A new mind­set for a shift­ing global econ­omy

The Pak Banker - - OPINION - Mo­hamed A. El-Erian

AS com­pa­nies and in­vestors painfully dis­cov­ered in 2008, liq­uid­ity can be most elu­sive when youneed it most. Go­ing for­ward, for both struc­tural and op­er­a­tional rea­sons, there is ev­ery rea­son to be­lieve that liq­uid­ity will be­come quite patchy when mar­kets en­counter the next ma­jor air pocket. The tur­moil of re­cent weeks pro­vided a vivid il­lus­tra­tion that the global econ­omy and fi­nan­cial mar­kets are un­der­go­ing two tran­si­tions.

The first has to do with the shift from a pro­longed regime of re­pressed fi­nan­cial volatil­ity to an en­vi­ron­ment of in­creased in­sta­bil­ity. The pri­mary rea­son is that cen­tral banks are less will­ing or able to act as sup­pres­sors of volatil­ity. The se­cond in­volves the on­go­ing move away from counter-cycli­cal bal­ance sheets. Fac­ing tighter regulation and sharply re­duced mar­ket ap­petite for short-term earn­ings de­vi­a­tions, bro­ker-deal­ers have shown they are a lot less will­ing to take on in­ven­tory when the mar­ket over­shoots.

Yet liq­uid­ity still tends to be un­der­ap­pre­ci­ated by fi­nan­cial in­vestors -- both in an ab­so­lute sense and rel­a­tive to cor­po­ra­tions that even to­day are in­clined to carry quite a bit of cash on their bal­ance sheets. There are two ma­jor rea­sons that fi­nan­cial in­vestors have tended to place so lit­tle value on liq­uid­ity, thereby un­der­ap­pre­ci­at­ing the con­sid­er­able op­tion­al­ity that comes with it. First, they have been re­peat­edly con­di­tioned to be­lieve that cen­tral banks will step in to nor­mal­ize mar­kets -- and do so at vir- could be de­ployed -- for ex­am­ple, earn­ing noth­ing on cash while you could in­vest in a high-yield bond, but sub­ject to a host of risk fac­tors. As valid as th­ese ar­gu­ments are, they should not be used to ob­fus­cate struc­tural re­al­i­ties on the ground. More­over, the longer cen­tral banks con­tinue to fill their role of the past decade as the "only game in town" -- that is, fol­low­ing poli­cies ded­i­cated to re­press­ing mar­ket volatil­ity and ar­ti­fi­cially boost­ing as­set prices -- the greater the sub­se­quent risk to their ef­fec­tive­ness and op­er­a­tional au­ton­omy.

This is not to say that fi­nan­cial in­vestors should rush to liq­ui­date their po­si­tions and hold ev­ery­thing in cash. There is clear ev­i­dence that the dis­tri­bu­tion of po­ten­tial out­comes from this pe­riod of tran­si­tion is bi­modal, with rel­a­tively high prob­a­bil­i­ties for both good and bad end­points. In­stead, in­vestors should strive for liq­uid­ity po­si­tion­ing at­tuned to this type of dis­tri­bu­tion as the global econ­omy ap­proaches a three-way in­ter­sec­tion, or what the Bri­tish call a T junc­tion.

The road that the global econ­omy is cur­rently trav­el­ing will ef­fec­tively come to an end soon and will yield to one of two quite dif­fer­ent, truly con­trast­ing al­ter­na­tives: a ma­te­ri­ally bet­ter state of the world or a ma­te­ri­ally worse one. There is noth­ing in­evitable about the path ahead. What cor­po­ra­tions, gov­ern­ments and house­holds do can have an im­por­tant in­flu­ence on what cur­rently are finely bal­anced prob­a­bil­i­ties. Sim­ply put, the ma­jor cat­a­lyst for tak­ing the good road out of the T is a com­bi­na­tion of bet­ter pol­i­tics and tur­bocharg­ers.

This can hap­pen if na­tional pol­icy mak­ing in a few sys­tem­i­cally im­por­tant coun­tries ex­pe­ri­ences a "Sputnik mo­ment" that unites politi­cians be­hind a com­mon vi­sion and a na­tional ob­jec­tive. That would al­low for the sus­tained im­ple­men­ta­tion of mea­sures in­clud­ing pro-growth struc­tural re­forms, more bal­anced ag­gre­gate de­mand and the lift­ing of stub­born debt over­hangs, to­gether with en­hanced global pol­icy co­or­di­na­tion. The chal­lenge is to en­sure that the turn com­ing out of the neck of the T junc­tion points to a bet­ter, and not worse, eco­nomic and fi­nan­cial ex­is­tence. Oth­er­wise the global econ­omy will find it­self mired in even lower growth, greater in­equal­ity and mar­ket in­sta­bil­ity -- all of which would put pres­sure on so­cial and political co­he­sion while in­creas­ing the risk of geopo­lit­i­cal ten­sions.

As hard as we try, and I have tried very hard, it is chal­leng­ing to pre­dict pre­cisely ei­ther when we will get to the neck of the T, or which road we'll take. But the cur­rent sit­u­a­tion is less about des­tiny and more about al­ter­na­tives that we col­lec­tively end up de­cid­ing on, ei­ther know­ingly or un­know­ingly. As a re­sult, a cen­tral ques­tion is how we are likely to re­act when the en­vi­ron­ment we have grown ac­cus­tomed to gives way to a more un­cer­tain one and what we can do now to en­hance our prob­a­bil­ity of suc­cess.

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