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«We may end up with a zombie market»

Mohamed El-Erian, chief economic adviser at Allianz, worries about the structural damage the current crisis might inflict.
Martin Lüscher, New York

When Mohamed El-Erian speaks, investors listen. The chief economic advisor at Allianz is well versed when it comes to navigating the global financial markets and explaining complex developments in a comprehensible way. In 2009, the internationally renowned economist coined the term «New Normal»: an economic environment with weak growth and historically low interest rates. Now he fears a new «New Normal» as a result of the coronavirus pandemic: a growth environment dampened by further structural impediments.

Dr. El-Erian, what worries you the most these days?
The risk that short-term damage to the economy and society becomes long-term structural damage.


About Mohamed El-Erian

Mohamed El-Erian is chief economic adviser at Allianz. Before that, he chaired President Barack Obama?s Global Development Council (2012 ? 2017), headed the operational business of US bond giant Pimco, was Co-CIO with Pimco-founder Bill Gross (2007 ? 2014), was president and CEO of Harvard Management Company, the entity that manages Harvard’s endowment, was managing director at Salomon Smith Barney/Citigroup in London and spent 15 years with the International Monetary Fund in Washington. He received his doctorate in economics from Oxford University and has written several New York Times bestsellers – his last book was published in 2016: «The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse».


What damage do you mean?
Everything from liquidity problems for companies becoming solvency problems and causing massive bankruptcies to defaults in developing countries to social divisions, because once again the most vulnerable segments of the population are suffering the most, to lots of small companies going bankrupt and we end up with a massive concentration in the economy. So my main concern is what hopefully is a short-term reversible shock becomes a long-term structural headwind to economic prosperity and social well-being.

Is enough being done?
It has taken time for people to realize how much of a shock this is. Now there is a recognition that not only is this a significant challenge. It is a generational moment. A lot depends on how we address this challenge not just for the current generation, but also for the next generation. But there isn?t enough focus on distinguishing between a journey and a destination or distinguishing between war and peace. We risk repeating the mistake we made in 2008 and 2009 coming out of the global financial crisis.

What mistake was that?
We succeeded in the economic war against an economic depression, but we failed in securing a peace of high, inclusive, and sustainable economic growth. We may end up repeating the mistake, which is doing the right thing, winning the war against a depression, but failing to secure peace.

You coined the term «new normal» after the crisis.
After the financial crisis structural damage that had been accumulated by the global economies impeded high, inclusive, and sustainable growth. I worry that we?re going to come out to a new «new normal» that has the elements of the «new normal» but has three additional impediments to high, inclusive, and sustainable growth: less productivity, less dynamic demand, and higher debt.

How bad do you think the crisis will get for the economy?
It?s very uncertain right now to answer that question with a high degree of confidence. A lot depends on the health issue. Whatever projections are made out there, they have a high risk of error.

The IMF is forecasting that the economy in the US shrinks 5,9% this year.
That is too optimistic. The IMF?s most recent predictions that came out last week were a significant revision from January, but they are still too optimistic. It will likely be a lot worse than the forecasted -5,9% in the US and -7,5% in the Eurozone. We are looking at -10%. ECB president, Cristine Lagarde, is warning governments in Europe that we could see even -15%.

Why are predictions still too optimistic?
There is a cognitive failure – a failure of analysis and also of models. We are deeply wired in the advanced countries to think in terms of cyclical economics; in Vs and Us. It?s hard to appreciate the structural side. That?s why, after the global financial crisis, the predictions consistently underestimated the weakness of growth. The second reason is that people are relying on historical models. Those historical models are simply not calibrated for what we?re going through now.

How do you rate the recent actions by the Federal Reserve?
I am very supportive of the Fed intervening in markets to ensure their smooth functioning. What the Fed did with respect to Treasuries was very important. What it did with respect to money markets was very important. All that was about and is about ensuring that liquidity problems don?t spill over to the real economy.

What about buying high yield?
That step went too far. I get worried when the Fed goes down the capital structure all the way to high yield. Because first, when you go all the way to high yield, you start picking winners and losers. Second, you start taking on significant default risk. Third, you become more of a fiscal agent. Fourth, you encourage a massive amount of moral hazard.

What?s next?
I hear people in the equity markets say, well, if the Fed is willing to go all the way to high yield, it?s only one step more, and it will be buying equities. Because after all high yield is just above equities in the capital structure. So they say that they might as well buy stocks because the Fed will bail them out.

Why would that be a problem?
We risk coming out of this not only with zombie companies, companies that take away productivity growth, but if we?re not careful, we may end up coming out with a zombie market, a market that no longer allocates capital properly.

Do you think that the Fed will buy equities?
I do not. But I didn?t expect the Fed to buy high yield either.

Is the Fed putting in danger its independence?
Absolutely. It?s acting more and more like a fiscal agency. It?s going to expose itself to significant political risk, as well as reputational risk.

But at least it?s preventing a crisis in the financial markets.
There are better ways to do that. There is this notion in game theory that it matters whether you?re playing one round game or a multi-round game. Governments and central banks have stumbled into something that companies have not, which is in assuming that this is one round game. They think that this is an awful period in our time, but that we will get over it and then we go back to the old normal. That is a big mistake. If you go to high yield at this stage, you are reducing your flexibility for what you can do later on.

The US-Government has also started bailing out industries.
The airline industry was treated as an exception. But it turns out that the airline industry is not an exception at all. There are many segments that are experiencing the same phenomenon, which is a simultaneous destruction in both demand and supply. It?s essential to figure out what to do.

Does the US have a structured bailout mechanism?
We don?t. The political system in the US is reacting in an ad hoc fashion to this systemic crisis. That?s a concern. I am very sympathetic to what I call the fog of war decision making. You?re in the middle of a war, and there?s fog everywhere. You don?t have clarity and you can make mistakes. The worst thing about crisis management is if you make the best the enemy of the good. Because if you make the best the enemy of the good you don?t move. Having said that we now have more clarity on what has hit us. It?s time to course-correct on several issues.

What should be corrected?
When it comes to corporate bailouts, there should be a set of principles that governs who you bail out, how you do so, on what terms, and what is the exit strategy. Instead, we?re going to end up with what I call a spaghetti bowl of public sector entanglement with the private sector.

What is the biggest problem with that?
I go back to that it?s not just about winning the war; it?s also about winning the peace. A spaghetti bowl entanglement of the public sector in the private sector will eat away at productivity. We?re going to emerge from this crisis with higher debt. The last thing we want is impediments to our ability to grow out of that debt. That?s why it?s essential to start looking at what the destination looks like. Make sure that we don?t make the challenge for this and the next generations even harder.

In what sectors are you expecting bailouts?
We are going to see it in the energy sector. At the same time, there is a big debate as to whether we should accelerate the journey to a green economy. Should we use money to bailout polluting industries or should we look into the future and keep that money and support a more sustainable growth prospect. These are questions that haven?t been debated. Because the political system is understandably responding to whatever pressure, whatever lobbying it feels immediately. There?s a notion that we should protect all shareholders. But bailouts should be about protecting people, not shareholders.

What about the policies that support people directly?
Ironically, we have accelerated the application of two theories that consensus dismissed as unrealistic. One is the Universal Basic Income. The other one is Modern Monetary Theory. In just a few weeks, both are being implemented. One of my daughter?s received a check for $1,200 from the government.

But that?s a one-time thing.
The lines at the food banks aren?t getting any shorter. The latest jobless claims were at 4.4 million. That?s over 26 million since mid-March, almost 17% of the labor force. Just like there was enormous pressure on the government to replenish the Paycheck Protection Program, there will be tremendous pressure to send out checks again.

Will all this government spending lead to inflation?
That is difficult to say. There?s no doubt that if you come out with an economy that is less productive and that has higher debt, the inclination of that economy is towards higher inflation. The reason why I?m not answering decisively is that I don?t know how risk-averse the consumer will be after this crisis.

Will the consumer be spending less?
One view is that we are going to get a repeat of the frugality that the generation that went to the great depression had. They increased their precautionary spending. That has been a problem in Japan. On the other side, the argument is that the consumer can?t wait to go back into the malls. I don?t know where we?ll come out of this because there isn?t enough data. While the supply side tells you yes, we are heading towards higher inflation, we may get a deficiency of aggregate demand.

What other consequences will the crisis have?
There will be a rewiring of the supply chains with a home bias. This rewiring means a less productive economy in the short term. We are also going to see a shift from physical to virtual. Some companies that only live in physical space are going to have more difficulties. If you?re a retailer that relies on big malls and that?s the only presence. Then you got problems.

And on the demand side?
There will be worse inequality trifecta: inequality of income, wealth, and opportunity.

What should investors do right now?
Investors should be going through the tedious job of going name by name and asking two questions. Is this holding well placed to manage a very bumpy journey? The question is, can it avoid default? Most investors? mistakes are recoverable over time, but there?s one that?s not, and that is when there is a default. And the second question is how well placed is this company for the post-crisis landscape.

Did the stock market reach the bottom in mid-March?
I don?t know. I don?t think anybody knows. What we do know, is that what drove that very sharp drop, the fastest correction in history, wasn?t just economics, but it was also liquidity. In the run-up to this crisis, investors were underestimating liquidity risk. They had gotten used to so much money being pumped in by central banks that they had stretched well beyond their typical habitat and had taken on a lot of liquidity risk. The first shock was so violent because it wasn?t just reacting to economic fundamentals, but also a change in the liquidity paradigm. Most of that liquidity shock has been countered by central bank activity.

And markets started to rise again.
Let me give you a ridiculous number. The PE-ratio today is the same as the PE-ratio of the high of February.

One could conclude that the stock market is too optimistic.
The stock market is too optimistic in that it thinks it?s in a win-win situation. It thinks it wins if the economy comes back very quickly. And it thinks it wins even if the economy doesn?t come back quickly because it thinks that the Fed will buy equities. That is not a bet I am willing to make. But I can understand why other people would make it. People have been conditioned to bet on central banks. It?s a strategy that has worked extremely well.