Mohamed El-Erian’s Odd Piece on Global Imbalances

Full disclosure: I’m normally a fan of Mohamed El-Erian, former head of Harvard Management, now co-president of bond giant Pimco. But his current comment in the Financial Times, “,” struck me as more than a tad disingenuous.

Let’s go through the article:

Whatever happened to the debate on global payments imbalances?…At its roots, the policy solution called for simultaneous implementation of three sets of measures. First, a reduction in US domestic aggregate demand to contain imports and encourage a shift to exports. Second, an increase in consumption in Asia and the Middle East, including having China adopt a higher and flexible exchange rate. Third, structural reforms in western Europe to enhance the growth potential of the global economy.

Most observers agreed on the elegance and theoretical potency of this policy combination, which reduces imbalances in the context of high global growth, contained inflation and relatively stable financial markets. Indeed, the question was never about design. It was about implementation.

I may be about to put foot in mouth and chew, but I follow the economic press pretty closely and saw no evidence of a discussion along the lines El-Erian indicates. Perhaps there was an article in Foreign Affairs that I missed, but the discussions I’ve read among top level economists seems still to be in the “is the culprit the savings glut in developing countries or is it overconsumptoin in America?” stage.

Now El-Erian does travel in elevated circles, so this idea may have been kicked around, but for it to have gotten anywhere, it would have had to either come out as an official recommendation of an august body or been otherwise pre-sold, via speeches and op-ed pieces. I have seen no trial balloons ANYWHERE in the US by anyone prominent arguing that a recession would be a good thing (um, that’s what “reduction in domestic aggregate demand” means). You’d need to do a pretty hard sales campaign, and I find no evidence of one.

And how could the Fed go along, given its mandate of full employment and price stability? That too would take a bit of artwork.

The only reference I have ever seen to something along El-Erian’s line of thinking was from El-Erian himself and Michael Spence in a Wall Street Journal op-ed more than a year ago, Except then they presented it as a scenario of how global imbalances could work themselves out on their own, not a policy recommendation. From the:

Now to the future. Over time, emerging markets will inevitably divert more of their assets to more sophisticated investments abroad. That shift will have many effects, some of which depend on the decisions taken by emerging economies while others depend on the evolution of the global context….

While the shift is inevitable, it would be unlikely that the emerging economies as a group would deliberately take actions that directly undermine global economic markets. There will also be domestic pressure on policy makers in emerging countries to gradually shift their emphasis away from the producer and towards the consumer…

Under this state of the world, domestic consumption in the rest of the world picks up over time, facilitating the needed adjustment in the U.S. The result is a gradual journey to a more normal relationship between assets and income returns, with savings moving to a more normal long-run pattern.

But this process is not automatic…. it is particularly sensitive to “policy mistakes.”

Among these policy mistakes, protectionism measures in the U.S. would derail the global adjustment So, too, would the inability of emerging economies to navigate their complex policy challenges.

Geopolitical shocks would also be a problem,….Finally, significant “market accidents” that, in the past, have been associated with excessive leverage and triggered sudden and large portfolio changes and credit rationing, would add to the policy complexity.

So where does all this leave us? The current configuration of global imbalances, while highly unusual is not a real puzzle. It is the result of a series of individual decisions in both advanced and emerging economies that were largely rational when considered at the micro level.

These decisions reflected individual self interest, and happened to coincide. The aggregation of these decisions at the national and international levels raises considerable challenges, as does the ability to maintain an orderly global reconciliation process over time. The fundamental question, therefore, is whether these global considerations will be sufficient to minimize the risk of “policy mistakes” in a world that is subject to geo-political risk and bouts of excessive leverage.

If this represented some sort of policy program agreed on in high circles, it was so coded that it went by me completely.

Back to the current offering from the FT:

The policy solution stalled because of a basic co-ordination problem, or what is known in game theory as the “prisoners’ dilemma”. While all parties had an interest in the outcome, any individual party that moved first risked being worse off if others did not follow. With multilateral co-ordination mechanisms such as the Group of Seven industrial countries and the International Monetary Fund lacking representation and legitimacy, there was no way to provide parties with sufficient assurances that their actions would be accompanied by others. As a result, no one took sufficiently meaningful action.

Again, El-Erian says pretty directly that this idea got at least to the talking stages. But who in the US has the authority to push the economy into a recession? The last guy who did that, Volcker, had Carter’s blessing and even broader support (at least initially) because there was a general recognition that inflation had gotten to a level that was painful. We aren’t even close to that sort of consensus on our trade deficit or lack of savings as a problem.

The Europeans agreeing to “structural solutions” I assume is code for more more flexible labor markets. But Europe is not a major actor in the global imbalances story, so it isn’t clear why they should go along and impose unpopular measures to solve a problem not of their making. And the Chinese building a consumer economy is a much longer time horizon process than cutting domestic demand might be in the US. How do you sync the two programs?

Back to El-Erian:

With the policy solution stuck, the process is now being driven by the reality that components of the imbalances have reached their natural point of exhaustion. The risk is that while the imbalances will be corrected over time, it will be at a high cost for the global economy. Relative prices are now leading the adjustment process through the impact of a substantial terms-of-trade shock led by the surge in oil and food prices. Second-round effects, via the prices of other goods and wages in some emerging economies, will also be in play.

The price shock will serve to undermine real incomes in the US and lower imports. On the policy front, it will accentuate the tug of war that the Federal Reserve faces on account of its now conflicting inflation and employment objectives. Emerging economies face greater inflation in the context of their buoyant liquidity conditions. Several will see their real effective exchange rates appreciate, by means including measures to allow the nominal exchange rate to appreciate markedly against the dollar. In Europe, growing demands for wage increases may force companies to step up structural reforms and will cause the European Central Bank to increase its hawkish rhetoric.

Under this scenario, the question for markets is no longer whether the global imbalances adjust. They will. Instead, the focus should be on the collateral damage of the adjustment process – damage that is region-specific given differences in policy flexibility and initial economic and financial conditions. In the US, look for renewed pressure for further fiscal stimulus and a monetary policy that, while appropriate for the US, is too inflationary for the rest of the world. In Asia and the Middle East, the spike in inflationary pressures may inadvertently slow the move towards more efficient tools of indirect economic management. In Europe, expect attempts to bypass fiscal responsibility guidelines in order to mute political protest.

As this bumpy and disorderly process plays out, it is important not to lose sight of important lessons. Indeed, the fact that the system has ended up eschewing the superior policy solution speaks to the urgency of learning from them. An increasingly interconnected world cannot maintain high growth and low inflation without a bold modernisation of the mechanisms for international policy co-ordination, starting with the G7. Governments must continue to refine their policy instruments and pay greater attention to the secondary and tertiary consequences of their actions. The private sector must assume greater responsibility for forward-looking risk management. In the absence of these changes, the inevitable adjustment of the global imbalances will continue to entail a serious cost in global welfare.

To be honest, I do not believe there is any pretty way out of the situation we are in.

However, I question El-Erian’s assumption at the beginning of the final paragraph, that we can have a highly interconnected world with high growth, low inflation, and some measure of stability. El-Erian believes that more powerful international institutions will do the trick, but there are limits to how much sovereignity nations are willing to sacrifice. I can’t see the US, China, or Russia ceding too much control.

And as we have noted before. some evidence suggests that free capital flows in and of themselves produce instability and crises. A recent paper by Kenneth Rogoff and Carmen Reinhart found that

Periods of high international capital mobility have repeatedly produced international banking crises, not only famously as they did in the 1990s, but historically.

Thus part of the solution may not lie in stronger international organizations, but more robust, and somewhat more self-contained domestic markets. The notion of China and India being less export and more domestic consumption oriented fits that pattern. And that in turn means a somewhat lower level of international trade and capital flows.

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16 comments

  1. JKH

    It’s an interesting comparison – between Volcker’s decision on inflation and a similar policy question re global imbalances.

    International capital flows are largely a function of international trade imbalances. The horse is trade, the cart is capital flows, and the natural result is some monetary instability. China’s concentration of its reserve position mostly in US treasuries and agencies has been a bottleneck and catalyst for such instability. This is a great distortion of global risk allocation, essentially forcing the global private sector to be overweight risky assets.

    As Brad Setser often reminds us, such analyses should pay a lot more attention to the usually high proportion of international capital flows that result from foreign central bank FX intervention and reserve positions, as well as their concentration in low risk assets. El-Erian doesn’t mention any of this.

    The most visible thrust of US policy response so far seems not to be trade protectionism or monetary policy, but reciprocal asset protectionism via SWF investment restrictions.

  2. Danny

    “However, I question El-Erian’s assumption at the beginning of the final paragraph, that we can have a highly interconnected world with high growth, low inflation, and some measure of stability.”

    There is a way to have this, but it would require international commodity based currencies. Some would say a gold standard, but the market would decide. In the short run, I do not see this happening. In the long run, however, I think this is how things will ultimately shape up. Trading things of value between each other, rather than paper money would create low inflation for sure, foster financial stability, and create a solid foundation for growth.

  3. PrintFaster

    Yves,
    I side with you in that there is no way out, and that there will be more international isolation.

    First off, the fundamental problem that the US faces is that of government indebtedness. It is excessive, and uncontrollable. This debt is responsible for creating currency based inflation. At its core this is creating current account deficits, trade deficits, high commodity prices, foreign buying of US assets, asset bubbles, and currency collapse.

    By the way, I am no fan of central bank manipulation to preserve high currency values. In the past this was done by selling gold. Today we have no gold to sell, only interest rates to adjust. Boosting rates simply pushes out the day of reckoning.

    Volcker in my book was the father of modern bubble creation and collapse, as credit kept racing around trying to avoid the government generated currency collapse through debt backed currency.

    What the high price of oil, generated by high government deficits, will do is to put a halt to globalization. Given the higher costs of transport, and travel, there will be less and less globalization. For example, shipping fruit from Chile will become prohibitive, traveling across the oceans on business will become impossible, shipping heavy goods such as concrete and iron will diminish.

    The world is headed for autarkies, and nasty little tin pot dictators like Chavez and Mubabe as isolation increases.

  4. Peripheral Visionary

    I agree that lower levels of trade and capital flows are inevitable. The flow of goods has brought about an inevitable pressure to equalize wages; but as wages equalize, the incentive to move goods drops, as they can be produced just as cheaply domestically. That has not happened yet, but when it does, trade will drop as formerly low wage countries see wages rise, formerly high wage countries see wages drop, and it no longer makes sense to move most goods from one country to another.

    With respect to El-Erian, at the risk of sounding pessimistic, I would say he is talking his book. Anyone sitting on top of a mountain of debt issued by multi-national companies is going to be hoping that somehow the governments of the world will figure out a way to keep it all going.

  5. etc

    pv,

    Pimco is trying to refocus itself from being known for bonds to being known for emerging markets investments, and El-Erian’s upcoming book when markets collide advocates investments outside the US. El-Erian is talking his book literally and figuratively by promoting policies that favor cross-border investment.

    And I wouldn’t be so optimistic about wages equalizing. I think there’ll be a nationalist backlash in a number of countries before that happens.

  6. Anonymous

    Off topic:

    I just read this FT article on Goldman’s SIV restructuring:

    “The Cheyne restructuring, which has been brokered after nearly 10 months of negotiations, will require the receivers to organise an auction of the Cheyne assets in the coming weeks, to establish a transparent price for these instruments. This is important because in recent months it has often proved impossible to value these murky assets.

    Once this price is established, Goldman will then create a new off-balance sheet vehicle to buy the assets, with the transfer of assets being funded by the US bank for just one day before being sold on to the new vehicle.”

    Does this sound to you like a genuine price establishing auction? Do you know that these SIVs are chockfull of bank equity (under the moniker bank loans, but the banks get to report the “loans” on their balance sheets as capital)?

    Has Goldman finally found a way to create that price obscuring super-SIV after all?

  7. Anonymous

    Yves –
    We can have declining domestic demand without a recession. We now have excess domestic demand – we just need to keep more of it at home without letting so much of it leak abroad through the trade deficit.
    JKH: wrt official capital flows, you have the cart before the horse. In fact, in most cases you probably do. Consider the classic model of exchange rate overshooting.
    don

  8. Yves Smith

    Anon of 6:33 PM,

    I beg to differ. We will run current account deficits as long as we run capital account sures (ie, we are importing capital from abroad, by selling Treasuries and whatnot to foreign investors). We will in turn import capital as long as our domestic savings rate is as low as it is.

    Consumption as a % of GDP is 70-71%. That’s a remarkably high level. We need to get consumption down substantially in order for us not to be dependent on foreign capital inflows. That challenge is made worse by our growing fiscal deficits, thanks to Iraq and Bush’s tax cuts.

    A reduction in consumption of the magnitude needed to square our accounts means a recession. There is no way around this.

  9. PrintFaster

    Hi Yves
    I will volley this one back to you.

    Foreigners buying our credit is simply mattress stuffing. It must be returned to the US for dollars or dollar denominated assets. When it does, it either becomes inflation, or is destroyed by tax sur collections. I suppose it could be rolled over yet again.

    As for needing a recession, I will differ. What will cure the current accounts/trade deficit is domestic production as a substitute for foreign production. In some measure an autarky, or at least a balance if there are sufficient exports.

    The big impediment to US production is the total lack of capital for production. It sometimes seems that US production capital is consumed by MBAs and lawyers, not to mention doctors with high medical care insurance expenses. Basically, production today requires heavy automation and that requires lots of capital. The more wall street friction on capital, the less there is for production.

    Basically, I am saying we need lots of domestic capital, and we have none. So I guess in that sense we need an accelerated savings, but given current tax indebtness, there will be no savings for years. Federal debt will simply need to be destroyed. It cannot be collected.

  10. hbl

    “…I follow the economic press pretty closely and saw no evidence of a discussion along the lines El-Erian indicates…”

    Perhaps I am misunderstanding which discussion you are referring to, but hasn’t Stephen Roach been writing about the need to address these global imbalances for years? And I don’t think he was alone… a quick search turns of this IMF communication for example:

    “The Committee reiterates that all countries have a shared responsibility to take advantage of the current favorable economic conditions to address key risks and vulnerabilities. To ensure orderly adjustment of global imbalances and to help achieve more sustainable external positions and stronger medium-term growth, the Committee calls for concrete actions by all to implement the agreed policy response in a timely and effective manner. This includes fiscal consolidation to increase national savings in the United States; greater exchange rate flexibility as appropriate, supported by continued financial sector reform, in emerging Asia; further structural reforms to boost growth and domestic demand in Europe; and further structural reforms, including fiscal consolidation, in Japan.”

  11. Yves Smith

    hbl,

    Agreed that quite a few economists have highlighted the global imbalances problem. However, my quibble is that El-Erian suggests that there was a consensus about what to do among the key actors that never got done. His own WSJ op-ed, by articulating the hopeful view that the imbalances will sort themselves out over time, in some ways contradicts what he is saying now.

    And the IMF statement you helpfully provided, while having some common elements with what El-Erian outlined, differs in material ways. Reducing aggregate demand in the US is broader than mere fiscal consolidation. China could argue, correctly, that it has gotten more flexible on exchange rates. The idea of financial sector reform circa 2005, which would have entailed more nations moving to the Anglo-Saxon model, now means something pretty different now, even if one were to invoke the same words.

  12. Michael McKinlay

    Yves Smith ,

    Agreed, I do not follow the reports on trade as you but I have not seen even a trial balloon on the issue of trade imbalance.As of this moment I think the world is waiting, very nervously, for the next administration in DC.

    I have not read even one economist that says these deficits are sustainable. The question is how do we go about initiating a credible answer to this problem.

    I would suggest tariffs. Your thoughts?

  13. Anonymous

    OT: The Interior Department estimates that the Outer Continental Shelf has more than 115 billion barrels of oil and 633 trillion cubic feet of natural gas available for extraction. At current levels of consumption, that would satisfy the nation’s oil needs for about 16 years and its natural gas needs for about 25 years.

    Opponents of drilling in United States waters are equally passionate in their arguments, saying that drilling for oil off the coast poses environmental risks and that drilling for finite supplies undermines long-term conservation solutions. They also say modest supplies of additional oil would not necessarily lower gasoline prices in the United States because oil is traded on a world market

  14. JKH

    Anon of June 17, 2008 6:33 PM

    I’m aware I’ve got the orthodox economic causality in reverse, but I’ve never been able to believe in it, particularly at the operational level.

    The fact is that all international trade transactions are settled immediately via the international capital account (i.e. via money, which is classified as an international capital account flow).

    E.g. each marginal Wal-Mart purchase from China represents a marginal contribution to the US current account deficit, settled by the export of dollars that in turn become the offsetting capital inflow to the US. The absence of an offsetting trade transaction in this example sustains that net capital inflow. The fact that the Chinese central bank then uses those dollars to buy bonds is a downstream operational aspect of China’s money management of its sur. It’s a consequential portfolio allocation decision. I find it hard to visualize that PBOC’s bond purchases cause marginal buying at Wal-Mart, because it contradicts the reality of the order in which international trade transactions are actually settled via the monetary system. So net trade flows cause net capital flows.

    Conversely, gross capital flows that are not the result or reallocated result of net trade flows are also settled with money and offsetting capital flows (both at the operational transaction level and the macro accounting identity level.)

    There are other debates about the subject – such as savings glut versus money glut – but none of these seems quite right – and it remains a debate.

  15. Richard Kline

    So Yves, I as definitive take your summary perspective re: the absence of a global consensus on the linked policies El-Erian professes in the FT article discussed. However, I rather think that El-E is stating the interlinked imbalance issue at a meta level; yes, his summary favors his preferred policy outcome, but I’m not sure that he is wrong, just not thorough in well-framing his argument.

    Consider the following substantive issues, each of which individually and regionally I _have_ heard discussed in the press in recent years. For the US: 1) savings presently riduculously low, largely due to excessive consumption, must increase; 2) the US Fed must cease and desist from excessively accomodative rates and credit creation, presently pursued for substantially domestic political reasons in contravention of all good financial governance; and 3)the US fisc must raise the revenue necessary to support at least its present level of expenditure, to say nothing of for needed further expenditures. For China (and less directly other major emerging sovereign exporters): 1) currency values must adjust to more nearly rational relationships to GDP, in the present case rise; 2) some portion of industrial expansion should be focused more on domestic demand to decrease destabilizing foreign currency denominated capital flows; and 3) coordination of macrofinancial policy in China needs to be more closely coordinated—i.e. negotiated—with other primary industrial actors [a G10 or something like it]. For the EU: 1) government subsidies of major exporters—read Airbus and agriculture among others—to offset high regional labor costs needs to decline if not end; b) revenue week Club Med statelets need to, like, get real and raise enough to fund their debt at sovereign levels; c) labor laws need to loosen enough to get full[er] employment going to stimulate regional demand.

    Now, I’m not necessarily advocating all of these positions, personally. And each and every one of them are huge domestic political hot potatos which would be difficult to implement in isolation, and have no little pain attached to implement at all. However, I think it a fair summary to say that a consensus exists for all of them, if not a uniform one, that these would be _desirable_ outcomes, both regionally and globally. The observation, which El-Erian skirts but I suspect because it’s very old hat to him, is that these positions are, of course, _interlinked_. All of them are predicated upon each of them, that is they each other even if each policy is supported for specific, discrete reasons. It may be disingenous to say that policies favored individually by consensus imply a comprehensive consensus on the direction of global financial policy, but that is the sum of the positions if I’m following this correctly.

    And I do think that El-E’s ‘prisoner dilemma’ reading of inaction on this interlinked problem set is accurate: no one will act alone to take the pain, particularly when they can’t be sure the other major actors will follow through. This is why we need a real global forum for _hard and binding bargaining_ on joint implementation. We won’t get it until after the US banking system crashes; we may not get it for ten years. In the end, we WILL get a joint global negotiation on this through; it won’t likely be held at Bretton Woods, or the Plaza Hotel, but it will codify the new ‘Rules of the Game’ when the time comes. What I don’t know is who will propose and facilitate the meeting? It won’t be the US, because we have the most to lose, and any new agreement will manifestly be less favorable to us than the rules we have explointed to our present prediciment. I’m betting the Europeans will propose it. If the Chinese were really, really smart, THEY would propose it but have it held in the US, just like the Japanese did twenty years ago. I don’t think they are that confident yet, whether they are that smart.

    And Yves, the issue with ‘high growth, low inflation, and some measure of stability,’ to me, is the high growth part. The industrialized world is addicted to ‘incessant, inevitable growth,’ in part because we waste so much, most especially because the illusion and occasional reality of growth allows Big Capital to keep the issue of income distribution off the political bargaining table. This is why we have growth: to keep the carrot before the nose of the donkeys as they trudge to the mill in the early morn. If we ever have the donkeys realize that the boss owns most of the carrots and keeps them, we can get away from this ‘high growth’ mania and its attendant destabilization. But if not, then, yes, I’m with you: attempts to grow big, hold down inflation, and stay stable are foredoomed.

    To PrintFaster: I’m with you on Volcker. We have had a debt backed currency since his tenure, and a policy of using rates to simulate rather than stimulate growth, the same basic macrofinancial policy for a generation. Each administration exploited the situation a little more than the last, until by Dubya II we are floating higher than a loony tune.

    And PeripheralVisionary: ” . . . [L]ower levels of trade and capital flows are inevitable.” I don’t think that they are inevitable, now, but lower capital flows are assuredly desirable, which implies that lower trade levels will follow. Big Money wants big growth, and to them that means big trade, and increasingly big money churn, so they are going to have their way until they’ve killed most of the money. Another ten-twenty hears of decreasing returns in fits and starts, _I_ think, but we can start planning and advocating for an alternative now.

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