment about the international financial systemthey have had to handle new problems with old instruments. The problems that have emerged are largely reflections of some major structural changes in the global financial system. Yet, the tools that are available to policymakers as well as a lot of Wall Street firms havent evolved as quickly as the system has evolved. So, you get a lot of effort but less-than-perfect outcomes.

FP: Theyre using outdated equipment.

ME: As is typical of any innovation, the world changes much more quickly than the infrastructure does. I have a whole book coming out on this issue in June that basically demonstrates that whatever you look atan individual firm, countries, or the multilateral systeminnovations have enabled activities that cannot as yet be sustained by the infrastructure we have. Im speaking in terms of the marketplacethe proliferation of structured finance that has lowered entries to all markets and resulted in massive financial alchemy that is not well understood. Im talking about the realignment of the global economy and the limited potency of traditional policy responses.

FP: Youve been critical in the past of the International Monetary Fund (IMF) as an organization that hasnt adapted well to this new world.

ME: Yeah, I think the IMF in particular got caught offsides in this. First, its income model is dependent on the IMF being a large lender. But with the realignment from West to East of growth and wealth, very few countries now borrow from the IMF. They dont need to. So, the first thing that has suffered is the IMFs ability to raise income to cover its expenses. The second thing thats suffered is that the IMF is a macroeconomy powerhouse, and increasingly it is financial markets that are impacting the macroeconomy, so the IMF has got caught still having to retool and enhance its understanding of the linkage from the financial system to the real economy. The third issue is that the IMF has a large representation and legitimacy deficit. It is still reflective of the world of yesterday and doesnt take sufficiently into account this major realignment that has taken place.

FP: But we have yet to see the United States and Europe show willingness to change the system. Why should they want to?

ME: Because its in their interest to have organizations that have legitimacy and that are representative of the world we live in rather than representative of a feudal system.

FP: If people dont take your advice and nothing changes, what happens then?

ME: We will have a series of increasingly acute market accidents and policy mistakes. That process will lead to a significant decline in global growth. It will lead to increasing poverty around the world and will lead to protectionism. So, the challenge that every level has is to recognize that the alternative is much worse. Retooling is uncomfortable, but not retooling is incredibly costly. This is not business as usual, and we will not go back to business as usual.

If I had told you a year ago to believe the following four hypotheses, tell me what you would have thought. I know I would have told myself, Mohamed, youve gone a little bit crazy. Suppose I would have told you the next systemic crisis is going to take place in the most sophisticated financial system in the worldthats hypothesis No. 1. Hypothesis No. 2: There will be collateral damage. There will be bank runs and bank failures, but they will occur in the first- and second-most sophisticated financial systems in the world: the United States and Britain, and not in the traditionally vulnerable emerging economies. Hypothesis No. 3 is that there will be lots of people resigning and losing their jobs, but guess what? Its not going to be central bank governors in emerging economies; its not going to be ministers of finance or even prime ministers. Its going to be the CEOs of some of the most respected and well-established financial organizations in the world. And issue No. 4: Emerging economies will not be seriously contaminated. In fact, theyre going to be viewed as a force for stability, including by buying assets in industrial countries. If I had made these four predictions publicly, a lot of people would have thought that Im a little bit crazy. But in fact every single one of those is fact today. Its just an illustration of how quickly things are changing.

Mohamed El-Erian is co-chief executive and co-chief investment officer at Pimco and author of the forthcoming When Markets Collide: Investment Strategies for the Age of Global Economic Change (New York: McGraw-Hill, June 2008).