Per Jacobsson Foundation Lecture
Click here to watch a video of the lecture on the International Monetary Fund's website.
I. Introduction
It is a great pleasure for me to appear in front of you today to deliver the 2010 Per Jacobsson Foundation Lecture. At the outset, please allow me to express my deep appreciation to the Board of Directors of the Foundation. Thank you very much for this great honor, for allowing me to reconnect with friends and acquaintances here in Washington, DC, and for deepening a personal tradition that started for me in 1982 when I attended my first Per Jacobsson lecture.
As someone who has had the privilege to learn and operate in many different cultures and countries, I feel particularly honored to be invited by a Foundation whose purpose is "to foster and stimulate discussion of international monetary problems, to support basic research in this field, and to disseminate the results of these activities."� At the same time, however, I must admit to you that my delight comes with a certain degree of personal discomfort.
It is intimidating to follow the outstanding people who delivered past lectures and who truly meet the Foundation's description of "persons of the highest international qualification and eminent experience in the world of international finance and monetary cooperation."� Indeed, I have had the honor over the years to interact with many who have spoken on this special occasion. Having also worked directly with some of them"”including Abdelatif Al-Hamad, Michel Camdessus, Andrew Crockett, Jacques de Larosiere, Stan Fischer, Alan Greenspan, Guillermo Ortiz, Raghu Rajan, and Larry Summers"”I can tell you with a high degree of confidence that I am a negative outlier"”the left tail of the distribution if you like! (And you will hear me talk a lot today about distributions and their tails.)
Given this reality, what could I possibly contribute to such a prestigious gathering?
My hope is to share with you an analysis of the global economy based on a rather eclectic approach that combines academic and policy dimensions with the daily realities of working at an investment management firm that is deeply involved in global financial markets. My presentation will be based on three, hopefully familiar, contextual hypotheses.
"� First, the international monetary system suffered a "sudden stop"� two years ago, 2 the adverse impact of which is still being felt today by millions, if not billions, of people around the world.
"� Second, the causes of the crisis were many years in the making and included balance sheet excesses, risk management failures at virtually every level of society, antiquated infrastructures, and outmoded governance and incentive systems in both the pubic and private sector.
"� Third, the dynamics coming out of the crisis management phase"”particularly the combination of deleveraging, re-regulation, debt overhangs and structural challenges in key industrial countries"”are combining with an accelerating secular re-alignment of the global economy to create what US Federal Reserve Chairman Ben Bernanke correctly called an "unusually uncertain outlook"�.3
In this context, my presentation will ask a simple, yet critical question about the disappointing effectiveness of post-crisis responses by both the private and public sectors in industrial countries: Why have outcomes consistently fallen short of expectations, and what are the implications?
In responding, I will refer to three specific examples which shed light on the ongoing dynamics complicating both policy and company responses. They are consequential for more than just what is being considered when it comes appropriate policy reactions, corporate strategies, and investment positioning; they also matter for the how and why.
They speak to challenges that were inadvertently misdiagnosed while others were placed in the wrong context or subjected to excessive operational restrictions. They also shed light on the view that the world has been ill-served by the understandable, yet regrettable temptation of using short-term mean reversion as shorthand for thinking about economic and financial dislocations.
Indeed, while industrial countries did well in the crisis management phase (think in terms of "winning the war"�), they have not done as well in the post-crisis phase (and thus are "losing the peace"�). As a result, too many industrial countries find themselves in a rather unsettling situation where expectations involve an unusually broad range of potential outcomes and equally unusually high risks.4 Increasingly, comforting images of normally distributed (bell curve) expectations"”characterized by a dominant mean and thin tails"”have given way to much flatter distributions with much fatter tails.
I will argue that this change is insufficiently recognized, even though it is a direct outcome of the three generally-accepted hypotheses just cited. Indeed, an unusual aggregation problem persists today: Multiple visible structural changes on the ground are not being sufficiently aggregated into an acknowledgment of the ongoing paradigm shift and in the formulation of appropriate responses"”particularly, though not exclusively, in industrial countries.
Recognition is the first part of meaningful course correction"”thus the objective of this lecture. And there is much at stake for the global economy.
The longer the recognition problems persist, the greater the risk of continued "active inertia"� and disappointing outcomes. The possibility of policy mistakes and business accidents will increase further; it will become harder for industrial country governments to convince their citizenry (as well as decision makers in emerging economies) to participate fully in the formulation and implementation of the required solutions; and multilateral institutions will not be able to fill the growing void at the core of the international system.
II. The Anatomy of a Global Financial Crisis
The domestic angle
Much has been written"”and much more will be written"”about the global financial crisis. Undoubtedly, there were many contributors. For a summary explanation, we can think in terms of multi-year balance sheet excesses and payments imbalances coinciding with the over-consumption and over-production of "innovative"� financial products which were only partially understood by consumers and too lightly regulated and supervised by prudential agencies.
As we now know, these innovative financial instruments were potent in lowering barriers to entry to many markets, including important segments of the US housing market. As a result, too many households purchased homes that they could not afford, using exotic mortgages they did not fully understand; and too many small companies took on debt they could not sustain. The situation was greatly aggravated by other lapses in risk management and misaligned incentives in both the private and public sectors.
Prior to the crisis, key industrial countries had embarked upon a multi-year, serial contamination of balance sheets. At PIMCO, we called it the great age of debt and credit-entitlements when massive leverage factories operated unhindered, and often outside the direct purview of regulators and even company CEOs (and thus the came to be known as the "shadow banking system,"� a term coined by my PIMCO colleague Paul McCulley).5
The initial phases of massive leverage involved the balance sheets of households and housing-related institutions. Soon, the balance sheets of banks were also contaminated. Consequently, the pinnacle of the crisis"”in September-October 2008"”disrupted the functioning of the international payments and settlements system.
Cascading market failures aggravated disruptive attempts at a massive and simultaneous deleveraging. The result was a sudden stop and a related, highly correlated collapse in economic activity around the world.
Governments and central banks had no choice but to step in with their own balance sheets to offset the massive deleveraging elsewhere. They did so in a bold and impressive manner, and they succeeded in avoiding a global depression.
Yet, like most things in life, this came with costs and risks. A new balance sheet was contaminated"”that of the public sector. And, once again, too many were subsequently surprised when as a new set of unthinkables and improbables became realities.
The multilateral angle
The 2008-09 crisis-management involved an unprecedented degree of effective cross-border coordination. It started here in Washington, DC at the October 2008 deliberations of the G's and of the IMFC, with the UK taking the lead. It reached its climax in April 2009 at the G-20 Summit in London.
It was global coordination at its best.6 Lecturing gave way to consultation and true collaboration. The commonality of focus and purpose was obvious to the markets, as was the alignment of narratives and interests. The design and implementation of measures were well coordinated. And, throughout this period, stubbornly hard-wired (and outmoded) concepts of global representation seemingly gave way to a greater acceptance of modern day realities.
The mix
The initial combination of effective national and global responses was highly successful in providing a floor for economies around the world. National authorities acted boldly to address cascading failures, and did so in a globally orchestrated fashion. A multi-year economic depression was averted, as was the tremendous suffering that would have been inflected on billions around the world.
Many emerging economies rebounded very quickly, in part because they had generally entered the crisis with much better initial conditions (including stronger international reserve cushions, greater policy flexibility, and smaller exposure to structured finance). In the process, they demonstrated the type of economic and financial resilience that would have been unthinkable just a few years earlier.
With the depression tail clipped, industrial country financial markets also found their footing. The sharp recovery in wealth (associated with the equity markets rebound) amplified the impact of government/central bank stimulus and the inventory cycle.7 Monthly job losses seemingly turned into accelerating gains, leading some to declare that the recovery had taken hold.
Unfortunately, such declarations proved premature, especially for the US and Europe. They also highlighted insufficient recognition of the potent mix of economic, political and social forces in play. Soon, the pace of job creation slowed, talk of a "recovery summer"� faded, GDP projections were revised significantly downwards, and the risk of a double dip and/or deflation rose.
III. Post Crises Realities
Crisis management is hard, very hard. Leaders must act urgently, and with only partial information. Policy imagination and boldness are needed to overcome malfunctioning transmission mechanisms. There is often little time to create the broad social consensus that is required to support strongly the legitimacy of the policy response, let alone time to make the mid-course corrections which are inevitably required.
In the post crisis phase, societies must also deal with the unintended consequences of the crisis management period. Inevitably, policy responses are second-guessed. Fairness issues feature more prominently. And the initial policy convergence formed in the midst of the crisis gives way to fragmentation and excessive political brinksmanship. Indeed, governments are often replaced by an electorate that is seeking greater accountability for the crisis.
None of this is news for emerging economies. Yet it has come as a surprise to too many in industrial countries. Indeed, there has been a distinct resistance among many policy makers to apply "emerging markets lessons"� to some of the challenges their countries are facing"”despite the important insights that such an approach can, and has provided.
The recent global financial crisis has also left an important balance sheet legacy. In particular, many industrial countries did not have sufficiently sound initial conditions to accommodate the massive use of public sector balance sheets.
Related concerns about debt and deficits have added industrial country sovereign risk to an already substantive list of systemic concerns"”a list that includes (still) overly-levered balance sheets elsewhere (albeit not to the same extent as before); unacceptably high and persistent unemployment; regulatory uncertainty; and political complications (namely, a situation where the economically desirable is not politically feasible, and the politically feasible is not economically desirable).
Fragilities are also evident at the global level. As countries' circumstances evolve differently post crisis, the delegation of national authority upward to multilateral institutions and groups has become difficult once again, especially as strong and credible global governance mechanisms are still lacking.
Sustaining a high degree of global coordination (or, if you are less charitable, maintaining a high level of "correlated actions"�) beyond the immediacy of a crisis is inherently hard"”a reality that adds to the complexity of post crisis periods. Sadly, a once promising global response has now been replaced by inadequately coordinated national economic policies and growing frictions among countries. Moreover, with an over-simplification of the debates (e.g., "austerity now"� versus "growth now"�), obsession with corner solutions has tended to obfuscate the critical policy nuances in play.
It is not surprising that the impressive degree of global coordination highlighted by the April 2009 G-20 meeting did not last long. It only took a few months for that moment of extraordinary collaboration to give way to solely domestic agendas. 8 Indeed, and ironically, it is precisely the success of globally coordinated policies which has allowed countries the luxury of returning so quickly to the pursuit of overly-narrow national agendas.
IV. The Situation Today
In the course of the second and third quarters of 2010, it became clear to many that both policymakers and markets had wrongly extrapolated a cyclical bounce in industrial countries, erroneously concluding that the apparent recovery had developed secular and structural roots.
Today, policymakers in industrial countries"”and especially in the UK and US, where a large bet was made on finance"”find themselves facing an important set of challenges on the "bumpy journey to a new normal."�
We coined the term "new normal"� at PIMCO in early 2009 in the context of cautioning against the prevailing (and dominant) market and policy view that post crisis industrial economies would revert to their most recent means.9 Instead, our research suggested that economic (as opposed to financial) normalization would be much more complex and uncertain"”thus the two-part analogy of an uneven journey and a new destination.
Our use of the term was an attempt to move the discussion beyond the notion that the crisis was a mere flesh wound, easily healed with time. Instead, the crisis cut to the bone. It was the inevitable result of an extraordinary, multi-year period which was anything but normal.
Also importantly, the new normal concept was not an attempt to capture what should happen. Instead, the concept spoke to what was likely to happen given the prevailing configuration of national and global factors"”some of which were inherited, and others that were the consequences of the choices being made. Put another way, the new normal postulated the world that would evolve absent a significant change in policy and business approaches.
Read Full Article »