El-Erian, The Only Game in Town

Although central banks take center stage in Mohamed El-Erian’s The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse (Random House, 2016), the action that occurs, or should occur, in the wings is the more interesting and challenging part of this book. Unless, of course, you’re a central banker.

The world, El-Erian argues, is traveling toward a T junction (or, if you prefer statistical models, will be confronted with a bimodal distribution). The road we are currently traveling on, “one engineered and maintained by hyperactive central banks, will likely end within the next three years, if not earlier, to be replaced by one of two roads that fundamentally contrast in their implications and destinations. One road … involves a restoration of high-inclusive growth that creates jobs, reduces the risk of financial instability, and counters excessive inequality. It … also lowers political tensions, eases governance dysfunction, and holds the hope of defusing some of the world’s geopolitical threats.” (p. 22) This is the utopian road. The other road would undermine all of these ideals. It is the task of governments, companies, institutions, and households—the task of all of us, to steer ourselves onto the better road.

Right now the advanced economies are trying to cope with ten critical issues. These issues are (and I quote El-Erian in each case because I assume he spent considerable time getting the wording just the way he wanted it):

1. “Repeatedly inadequate and unbalanced economic expansion, reflecting cyclical/secular headwinds, highlights the extent to which many advanced economies still lack proper growth models.”
2. “Unemployment remains too high in far too many advanced countries; and it is getting more deeply embedded in the structure of those economies and, therefore, will become that much harder to solve.”
3. “Fueled by an unusual combination of cyclical, secular, and structural factors, the worsening of income and wealth inequality has been so pronounced within countries that it now also undermines opportunities.”
4. “The loss of institutional credibility is part of a more generalized erosion of trust in politicians and the ‘system’ as a whole.”
5. “National political dysfunction is still a headwind to overcoming economic malaise and restoring genuine and durable financial stability.”
6. “As national dysfunction undermines global policy coordination, traditional core/periphery relations fail and geopolitical tensions escalate.”
7. “With systemic risks migrating from banks to nonbanks, and morphing in the process, regulators are again challenged to get ahead of future problems.”
8. “When the market paradigm changes, as it inevitably will, the desire to reposition portfolios will far exceed what the system can accommodate in an orderly fashion.”
9. “Yet none of these uncertainties and fluidities seemed to disturb financial markets that, operating with unusually low volatility, went from one record to another. As such, the contrasting gap between financial risk taking (high) and economic risk taking (low) has never been so wide.”
10. “All of this adds up to considerable headwinds for the better-managed part of national, regional, and global systems.”

How can we address these issues? Central banks, however willing they may be to do whatever it takes, cannot deliver the desired outcomes, cannot effect systemic and lasting change. Instead, every decision maker in both the public and private sectors must pitch in.

El-Erian sets forth some specific recommendations for achieving the better alternative. As an investor, however, he has to accept the high probability that things could go either way, that the distribution of potential outcomes is bimodal. In light of this distribution, how should investors position their portfolios? Here are a few of his ideas. Beware of liquidity traps, trade up in quality, barbell risk exposures, and hold relative (e.g., foreign exchange) as well as absolute positions.

The stakes are high, but “where we actually end up is still a function of choice rather than destiny.” It is up to all of us to help improve the prospects for good outcomes, “in the process also increasing our ability to better navigate bad outcomes should the world come out of the T on the wrong road.” (p. 242)