The noted economist Mohamed El Erian’s latest book The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse, is being released worldwide today.
A former chief executive of Pimco the bond fund, and currently chief economic adviser at Allianz, El Erian is also chairman of the US president Barack Obama’s Global Development Council.
In his new book, the author identifies 10 main challenges to the global economy: inclusive growth; long-term unemployment; inequality; a lack of trust in institutions; national political dysfunction; insufficient global policy coordination; the migration and morphing of financial risks; the delusion of ample liquidity; the gap between financial markets and fundamentals; and an overall economic environment that can frustrate growth.
Trying to cut through this jumble is where central banks come in, hopefully for the better, he writes in this exclusive excerpt.
The well-being of current and future generations depends on successfully addressing the 10 big issues just outlined. By now, I suspect or at least hope that they are on the radar screens of every major central bank around the world. If they had the tools, they would be addressing them more effectively, conscious of how much is at stake. I would even venture that central bankers would willingly embark on a reinvigorated policy path even if they were initially incapable of identifying the entirety of the required response and its consequences.
I also suspect that central banks agree that time is of the essence. The longer these issues persist, the more entrenched they become in the global economy, the greater the adverse feedback loops and, consequently, the harder the solutions become. The longer we wait, the harder it gets.
Self-interest also plays a role here. Being “the only game in town” means that central banks are especially vulnerable to the winds of political backlash should economic mediocrity continue and financial instability return. This is particularly important in a world in which unconventional monetary policy is also altering the configuration of financial services, actively taxing one segment of the population to subsidise another, and visibly inserting public sector institutions in the pricing of financial markets and the resulting allocation of resources. Rather than just act as referees, central banks have also taken the field in quite a range of sports.
In the United States, there are already mounting legislative attempts – unsuccessful so far – to subject the Federal Reserve to greater scrutiny, auditing and accountability. Should any of these attempts gain traction, these institutions’ operational autonomy and policy responsiveness would almost certainly be undermined. With that, yet another important component of policy management would be unduly constrained, limiting the ability of the system to address challenges to its economic and financial well-being. It would be the equivalent of a boxer competing with both hands tied behind his back.
Across the Atlantic, an even greater sense of irritation is visible and growing, fuelled by economic underperformance and the horrid crisis in Greece. In Germany, for instance, politicians increasingly feel that the ECB has gone too far in constantly trying to support governments that delay reforms and instead are enabled to act on their inclination to overspend. They also do not like the way that the ECB is perceived to be following the Fed in taxing savers in order to subsidise borrowers. And being inherent savers, they lament the extent to which artificially repressed interest rates are undermining institutions that provide longer-term financial services, be it life insurance or pensions.
Rumblings are also evident within the halls of monetary institutions themselves. Already, some “hawkish” central bankers on both sides of the Atlantic have publicly expressed concerns about institutional mission creep. For them it is not just about the extent to which central banks have had to venture into experimental policy space, using untested instruments and doubling down on them. It is also about what they perceive as a tendency by the central banks to expand beyond their traditional policy purview, taking on too many responsibilities.
Before stepping down in March 2015 as president of the Philadelphia Fed, Charles Plosser stated that he worries about “the longer-term implications for the institution. Part of my criticism has been that we have pushed the boundaries into fiscal rather than monetary policy … What happens to our independence? What happens to our ability to do things effectively?” Other figures, including some not already known for hawkish tendencies, stated similar opinions.
Speaking in London on March 23, 2015, James Bullard, the thoughtful president of the St Louis Fed, warned on the risk of artificially low interest rates causing damaging financial bubbles. “Zero is too low in that kind of environment.” In saying so, he was reinforcing one of the messages that Fed vice chair Stanley Fischer had delivered on several occasions; indeed, Stanley Fischer had just reiterated it that week in his speech to the Economic Club of New York, warning that markets would be ill-advised to behave as if zero rates were anything other than an anomaly that needs to be corrected.
Yet none of this has been decisive in stopping central banks from being the only game in town – so much so that it has become quite common for them to be even more dovish than what they have conditioned financial markets to expect. Just look at how, to the surprise of many given the controversial nature of the policy step and the divided set-up in the governing council, the ECB opted in January 2015 for a new large-scale asset purchase programme that was larger and more open-ended than consensus market expectations. And look at how, in removing the word “patient” from its policy statement in March 2015, the Fed went out of its way to remind markets that this did not mean it would be impatient.
What can they do?
At every occasion, central banks have erred on the side of short-term caution, almost irrespective of the longer-term consequences. And this will not change any time soon. Indeed, even when they embark on removing all the exceptional monetary policy stimulus – a process that the Federal Reserve will lead given the more advanced stage of economic healing in the United States – the result will be what I have called the “loosest tightening” in the history of modern central banking.
Whichever way you look at it, there should be little doubt about central banks’ motivation and therefore willingness to take action to generally maintain the current path until reinvigorated growth helps address the 10 issues discussed in the previous part. Both are huge. But central banks also know well that these are not just their issues – the global system as a whole is in play and multiple policies are required, including crucial ones that go beyond central banks. And it is just a matter of time before the realisation sinks in that motivation and willingness, no matter how strong, may not be sufficient to deliver effectiveness and, therefore, the desired outcomes.
It needs to be stressed that the fundamental problem confronting central banks is their ability to effect systemic and lasting change. And here there are grave uncertainties.
No one should doubt that if they remain “the only game in town,” there is a very real chance that central banks will go from being part of the solution to being part of the problem. Moreover, the destiny and future standing of central banks are no longer in their own hands.
There isn’t much central banks can do to improve countries’ growth engines. These institutions have neither the expertise nor the mandate to pursue reforms in education and labour markets. They are not in a position to lead national and regional infrastructure drives. They simply do not have the power to influence fiscal reforms, let alone impose them.
So what can they do? A few small things, though they are limited and unlikely to prove decisive as long as other policymaking entities remain on the sidelines.
Central banks can do a little bit more when it comes to the problems of inadequate demand and debt overhangs – though, again, we need to understand that because they are just one part of the required policy response, their efforts come with unintended consequences, including increasing the risk of financial instability down the road.
A few small central banks can also try to facilitate economic recovery by making their individual currencies more competitive – though you will never hear them say so. Indeed, even when some G7 member countries de facto embarked on such an approach, they found it necessary to obfuscate the issue by stating that they were not in fact pursuing such a path!
Despite some obfuscation (meant essentially to stop any talk of “currency wars”), the policy approach is quite straightforward. A weaker exchange rate is meant to boost activities of both export-orientated companies and those whose domestic sales compete with foreign-supplied goods and services. But again, effectiveness is far from complete, and, again, there are costs involved as noted above, including the risks of triggering a currency war. After all, and critically, not every country can devalue at the same time.
Finally, when it comes to policy coordination, the problem is not with central banks. Of all the economic agencies across the globe, they remain the gold standard when it comes to consultation, sharing ideas, and, when needed, applying coordinated action. And what they do is greatly facilitated by one of the best-kept policy secrets in the world of policy coordination – those highly effective and regularly scheduled meetings held in Switzerland.
Having been invited as an external speaker to a few of these meetings, I have come to appreciate their effectiveness, and this despite the fact that I have been only partially exposed to what goes on in that circular building across from the train station in the Swiss city of Basel. Held away from the cameras and fanfare of the press, the BIS (Bank for International Settlements) gatherings are said to provide for a rather candid exchange of views that in recent years has involved a larger number of systemically important countries. They have also greatly facilitated the critical emergency institutional phone calls that are required during periods of crises. Indeed, I have yet to meet a central bank official who has not praised BIS as the best gatherings for frank and effective policy exchanges.
The problem with the central banks is not lack of a venue or a conductor. It’s that those present in the room lack a full orchestra – their instruments are limited. No matter how well they discuss and coordinate, they can offer only partial solutions to vast and deeply entrenched problems.
But one thing they can do, and have been doing, is to continue to try to intelligently buy time for other policymaking entities, with tools better suited to implement the four policy components discussed above to get their act together. As these entities are already quite late, and as central bank bridging is far from a costless or riskless exercise, our current circumstances will yield a rather unusual distribution of potential outcomes for the next few years, ones that will challenge our comfort zones, whether we are individuals, companies or governments.
Copyright © 2016 by Mohamed El Erian
Published by arrangement with Random House, an imprint and division of Penguin Random House.
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