Repairing the Global Plumbing

NEWPORT BEACH – More than three years after the global financial crisis, the world still has a nasty plumbing problem. Credit pipes remain clogged, and only central banks are working to clear them. But their ability to do so is waning, posing yet another set of risks for Western economies blocked by too little growth, too much unemployment, deepening inequality, and debt in all the wrong places. Fortunately, it is not too late to build broader pipes that compliment and replace the damaged infrastructure. The current situation embodies two narratives that seem contradictory, but are not. One speaks to the reality that most large companies with access to capital markets have no problem securing new funding. In fact, they have been remarkably successful in lengthening their debt maturities, accumulating cash, and lowering their future interest payments. In sum, they now have “fortress” balance sheets. The other narrative speaks to an opposing, but equally valid reality. Too many small companies and households still find it difficult to borrow at reasonable terms. This includes those reliant on bank credit, as well as many mortgage holders with very high legacy interest rates and balances that exceed their homes’ market value. From every angle, the extremity of this state of affairs – in which those with access to credit do not need it, and those who do cannot get it – is highly problematic. If left unattended, it leads to a gradual, and then accelerated, renewed deleveraging of the economic system, with the highest first-round costs – a longer unemployment and growth crisis – borne disproportionately by those least able to suffer them. In the next round, as the system slowly implodes, even those with healthy balance sheets would be impacted, accelerating their disengagement from a deleveraging world economy. All of this slows social mobility, tears already-stretched safety nets, worsens inequality, and accentuates genuine concerns about the functioning and sustainability of today’s global economic system. This is not just about socio-economic issues. There is also a political angle. With two competing, yet simultaneously valid narratives, ideological extremes harden. The result is even greater dysfunction in both process and content, ruling out any sustained policy attempt to make things better. The problem has become acute in Europe, whose crisis has been belatedly recognized as reflecting something more than turmoil in the eurozone’s weakest countries. It also reflects broad-based contamination, resulting, most recently, in France’s loss of its vaunted AAA sovereign credit rating. In the process, the efficacy of pan-European rescue mechanisms is being undermined. And, as fragilities increase – and as a financial wedge is driven into the eurozone’s core (Germany and France) – growth and employment prospects dim. Central banks have recognized all of this for some time, prompting them to take enormous reputational and operational risks to slow the process. They have implemented a host of “unconventional policies” that previously would have been deemed unthinkable, even outrageous – and that can be seen in the enormous growth in their balance sheets. In the last four years, the United States Federal Reserve’s balance sheet has more than tripled, from under $1 trillion to a mammoth $3 trillion. The growth relative to the size of the economy is even more stunning – from slightly more than 5% of GDP to 20%. The Bank of England’s balance sheet is also at 20% of GDP. And both seem to be itching to do even more. The European Central Bank is often viewed as a laggard. No longer. Its balance sheet has now doubled, to a whopping 30% of GDP – and it, too, appears set to do even more. Mario Draghi, the ECB’s new president, recently said that he expects heavy take-up on the next three-year long-term refinancing operation, a powerful tool to pump cheap liquidity into the banks. Unfortunately, the economic outcomes have come nowhere close to matching the intensity of these efforts. Effectively, the central banks have been unconventional bridges to nowhere, owing mainly to their imperfect tools and other government agencies’ inability or unwillingness to act. At some point – and we are nearing it – bridges to nowhere become a standalone risk: they can topple over. Rather than just pumping liquidity into clogged pipes, countries can and should do more to build a more effective network of compensating conduits. In doing so, their main objective (indeed, the test for effectiveness) would be the extent to which new private-sector investment is “crowded in.” It is high time to move on five fronts, simultaneously: • Countries such as Spain and the US need to be more forceful in unblocking the housing sector by making overdue decisions on burden sharing, refinancing, and conversion of idle and foreclosed housing stock. • Countries with excessive debt, such as Greece and Portugal, need to impose sizeable “haircuts” on creditors in order to have a reasonable chance to restore medium-term debt sustainability and growth. • In several Western countries, public-private partnerships should be formed to finance urgently needed infrastructure investment. • Regulators should stop bickering about the future configuration of key financial institutions, and instead set a clearer multi-year vision that is also consistent across borders. • Finally, governments should inform their electorates explicitly and comprehensively that a few contracts written during the inadvisable “great age” of leverage, debt, and credit entitlements cannot be met, and must be rewritten in a transparent way that strikes a balance between generations, labor and capital, and recipients and taxpayers. Such policies would allow healthy balance sheets around the world, both public and private, to engage in a pro-growth and pro-jobs process. They require leadership, focus, and education. Absent that, plumbing problems will become more acute, and the repairs more complex and threatening to virtually everyone – including both the “one percenters” and those who worrisomely are struggling at the margins of society. Mohamed A. El-Erian is CEO and co-CIO of PIMCO, and author of When Markets Collide. Copyright: Project Syndicate, 2012.