It's Time to Take the Economy Away From the Central Bankers

There are few things that keep me up at night. And until recently, I would not have included “the shaky role of central bankers” on that list.

Then I read The Only Game in Town, by Allianz chief economic adviser and former Pimco CEO Mohamed El-Erian. In his book, El-Erian paints a terrifying picture of an economy that is being managed by a group of academics who never asked for the job; who don’t have the tools to keep performing the task; and who have no relief in the wings. “They have been forced to make things up on the spot,” El-Erian writes of the world’s central bankers. “Repeatedly, they have been compelled to resort to untested policy instruments. And, with their expectations for better outcomes often disappointed, many have felt (and still feel) the need to venture ever deeper into unknown and unfamiliar policy terrains.”

El-Erian came by LinkedIn to talk about the transformation of central banks into managers of last resort and the results of their almost heroic actions in the face of politicians refusing to act: less volatility, yes, but widening income inequality, slowing growth and the breakdown of international coordination — among many other issues.

In our conversation and in his frequent posts on the topic, El-Erian’s focus is less on dwelling on the history of how we ended up with such financial stewards and more on why policymakers and businesses need to take responsibility for investing in long-term fixes before it’s too late. And soon, he says, it will be too late.

El-Erian — whose resume includes a 15-year tenure at the International Monetary Fund, a two-year stint managing Harvard's then $35 billion endowment and on-going role as chair of President Obama's Global Development Council — is incredibly down to earth, looking for ways to make the urgency of economic decisions palpable. And if that means forcing you to think about the financial system as a McDonald's drive-through, that's fine with him. 

Here’s an edited version of our Influencer Interview:

You talk about one sign that things had gone off the rails was that banks stopped calling themselves “financial services” providers but simply “finance.” Have we returned to “financial services” or is there still swagger left in the system?

We're on the way back. We're not quite at the destination but we've traveled quite a bit of the journey and there's been two engines; regulation and markets. Both have reduced the ability of banks to take excessive risk. Hasn't eliminated it, but has reduced it.

What hasn't yet evolved enough is the replacement in our minds as to what actually is the engine for economic growth. The transition from banks being viewed as serving the economy to banks being viewed as a standalone, occurred in a bigger context where somehow “finance” became the next level of cataclysm.

Are there other pockets of the economy that worry you?

Until recently, we had a very notable disconnect between financial risk taking and economical risk taking. People in finance — investors, traders — felt comfortable taking on more and more risk. Companies, even though they're sitting on a ton of cash that's earning zero, felt less comfortable deploying it into new productive investments. To the extent, they deployed it. It went into share buybacks, higher dividends, or defensive m&a.

So the first disconnect is between financial risk taking and economic risk taking, which is really unhealthy. The second disconnect is between the creation of incremental income growth and who gets it. We've had this very unusual situation whereby the vast majority of the incremental income created since the global financial crisis has gone to the very rich.

Now whether you have a moral judgement, a political judgement, that's up to you, but I'll give you the economic judgement.

When that happens, inequality goes from being an incentive for hard work — that's what a bit of inequality does — to being something that undermines the economy as a whole. That's what too much inequality does. Why? The rich spend less of their income. If they capture the vast majority of the income and they spend less of it, they'll be too little demand in the economy.

So we now have a problem of deficient economic demand.

On the supply side, if you like, we have a disconnect between financial risk taking and economic risk taking. And on the demand side, we don't have enough demand. These things can feed on each other.

So I would assume you’d think falling oil prices are a good thing, in general, for the economy.

It's a puzzle to me as to how we've gone from viewing low oil prices as a blessing to now viewing it as a curse.

Now, there's one good reason and there's many silly reasons. The good reason is that the U.S. now produces energy. It's not as obvious that it's an unambiguous good. But if you look at the numbers, the people who benefit are much larger in scale scope than the producers who get hurt. Why? Because lower oil price is an immediate tax cut. You go to fill up your car and you've got more cash in your pocket as a result.

When you put these two things together, yes it's not as much of a benefit as it was when we produced less energy, but it's still a significant positive. Why is it being viewed in such a negative way and why are equity traders always blaming the old market whenever something goes wrong in their market? What the oil market has does is add to financial volatility. Given how decoupled risk taking was from fundamentals, the minute you have a bit of volatility, then you start having convergence from the wrong side. Rather than fundamentals going up and validating asset prices, you have the other way around.

There's no doubt in my mind that if and when things calm down, people will see that this is an unambiguous blessing for the U.S. economy as a whole.

After reading your book, it feels like central bankers are the nanny of the economy, waiting for the politicians to come home — except they never do. When you watch the debates, what do you think we should be listening for to figure out whether the politicians are going to take back their role?

I love the image of leaving it with babysitter. I had a more dark image of the parents leaving the baby at a door of the fire brigade and leaving.

Good news, bad news. Good news is awareness. Both sides of the political spectrum are talking about excessive inequality. Both sides are talking about the need to have genuine growth. Both sides are talking about how important it is to coordinate the global economy better. What we haven't seen yet is how they would implement all this.

The “what” is being discussed. The “how” isn't really. Part of it is because there's still so many people in the race that the media is focusing on soundbites. Then the candidates have not been pushed to develop.

I was also struck about how worried you are still about liquidity risks. You call it the “most underappreciated risk factor for investors today.”

I'm very worried and this is why every time we have this small bit of news, we have outsized movements in markets and too much damage gets created by too little news. We've seen this over and over again. We have seen triple digit changes in the Dow on nothing at all. Nothing at all.

We believe that liquidity will be there when we [make a financial decision], but in reality it's not. Then we are put in a lose-lose situation. You change your mind, but you can't do anything about it or you change your mind and you have to pay a lot to do something about it.

In 2008 you called your wife at one point and said, "Take as much money out of the ATM as possible." Still good advice?

No, 2008 was different and I remember that very well. The reason why I did that is because I was on the trade floor and the most basic, basic function — cash management and collateral management — couldn’t get done. Why? Because banks didn't trust each other.

In California, we have the most efficient McDonald's and Burger Kings. You drive up in your car, the minute you order a stopwatch starts and within 30 seconds to 45 seconds, you're out of there. Why? Because the system assumes that you are willing to take a risk. You order, you go to the first window, you pay, and then you go up 10 yards to the second window and you get your Big Mac.

Here’s what happened in 2008: Imagine you're the person and you go to the first window and they say, "It's going to be five dollars." And you'll say, "Fine, where's my Big Mac?" And they say, "It's 10 yards." And you say, "I don't trust those 10 yards because I heard what happened to Lehman. People lost money on this. I'm not going to give you my money unless you give me my hamburger." And they say, "I'm sorry the system is built on the assumption that you will trust that." So what happens? You go away hungry even though you can pay for it and at the next window, they throw away the food even though they have it.

That is what happened in 2008. It was a great kind of what's called the Payments and Settlement. You pay and then you settle. Today, that is not a risk. The central bankers have realized that the Payments and Settlement system, if it fails you're talking about a global depression. The risk is different.

There are other liquidity risks today...

Liquidity risks basically is that people would not be able to reposition. You will get very big fluctuations in asset crisis. Then people are going to become more cautious. They're going to be worried about their retirement and they're going to spend less.

As they spend less, companies invest less because there's less demand. The next thing you know, that spills back to market volatility. Then we end up in this vicious cycle.

That is the risk of today.