- - El-Erian Breaches The Final Frontier
Submitted by Tyler Durden on 04/12/2012 12:45 -0400"In the last three plus years, central banks have had little choice but to do the unsustainable in order to sustain the unsustainable until others do the sustainable to restore
sustainability!" is how PIMCO's El-Erian introduces the game-theoretic catastrophe that is potentially occurring around us.
In a lecture to the St.Louis Fed, the moustachioed maestro of monetary munificence states "let me say right here that the analysis will suggest that central banks can no longer – indeed, should no longer – carry the bulk of the policy burden" and "it is a recognition of the declining effectiveness of central banks’ tools in countering deleveraging forces amid impediments to growth that dominate the outlook. It is also about the growing risk of collateral damage and unintended circumstances." It appears that we have reached the legitimate point of – and the need for – much greater debate on whether the benefits of such unusual central bank activism sufficiently justify the costs and risks.
This is not an issue of central banks’ desire to do good in a world facing an “unusually uncertain” outlook. Rather, it relates to questions about diminishing returns and the eroding potency of the current policy stances. The question is will investors remain "numb and sedated…. by the money sloshing around the system?"
Today, I will ignore the professor’s advice in multiple ways. I will speak in a central bank and to central bankers about the role of their institutions – particularly the Federal Reserve and the European Central Bank – in today’s highly complex, perplexing and historically unusual policymaking environment. I will go further and try to link actions to motivations. And, when it comes to implications, I will attempt to put forward questions and hypotheses that, I believe, are critical for the future of the U.S. and global economies but for which I, like others, have only partial answers.
I do all this for a reason. I believe that, whether you look at the U.S. or Europe, central banks have essentially been the only policymaking entities consistently willing and able to take bold measures to deal with an unusually complex set of national, regional and global economic and financial challenges. In doing so, they have evaluated, to use Chairman Bernanke’s phrase, an “unusually uncertain outlook;”3 they have confronted some unknowable cost-benefit equations and related economic and political trade-offs; and, in some cases, they have even had to make things up as they go along (including moving way ahead of other government agencies that, frustratingly, have remained on the sideline).
The result of all this is a global configuration of previously unthinkable monetary policy parameters. While their immediate effects may be known, the longer term ones are less clear, and yet they are important for the wellbeing of millions around the world.
Moreover, there is already evidence to suggest that the impact could well alter for years some of the behavioral relationships that underpin the traditional formulation and effectiveness of the trio of policies, business plans and financial investment positioning. Accordingly, it is critical that all of us – policy makers, business leaders, investors and researchers – work to understand why so many unthinkables have become facts, why the outlook remains unusually uncertain, and what changes are needed to limit the risks of further disruptions and bad surprises down the road.
For those who are eager to get to the bottom line of my presentation, let me say right here that the analysis will suggest that central banks can no longer – indeed, should no longer – carry the bulk of the policy burden. This is not a question of willingness or ability. Rather, it is a recognition of the declining effectiveness of central banks’ tools in countering deleveraging forces amid impediments to growth that dominate the outlook. It is also about the growing risk of collateral damage and unintended circumstances.
It is high time for other agencies, in both the public and private sector, to step up to the plate. They should – indeed, must – use their better-suited instruments to help lift impediments to sustainable non-inflationary growth and job creation. In other words, it is about improving the prospects for higher economic activity and, therefore, “safe de-leveraging.”
This is not to say that central banks will no longer have an important role. They will. Specifically, in what may gradually morph into an increasingly bi-modal distribution of expected outcomes in some parts of the world (such as Europe), central banks could find themselves in one of two extremes: At one end, they may end up complementing (rather than trying to substitute imperfectly for) policies by other agencies that put the global economy back on the path of high sustained growth and ample job creation. At the other end, they may find themselves having to clean up in the midst of a global recession, forced de-leveraging and disorderly debt deflation.
Finally, there is a real question about how the overall global system will evolve. Most agree that its Western core is weakened and multilateralism is challenged. As a result, the system is likely to struggle to accommodate the development breakout phase in systemically important emerging economie and absorbing the de-leveraging of finance-dependent advanced countries. What is yet to be seen is whether the outcome will be a bumpy transition to a more multi-polar global system, or the healing and re-assertion of a uni-polar one.
The key hypothesis
To crystallize our conversation today, allow me to use a very – and I stress very – clumsy sentence to summarize the current state of affairs: In the last three plus years, central banks have had little choice but to do the unsustainable in order to sustain the unsustainable until others do the sustainable to restore sustainability!
To translate this purposely awful sentence:
- Central banks have had to innovate and stretch policy tools and mandates, including the use of liquidity facilities and communication, to render less disorderly a set of fundamental multi-year economic and financial re-alignments.
- While initially successful – indeed, critical to avoid a global depression – the policy stance, both here in the United States and over the Atlantic in Europe, appears now to increasingly involve an unfavorable change in the balance between what Chairman Bernanke has labeled as the “benefits, costs and risks.”
- Having built a bridge for other policymakers and for healthy balance sheets in the private sector, central banks must now hope that a more timely, comprehensive and effective response will finally be forthcoming (and push for it, as appropriate).
- Should this fail to materialize, central banks risk finding themselves having built expensive bridges to nowhere and, accordingly, will come under severe pressure with implications for the future of central banking itself, as well as for the welfare of economies at the national, regional and global levels.
- Meanwhile, the ripple effects from central bank policies will increasingly be felt in the functioning and, in some cases, viability of whole segments of the financial markets – thus adding to the need for both public and private entities to become more intellectually and operationally agile.
The best way to get a handle on the unusual activism of central banks is to look at Chart 1. Central banks in advanced economies have ballooned their balance sheets to previously unthinkable levels – be it an astonishing 20% of GDP for the Fed or 30% for the ECB.
These unprecedented – indeed, improbable – numbers have been accompanied by other steps also deemed unthinkable not so long ago. In the case of the Fed, the securities purchase program (QE2) has been supplemented by operation “twist” and the aggressive use of the communication tool, including signaling that economic conditions “are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”5 The FOMC has also disseminated individual members’ forecasts for key macro variables and the policy rate.6
The ECB, not so long ago considered a “Germanic” central bank, has undertaken a range of quasi-fiscal operations – from outright purchases of sovereign bonds under its SMP, including those subject to material credit/default risk, to a relaxation of collateral requirements and the extension to three years in the maturity of a massive 1% “liquidity” facility (the LTROs, or long-term refinancing operations). Having said this, the ECB has been less willing than some other central banks to take credit risk completely out of the market.
In assessing all this, and for presentational simplicity, we can think of central banks as having been involved in two distinct, but of course inter-related, operations since the breakout of the global financial crisis in 2007/08: first, crisis management, including minimizing the risk of a liquidity sudden stop (and related market failures) translating into a major economic depression; and second, maximizing the prospects for a resumption in growth, employment and inflation containment.
The first dealt primarily with the functioning of markets while the second spoke to targeting economic outcomes. Let us discuss each in turn.
The context
The first set of actions, be it the series of emergency facilities activated by the Fed in late 2008/early 2009 or the steps taken by the ECB back then and again more recently, were aimed at breaking the back of a particularly nasty set of multiple equilibria – what Olivier Blanchard, the chief economist at the IMF, described as “self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications.”
Think here of the series of path-dependent outcomes that have usually occurred in the debt crises experienced by emerging economies. As shown in a recent paper,10 the underlying dynamics combine endogenous expectation formation with influences on behavior and hence market outcomes. These dynamics are subject to overshoots in the absence of credible circuit breakers. Specifically, a move to a bad (good) outcome increases the probability of a subsequent movement to an even worse (better) situation. It becomes even more difficult for policymakers to agree on the analysis, let alone the solutions. Meanwhile, the social and political costs increase in a non-linear fashion, making it even harder to recover quickly.
The emphasis in such situations is to boldly break the path-dependent dynamics; and to do so by directing emergency policy measures to address specific market failures as well as strengthening firewalls. General Colin Powell’s doctrine is often used here as a guiding principle, including its important qualifier about avoiding costly entanglements via plausible exit strategies alongside a clear intention for such interventions to be both temporary and reversible.
This phase was highly effective in the U.S. Think of the Commercial Paper Financing Facility (CPFF) and other measures deployed in the fourth quarter of 2008 and the first quarter of 2009. Starting from where large and multiplying market failures were fueling sudden stops around the world, these policy measures contributed to a return of a more “normal” functioning of markets and, as such, both the disturbance and the policy measures proved largely temporary and reversible, thereby allowing for a handoff back to the private sector.
In Europe, the outcome has been more mixed. The ECB’s ample liquidity provisions, and in particular the powerful 3-year LTROs, have had a significant impact on bank liquidity and meaningful segments of the sovereign debt markets. Yet they are not a panacea for insolvency risk, exit risk and insufficient growth. As a result, some market segments remain impaired. Too many participants still prefer to face the ECB as a counterparty, as opposed to facing each other. Moreover, with the debt crisis still ongoing and bank fragility not yet eliminated, it is too early to make a definitive assessment.
Now for the experience with the second phase – that aimed at securing certain economic outcomes. Finish reading>>
