Mohamed A. El-Erian has a long memory for financial crises. As the former CEO and co-CIO of PIMCO, he helped lead the bond giant through the Great Recession, and was a voice of economic reason for investors. Before that, he worked for 15 years at the International Monetary Fund (IMF), where his main focus was on crisis countries and debt issues. Since 2014, he has been the chief economic advisor for Allianz, the corporate parent of PIMCO, and he is president-elect of Queens’ College, Cambridge, a post he will assume in the fall.
El-Erian was an early voice warning about income inequality and the lopsided nature of the economic recovery, or what he labeled the “New Normal” in 2009. He has started to have similar concerns about the trillions of dollars in fiscal and monetary stimulus being thrown at the economic crisis brought on by the coronavirus pandemic. His 2016 book, The Only Game in Town, chronicles the 2009 bailouts and unprecedented measures taken by the Federal Reserve not just to keep the U.S. out of a depression but also to maintain the anemic growth that followed. Beyond the problems directly in front of us as we battle this pandemic on the health front are the long-term economic implications of what has happened—and the remedies being used by governments and central banks around the world to stabilize their economies.
I caught up with Dr. El-Erian to discuss how the current crisis and the response to it will shape the U.S. and global economy in five to ten years.
Long-Term Economic Impact of COVID-19
Silver: In your mind, what will be the most important economic consequences of the coronavirus crisis that will manifest themselves in five to 10 years from now?
El-Erian: There are going to be three effects: two of which are relatively certain, and the third one, which is more uncertain. First, for good reasons, every segment of society will emerge with more debt—government, companies, and households. And, I say, for good reasons because debt is a way to make sure that short term problems don't become long term calamities, from an even greater surge in unemployment to corporate liquidity problems that become solvency issues.
Second, we will probably emerge with lower productivity and that lower productivity is going to come from three things:
One is that companies now will put greater emphasis on resilience versus efficiency. Part of that resilience will be to rewire some supply chains to reduce vulnerabilities to sudden interruptions. This would imply a partial re-shoring or bringing home of certain activities, and all this would mean lower productivity as the wires of the global economy are being changed.
The second element leading to lower productivity will be a general impetus to de-globalization. This will be the third shock to globalization in the last 10 years. The first shock was mainly socially driven, fueled by a recognition that globalization had alienated and marginalized segments of the population. The second shock was the trade war. This is the third shock and I suspect most likely will lead to an era of de-globalization.
We are also going to see a lot of entanglement of the public sector in the private sector during this crisis management stage. It goes from bailouts to the Federal Reserve involved in the lower parts of the capital structure like parts of high yield, and therefore taking on more credit and default risk. It is being driven by ad hoc crisis management reactions rather than governed by principles. So, the result will literally be a spaghetti bowl of public-private entanglements that has to be sorted out over time.
The third element—which is less certain, but which we have to keep an eye on—is what happens to consumer risk aversion. A lot will depend on the duration and severity of the shock, but we've got to monitor the possibility that we come out from the crisis with a more cautious household sector. It may even be one that resembles the frugal generation of the Great Depression.
In sum, we may have higher debt, lower productivity and, perhaps, lower demand as well.
Zombie Markets & Zombie Companies
Silver: You wrote recently about zombie companies that could come about as a result of certain Federal Reserve intervention, as well as the government subsidizing—or having to take some ownership in—publicly traded companies. How does that play out if they cannot fundamentally evaluate these companies? And what does it mean for investors?
El-Erian: Zombie companies are what you have witnessed in Japan. That is, you keep alive companies that shouldn't be kept alive as a byproduct of financial repression, including keeping interest rates very low, and of maintaining markets open at any cost. They are an unintended outcome and they eat away at the productivity and dynamism of an economy.
Investors can live with that with a certain amount of cautions and adaptation. What's much harder is a possible move towards zombie markets where investment decision and the allocation of capital are driven less by fundamentals, and more by the amount of public sector support and by the strength of the Fed put. Because the Fed has ventured into high yield, which was unthinkable just two months ago, it has given rise to the notion of a win-win stock market investment. You win if you bet right on a big recovery and you win if you bet wrong because the fed would have no choice but to buy equities.
Now the result of that zombie-fi-cation of markets is two-fold. One is a loss of price discovery and, with that, you erode the ability to allocate capital efficiency across the marketplace. The second thing that you weaken is the ability for the market to discipline companies. There is a risk if we continue with all this massive intervention, which is well intentioned, that we may take a big step towards zombie markets and that's something that we have to be very careful about.
The Moral Hazard of Bailouts
Silver: There is a moral hazard in there, too. We saw it in 2008 and 2009 when the government bailed out the banks, which led to Occupy Wall Street and other activism. Ultimately what happens to investor confidence? Looking out five or 10 years, do you see a further mistrust of the financial markets by everyday Americans, or do you see a wider embrace of it?
El-Erian: I keep on telling people over and over again, we cannot repeat the mistake of 2008 Global Financial Crisis. We won the war against a global depression, but we lost the peace of establishing high, sustainable and inclusive growth. Currently, we are in the midst of another war against a global depression. Winning it needs to be accompanied by the equally important challenge of securing the peace, which talks to economic well-being, the inequality trifecta related to income-wealth-opportunity, and other social and political issues.
The important lesson we should draw from the 2008 experience is that, even as you battle the depression, you have to think about securing the peace.
The banks have gone out of their way to say we are part of the solutions. We are not part of the problem. The challenge is that being part of the solution means extending credit when the credit quality of the economy is under pressure. If this is a short crisis, then that's fine. If this becomes a long crisis—or a series of crises—there would be a risk that the banks’ credit quality becomes an issue and then they will no longer be able to differentiate as clearly that they are being part of the solution and not part of the problem.
The Collapse of the Fossil Fuel Industry
Silver: How does the collapse in oil prices shape the global economy five to 10 years from now? What does it mean for things like climate change policies? What does it mean for GDP? And what does it mean for the economic power ladder across the world?
El-Erian: We have a golden opportunity, a golden opportunity to address two related issues that have been ignored.
One is the shift to green technology. And two, more generally, is a better proactive approach to climate change because the shift to green technology is one element of dealing with climate change, but it's not the entire solution.
There's going to be massive supply destruction in the energy complex, and governments will be making decisions as to whom to rescue and on what terms to provide public support. This is a good time to allocate public support to green alternatives and not just restart old-fashioned hydrocarbon and highly polluting industries.
The other thing is that there's a small window that has opened that recognizes tail risks much more. It's the equivalent of people rushing to buy flood insurance after a flood, even though the price of such insurance has gone up. Tail risks matter. They may have a very small probability, but they are so consequential that they should be managed seriously.
Many people who have questioned the need for a climate change focus have said it's a tail risk. It's not a tail risk, but some have treated as such. Now we have an opportunity to treat it for what it is, which is something that requires immediate action. I'm hopeful that this will be one of them.
In terms of what it does to the geopolitical order, you have to think of what happens to developing countries. That is where the potential for upheaval is the highest. I'll give you a simple number: 106 countries have already approached the IMF for assistance, and we have had no massive outbreak of the coronavirus yet in the developing world. They are dealing mainly with the spillover effects from the crisis in the West and parts of Asia.
The great hope—and there's some reason to be hopeful—is that there won’t be major outbreaks in Africa in particular. But if there are, countries will be dealing with the spillover effects, where they are already stretched, and health systems will be quickly overwhelmed. The whole of Zimbabwe has five ventilators. Nigeria, with a population of 200 million people, has 500 ventilators. That would cause major human tragedies.
While the coronavirus is calling for greater global policy coordination, we are seeing less cooperation than during the global financial crisis. Instead, great power rivalry has increased, as has the blame game. There's no doubt that this makes the geopolitical environment more uncertain.
Investor Expectations for the Next Decade
Silver: Should individual investors still assume that the U.S. equity markets will return somewhere between 5% and 8% every year, on average, as they have for more than 50 years? Could this event fundamentally change the way we think about investing and how we think about the stock market as a place where we could count on those returns even though we've had up and down years?
El-Erian: The only thing that individual investors can count on is that the U.S. is likely to continue to outperform the rest of the world. OK. That's a relative statement. But if you look at issues of resilience and agility, if you look at so-called "policy space," the ability to respond, if you look at the advantages of being the global reserve currency, if you look at all of these things, the U.S. dominates in all but one state of the world —and that is when you get a massive synchronized global recovery, and I don’t see that happening anytime soon.
Now, of course, telling an individual investor a relative statement doesn't help much because most individual investors live in an absolute space. Maybe they weigh their exposures differently, but then what they really want to know how much equity beta to take.
That is a call on two things: health and the Fed. Are you comfortable that the health response will shorten the duration of the infection stage and reduce the severity and risk of recurrence? If you are not, the longer the journey, the worse the outlook for equities over the long term because it creates serious structural damage.
The second call is, will the Fed buy equities? It's that simple. Those are the two calls and I'm not confident making either call, so I am telling people that it’s important to go up in quality and to be more tactical than you've been in the past. You've got to look again at your automatic index-based rebalancing, which assumes that the world is like a rubber band, and that it always resets properly. I hope that these things work. And most importantly, you've got to ask yourself that really difficult question, which is, "What mistake can I not afford to make?" because we are living in a highly uncertain world. Hopefully, everything will turn out fine, but high uncertainty means more likelihood of a mistake.