Interview with Mohamed El-Erian/ YOICHI FUNABASHI, Editor in Chief: After crisis subsides, investment nations can expect muted growth

Editor's note: This is the third installment of an interview series that appeared in the vernacular Asahi Shimbun under the title "Brave, grave new world."

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The world has just experienced a rare financial crisis that attacked the core, rather than the periphery, of the system, the leader of one of the largest bond investment companies says. Now, we are entering a "new normal" period, in which the flow of wealth will change and investors need to hedge more against their mistakes.

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Question: Could you please elaborate on what you mean by "new normal"?

Answer: The crisis exposed very deep structural weaknesses in investment countries, the result of which is what we have labeled as "the new normal." Once a cyclical recovery or a cyclical bounce from the crisis has played its course, which is in the second half of this year, the global economy is going to be characterized by the following features that differ from what we have seen before.

First and foremost, we have the muted growth among investment countries as they overcome balance-sheet issues. And the balance-sheet problems are both in the private sector and in the public sector.

Secondly, we're going to see a change in regulation. We're going to see much more emphasis on stability. And that therefore reverses what was a great age of leverage, a great age of credit and a great age of debt entitlement. So we're going to have a reversal of the credit conditions.

Thirdly, we are going to see a much bigger role for politics in the economy. Political economy will become very important. One reason is because we expect unemployment to stay stubbornly high in countries. Another reason is because the politicians rightly cannot tolerate a system that privatizes massive gains and then socializes major losses.

And the fourth element is that we are going to see a number of structural conflicts arising; they will arise within countries and they will arise between countries. For example, we should expect greater trade tensions between the U.S. and China. You put all that together and it results in a world that accelerates the shift from West to East, from North to South. The only question is at what level does it take place.

Q: The situation of the United States, particularly in terms of public finance and debt as a percentage of GDP, is precarious. Are we witnessing a crisis of the developed, mature economies? Or, as exemplified in the case of Dubai, is this more of a global issue?

A: Yes, there are some important elements of what you cite. The first one is that the crisis happened at the core of the system, not the periphery. Normally, you get crises at the periphery. Now why is that important? Because a core-periphery system is built with the assumption that the core is strong, and the periphery is twice as strong. So the circuit breakers protect the core from the periphery.

This one is the crisis that happened at the core. And in particular, it happened in the United States. That's important because the United States is a provider of global public goods.

It has provided the dollar as a reserve currency. It has provided the U.S. consumer as the consumer of both first and last resorts in the global economy, it has provided the U.S. financial markets as the deepest and most predictable markets. Now, you cannot replace something with nothing. You cannot have other local public goods suddenly coming in. But we now have a system that has been weakened by the integrity of the public goods. Now that's very important because that suggested that there's going to be long-term implications.

The second element is that while the crisis happened at the core, some part of the periphery had that crisis earlier on. I tell people, if you're gonna have a large heart attack, it's better to have a small one first. Because if you have a small one first, you can change your behavior.

Q: What about Asia's economic crises in 1997 and 1998?

A: '97 in the case of Asia, '98 in the case of Russia, and 2001 in the case of Brazil. Because they had a small heart attack, by the time the big heart attack came, they were much better prepared to deal with it. So we have this funny situation that the periphery was much better prepared than the core was for a crisis. That is also historically unusual.

We had a whole host of activities that had been taking place that neither the public infrastructure nor the private infrastructure could handle.

Q: What do you mean by this infrastructure?

A: For example, in Europe, the most obvious one is that there are no instruments to handle Greece.

Secondly, we now are entering a period of more intense challenges for the global economy because the global economy has to make room for the break-out things in emerging economies. If you like, the mature investment countries have to step back and provide scope and scale to the emerging economies. They're finding that very difficult to do.

If you look at the debate on the quotas in the IMF--the voting power--it is glacial, the pace at which these investments are taking place. So the multilateral system cannot adjust quickly enough to the realities that have taken place.

Finally, regulation. We are finding that regulation is not able to react quickly enough, so some of the old habits in the financial markets--some of the very short-term focus that I mentioned earlier--is coming back. And it's coming because the regulatory response is taking time.

Q: What about the G-20? Will the world's major players try to respond to a global financial crisis by coming up with public goods or infrastructure?

A: Yes, the G-20 is one step in the right direction. And really, the G-20 didn't come into effective existence until April 2009, when it was clear that this was the global crisis of consequence and that you need a global reaction. Since then, unfortunately, we've seen that the energy and the enthusiasm of the G-20 has started to lapse. We're seeing the G-7 and G-8 come back from there, and that's because the G-20 is not yet anchored either by history or by institutions. So we have to institutionalize the G-20.

Now there are two ways to institutionalize the G-20. One way is to move it into an existing institution, which then takes us back to the reform of the IMF, the fundamental reform of the IMF. The Europeans are finding that a very difficult notion to accept. America and Japan are much more willing to accept that, but the Europeans are not.

The other way is to institutionalize the G-20 in itself; to build the G-20 infrastructure. There's again hesitancy to do that because that would be yet another multilateral body. While all this is being sorted out, we have seen a tremendous amount of regionalism taking place.

It's taking place in Asia. Europe is now talking about a European monetary fund, something which they have proposed for Asia, but are now talking about it. So there is a concern among the markets that while the multilateral approach is the right one, the regional approach may dominate.

Q: Will the G-20 function in the way that the G-7 did as a mechanism to correct global imbalances?

A: Yes, I think if you wanted a new body, you would take the G-7, you would thank Canada and Italy for their contributions, and say that the time has come to reinvent the G-7. You would say thank you, and now I would ask you to leave the club. You would have the G-5, and then you would add China, Russia, Brazil and South Africa, and make a G-9. The G-9 would be representative enough, but not too big, which is what the G-20 is.

Improving the G-7 and G-20

If you want a solution, we recognize that the G-7 is outdated, is outmoded, and we keep five of the seven and supplement it by four emerging economies. That would be a solution. As opposed to a cheap G-7, G-8 and G-20, all of which operate in different contexts, but unfortunately again you need leadership.

And typically that would be the United States, but the U.S. right now is inwardly focused and Europe has lost self-confidence.

Q: Do you think more fiscal discipline is required to overcome structural problems in the United States? Health-care reform could further worsen the fiscal situation over the next decade or so. Do you think that could really have an impact on the dollar's restoration?

A: I think of this in a sequential manner. So, the first thing is: The U.S. today faces a very unusual situation. The first thing is high unemployment. Now it's generally understood that the U.S. unfortunately will have persistently high unemployment. When you look at what a persistently high unemployment rate means for the U.S., it immediately points to the inadequacy of the social safety nets. Health is a part of the inadequacies of the social safety net.

So I tend to look at the health reform as being part and parcel of a society that has to recognize the need to strengthen its social safety nets.

So the first thing is I will put the health reform in the context of the bigger issue, which is: Does the U.S. have enough social safety nets to navigate this new normal of muted growth and high unemployment?

There are consequences to that. But the consequences speak to something much larger, which is a need to step back and look at the budget not through a cyclical mind-set, but a structural mind-set. We are still stuck in a cyclical mind-set.

If you look at the budgetary assumptions, they basically rely on growth coming back, and growth being the solution. We worry that growth might end up being what we call "immaculate growth"--it is not sure how you will get growth.

You need to think much more structurally about the deficit. Now, thinking structurally about the deficit brings you to issues that have to be addressed. A countrywide value-added tax. The first thing that should be on the table, that should be discussed is: What to do with entitlement now that provides me as much access to social security as someone who is less privileged.

So these are important issues that have to be put on the table and tackled earlier. The political system right now, especially the massive polarization ahead of the November elections, means that these things will not be looked at until after the elections, unfortunately.

Q: Japanese public deficit is almost 200 percent of GDP and getting worse. So Japan is in an even worse situation than Greece. What do you think will transpire with Japan's government over the next few years?

A: Japan has on paper the ability to sustain much higher deficit-to-GDP numbers than anywhere else for two reasons. It is still a surplus country when it comes to the external accounts. And secondly, there's still a tremendous number of home buyers in terms of the allocation of savings in Japan. So as long as these two conditions remain, the Japanese public sector is going to be able to fund itself by domestic resources.

Japan would be facing more difficulty if one of these conditions changes, or if both conditions change, if the private sector in Japan does what the Mexican private sector did in the 1980s. If you look at the prior period to the 1982 Mexican crisis, Mexico ran a surplus. The private sector was running a surplus, the public sector was running a deficit, and the Mexican private sector said: "You know what? I'll take my surplus outside Mexico."

Q: Capital flight?

A: Capital flight. So if the Japanese were ever to change their home buyers, then this would change the situation for the Japanese bond market very quickly. This is unlikely. This is unlikely because of the market, it's unlikely because of tradition and because of culture.

Q: The United States put tremendous pressure on Germany and Japan, particularly Japan, in the mid-1980s to appreciate their respective currencies, so they came up with the Plaza Accord. Why has the United States at this point not resorted to a "Plaza 2" against China?

A: The first thing we have to remember is that China is not like Germany, it's not like Japan, because its per capita income is fundamentally lower than those other countries when they assumed international responsibility. So that's the first thing. And that's why the debate about the currency is subject to so many points of view.

The second element, which is as important, is that China has accumulated massive treasuries. To quote Larry Summers, China and the United States were involved in a vendor-financier relationship. China produces goods and China produces the financing for the consumer to buy those goods.

The Plaza Accord was possible because there was the G-7 and both Japan and Germany were members of the G-7. Up to today, China is not a member of the G-7 or the G-8. China is invited to breakfast. Or China is invited to dinner. So this is much more complex than (what) gave way to the (Plaza and) Louvre accords, because of all of these dimensions.

Q: You mentioned that this is the first time in history that low-income countries have been forced to take on a global responsibility, and China's case is extremely unique in that sense. But I think the low-income countries are now financing the current account deficit of the global hegemonic power. Perhaps this is even more unique? I'm talking about the G-2.

A: I think the G-2 thing is unique in a sense, that China needed to produce employment opportunities. So the objective in China has been, for a very long time, to create jobs for people coming out of the rural sector, and for people coming from the state enterprise.

The accumulation of reserves was not the objective; that was a side effect.

And that model has been very successful. China has taken a lot of people out of poverty ... through that. One thing that we have to realize is that emerging economies .. go from being a crisis form to advanced economies in four stages, and we've looked at that.

Pressure on China counterproductive

The first stage is what I call benign neglect: Things start getting better but typically governments don't believe it. Governments are so used to being stuck in a low-level equilibrium, they don't recognize that things are improving. The result of that is massive capital flows that put pressures on the currency and/or inflation. At that point, countries recognize and go to phase two.

Phase two has to do with liability management. Countries say "yes, we are better off, but we are not permanently better off, so I, as a wise government, will use this situation to pay off my debt." And countries start paying back debt. And the emphasis is all on liability management.

Phase three is you exit liability management and enter asset management. You start having significant reserves. You start creating a sovereign wealth fund.

Stage four, which is the most difficult stage for a country to accept, is to say: "I am not just temporarily better off, I am permanently better off, and therefore I will allow my economic structure to reflect that, I will allow my economic structure to mature. I will move from direct instruments of economic control to indirect market-based instruments. I will open up my economy. I will not just worry about the quantity but I will worry about efficiency."

That is a very difficult step to take, because if you make a mistake going from step three to step four, it's almost irreversible. And China right now is at stage three, has gone through every stage, looking at stage four, and building up its courage to move to stage four.

I want to make sure that in the next few years, that we move. Not because it's in the global interest, but because it's in China's interest. But we have to understand that it's very difficult.

Now, if a country comes along and tries to push you into that stage, you will naturally resist. Already you have natural hesitation, but if someone comes along and begins pushing you, you will become even more hesitant. That's why I think when the Chinese say that external pressure can be counter-productive, we have to take them seriously.

Q: You talked about the great shock to public expenditures caused by the financial crisis. What do you think the prospects are for an exit strategy, against the background of worsening public expenditures and the shock, over the next three to five years?

A: There are two exits. One is (an) exit from unconventional policies. And the other one (is) an exit from extremely loose monetary policies.

We will see continued exit for the United States, the U.K., on unconventional policies. And that is because, in the United States in particular, unconventional policies have exposed the Fed to tremendous political visibility.

What unconventional policy told the politicians is that you have a non-elected institution that has fiscal powers.

The U.K is on the same road, but slower. Japan is interesting because Japan is on that road but cannot move very quickly because of deflationary forces.

When we come to conventional policy, which is unusually low interest rates, we should expect that to last a while longer. The economy right now, because of this handoff from the public sector to somebody else, is not that easy, the economy's having difficulty gaining momentum. So the Fed, which has the dual mandate, is going to be pinned at low interest rates much longer. Which is why, if we met again in a year's time, a year and a half's time, we're going to be talking about inflation. And that's the reality of a bank that has a dual mandate. And right now the employment mandate is very important.

Q: Charles de Gaulle characterized the late nineteenth century as an "epoch of 3 percent," with government bonds and high quality bonds with stable 3 percent return rates. Do you think we could also enter a quiet zone of expecting returns of about 3 percent in the coming years?

A: I think we have a journey and a destination.

I don't know whether you've ever played Monopoly? You remember in Monopoly that there are dark blue and dark green properties, very expensive to buy. But once you buy them you can live in them, you can build houses and hotels. And you sit back and you earn your wonderful reward. That is casino financing. That is what dominated the financial sector until the crisis.

The perception was you could lever the balance sheet enormously, and you could lever any risk, and you could get paid very heavily, very well.

The destination is the two utilities on the Monopoly board. If you remember the utilities, one was electricity, and the other one was water. They were very cheap to buy. You couldn't lever them. You're not allowed to build houses and hotels. You could still earn a good living, but nothing compared to the levered ones. We are on this journey to a more utility way of financing.

Regulations are going to get us there. The risk-aversion of people who were stung by the crisis will get us there, and the due risking of institutional bankers. So when we ultimately get there, it's going to be the world of lower nominal returns, at less volume.

It's a little bit like saying, on the highway we're going to lower the speed limit to stop accidents. Now, getting there is very hard. Imagine on the highway you suddenly pull up at 60 kph. It's not smooth because the journey to this world doesn't start at the best place. It starts where everybody's used to driving at 120 kph. So the short term, the journey is going to be one of very bumpy returns.

It's going to be one where investors are going to have to ask the very uncomfortable question, not of what can go right, but what can go wrong. In this world we're describing, the most important question for investors to ask is, "What mistake can I afford to make?"

It's going to be about asking the question if because the world is going through a paradigm shift, I end up making a mistake, what mistake can I afford to make? And we're going to think much more about what we call "tail hedging," which is, if I can't afford this mistake, can I hedge against it? The same thing as what happens when we buy a car.

When we buy a car, we don't buy a car on the notion that we're going to crash it, because if we believed we were going to crash the car, we would be worried about the consequences. We buy the car knowing that there's a small probability that we could make a mistake and have a crash, so therefore we buy insurance.

So what we're going to see is an evolution in the mind-set of investors, that recognizes that we are on this bumpy journey to something new, but that you have to manage the journey. The first part of managing the journey is being very honest about what mistake you can afford to make. Because if you cannot afford to make that mistake, you should minimize your risk.

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Mohamed El-Erian is chief executive officer of PIMCO, a major U.S. investment management firm. After 15 years as an economist at the International Monetary Fund, El-Erian worked at the London branch of Salomon Smith Barney, a securities company belonging to Citigroup. Through a head-hunting firm, he was made a portfolio manager for emerging markets at PIMCO in 1999, although he had no prior experience. He later was president at the company that manages Harvard University's endowment for two years. He achieved a 23-percent return for the endowment for fiscal 2007 that ended in June 2007. El-Erian then returned to PIMCO in 2007. His father was an Egyptian diplomat and his mother was French.