Tuesday, June 16, 2009
Hold on tight for a bumpy ride to the 'new normal'
By Mohammad El-Erian Published: June 16 2009 03:00 Last updated: June 16 2009 03:00 Most investment professionals I meet are no longer hesitant to talk of their experiences in 2008. The phenomenon is reminiscent of a group that, having survived a near-death experience, now feels the need (and has the confidence) to talk about it. This is understandable. Last year's shocks have given way to a greater sense of stability in financial markets. Yet it would be wrong to conclude that we are returning to "business as usual". The next few quarters will be about the aftershocks, driven not by a financial system in disarray but by the lagged reactions of the real economy, the political system and the financial services industry. At its most fundamental level, 2009 is about the interaction of three factors: the healing of financial markets, second-round economic and political effects and partial reconfiguration of the longer-term landscape. We face the challenge of navigating a bumpy journey to a "new normal". The answers to four basic questions are the key to addressing this challenge successfully. First, how far will the balance shift from markets to governments? Industrial nations' governments are getting more involved in modes of production, exchange and distribution - see the US, long committed to minimum state involvement. The drivers of more government involvement in markets are primarily non-commercial. Entry is dictated by a desire to offset market failures and exit is often delayed by the lobbying of those favourably affected by such interventions. The risk of the latter is higher when market interventions lack a clear notion of when and how governments will exit, as well as delays in addressing unintended consequences. Business leaders now need to design strategies that recognise a more influential public policy risk factor. Second, how will governments finance their growing involvement in the economy? Markets are increasingly worried about the longer-term cost of the rise in public sector borrowing. Given the huge numbers, policymakers must find a way to upgrade liability management approaches. They must also signal their intention credibly to return to longer-term fiscal sustainability through the generation of meaningful primary budgetary surpluses. Neither is easy. Yet the impact is far from straightforward. For example, we also have the Federal Reserve buying Treasuries, agencies and mortgages in the secondary markets. This means that with the Treasury as seller, we have two non-commercial players on different sides of the bid/offer in benchmark markets that also influence the levered financing of other instruments further down the risk spectrum. Third, to what extent will this alter the role of the US in the global economy? The US supplies two critical global public goods: the reserve currency and deep and predictable financial markets. The rent it collects has allowed the US to contain funding costs and gain macro-policy flexibility. The greater the questioning of these public goods, the more investors will reduce their large exposure to US assets. As such, the US may find it more difficult to operate like a large closed economy at a time when it has become a more open economy that is losing its size advantage gradually. Fourth, how far will governments go in de-risking the financial system? The economic crisis of 2009, characterised by high and rising unemployment, is a result of the financial crisis of 2008. Expect even louder reactions from politicians, especially those facing elections in the next two years. The politically driven de-risking reduces the credit that lubricates economic activity. While limiting systemic risk, this lowers the potential rate of growth and fuels significant consolidation in the financial services sector. These four issues are consequential and call for a re-tooling of mindsets, institutions and approaches. Those who recognise this will fare better during a year that promises both the best and worst of times for businesses.