A brilliant take on monetary and fiscal stimulus

By Morningstar |  29-03-20 | 

Mohamed El-Erian is chief economic adviser at Allianz, the parent of Pimco, where he formerly served as chief executive and co-chief investment officer.

Here are some extracts from his conversation with Jeff Ptak, Morningstar’s global director of manager research.

What are Financial Sudden Stops?

Financial sudden stops, while they happen instantaneously and seem catastrophic, are easier to identify and address. It's like a major heart attack. It happens. You have to respond quickly to it. It doesn't come up from behind. It doesn't sneak up on you, like economic sudden stops do.

A financial sudden stop basically boils down to counterparty and which counterparty can you trust? In 2008, a classic financial sudden stop, banks didn't trust each other. And with that, the payments and settlement system was crippled. But there is one balance sheet that everybody will trust because it has a printing press in the basement, and that is the Federal Reserve. So, the Federal Reserve could insert itself in the counterparty breakdown, fix that market failure, and then the system slowly restarts.

What are Economic Sudden Stops?

Economic sudden stops sneak up on you. Don't underestimate how they spread through a system. They bring everything to a halt. They destroy supply and demand simultaneously. And the result of that is that things break down quickly.

They reach critical mass before you realise what's going on. It starts small, as it did in this case in one province in China. People don't pay much attention, but it spreads, and it reaches critical mass, which is what has happened in the global economy. And then, dealing with the underlying source is very difficult. In this case, it's a health issue.

Will stimulus policy help? 

Stimulus policy, which is the equivalent of the central bank intervention in the case of financial sudden stops, policy does not work. No matter what tax break you give to people, no matter how cheap the loans are, no matter how much cash is in their pocket from refinancing their mortgages, this will not let them go out and spend.

They will wait.

You can help with the balance sheets. You can protect people that way. But unfortunately, you cannot reactivate economic activity until the health issue is addressed.

Before we were mandated in California to stay home, the person who cuts my hair who I've been going to for decades, called and said they are saying home. I asked why. And the person said, “I'm scared. I am in the vulnerable age group and I'm scared.” When I asked what about income, she said she puts her health ahead of her income.

What sort of measures or policy prescriptions do you favour?

Monetary policies should aim at addressing market failures. And the most efficient way of doing that is by targeting them directly. And that's why the series of emergency funding windows that have been introduced for commercial paper, for the money market sector and others are absolutely essential.

Cutting interest rates now will not do very much. The time will come to provide an interest rate cut. But let's not use the scarce tool we have right now. And as you see, the 150 basis points cut actually got a thumbs down from the marketplace. Because people realise very quickly that low interest rates are not going to reactivate economic activity, because people are scared. And secondly, they're not going to do much on your mortgage bill or anything else because it's a much bigger problem. So, monetary policy should be focused on ensuring that market malfunctions don't reverse contaminate the real economy.

Fiscal policy is different. And what fiscal policy can do is help people through this economic sudden stop, help support their balance sheets, make sure that they can afford the payments or as we're seeing increasingly, press pause on certain payments, so that people can manage, protect the most strategic sectors of our economy, including health and importantly, make sure that when we restart this economy, liquidity problems haven't turned into solvency issues. Fiscal policy can be incredibly effective in all that. Low interest rates will not do much.

Is there a fiscal approach that you think is particularly advisable in the current environment?

I think you're going to need lots and lots of different approaches. You're going to have to learn as you go along, you're going to have to be open to feedback. Because a lot of the transmission mechanisms, a lot of the pipes we need are not in place. We did not prepare, understandably, for something that is as severe as what we're facing. A global economic sudden stop was unthinkable. There will be some really difficult choices to make. We're going to need principles to govern who gets and who does not get bailouts because the line is going to be very long.

There was a mistake initially to think of the airline industry as the exception. No. Every single segment in the economy, except for a handful, will go through the demand and supply destruction that the airline industry has gone through. Already the rental car companies have approached the government for a bailout. We're going to have more and more of this.

So, it's important that the government figures out very early on what are the technocratic principles that are going to govern why we're bailing out, who we're bailing out, when, on what terms and what's the exit strategy. Because unless you have a technocratic baseline, the politics will take over and you're going to end up by creating so many precedents that's going to be very difficult to manage.

You believe that one of the lasting consequences of novel coronavirus will be accelerating de-globalization and de-regionalization. Global supply chain management and trade interconnection has been the dominant trend in recent decades. Why would we retreat from that? 

What people have realized, especially people with global supply chains, is that as efficient as they are and as cost effective as they are, they are not as resilient as they thought they were.

The conventional wisdom was first shocked by the trade war, which was unthinkable. How could the U.S., the champion of free trade, become the most protectionist advanced economy? But it became that, and it opened up the possibility in future of weaponizing economic tools much more. That was the first shock, if you like, to the conventional wisdom that it's all about efficient cost-effective supply lines.

The second shock, which makes the first one pale in comparison, is the coronavirus shock, where you simply can't get things moving, you can't manage inventory. And that is making people think a lot more about resilience. How do I build in resilience into my system? And part of building in the resilience is having more of your supply chain wiped close to you, even if that is more costly.

We are going to see, unfortunately, a dynamic that you often see in the insurance market, which is that when the shock hits, after the shock, people over-insure and if they cannot over-insure collectively, i.e., if there isn't an insurance company that pulls their risks, sometimes there isn't after a huge natural disaster, but if there isn't one, they will self-insure. So, we will see the self-insurance behaviour more which will mean a de-globalization of supply chains.

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