GLOBAL INVESTOR
Mohamed A. El-erian

China may be the rare case of a modern, fast-growth economy that has turned the terms of the trade against itself.

Jun 9, 2008 Issue
 
Every year, PIMCO employees lock themselves (mentally, that is) in a room for three days to discuss what the world will look like in three to five years. In the process we draw on the expertise of outsiders and the fresh ideas of our new recruits.

This exercise attracts a lot of attention, focused mainly on the baseline scenarios for global growth, inflation and capital flows. Also of interest is the identification of what investor Nassim Taleb would call "Black Swans"—the events and scenarios no one is considering, because markets currently treat them as "unthinkable."

Black Swans should be taken seriously, not necessarily because they are likely to happen, but because they would have a sizable impact that cannot be easily handled by existing market and policy infrastructures. We see four main risk hypotheses in this category: first, China may now be too big for the global economy; second, the United States may matter less for global growth than commonly thought; third, markets may soon realize that the notion of core inflation (which excludes food and oil prices as misleadingly volatile) is no longer a meaningful concept for the design of policies and market pricing, and fourth, a deep institutional realignment of the U.S. financial system may follow the recent crisis actions taken by the Federal Reserve to manage Bear Stearns' demise.
 
The Black Swan scenarios for China and the United States undermine the conventional depictions of the global economic system. Many of us have grown up with the notion of a resilient world, led by the United States, and able to handle breakout growth spurts in individual emerging economies.

Yet in China, we may be witnessing the first modern-day case of a rapidly growing economy that has turned the terms of trade against itself. China has added upward pressure on global commodities like oil and steel that it imports heavily, while helping to contain global prices for the manufactured goods that are its key exports. Without policies that help shift the emphasis of the Chinese economy toward domestic consumption, and that give China a proper voice and representation in multilateral discussions on policy coordination, these dynamics can become unsustainable and subject to disorderly correction.

How about the United States? While there's no doubt that it will continue to be an engine of growth, it will no longer be the strongest locomotive. A partial, albeit too extreme reminder here is what happened to Japan, which, in 1990, was the second largest economy in the world and thought by some on a course to overtake the United States. Who would have predicted that Japan would stagnate for a decade, yet the global economy would hardly miss a beat?

Now for the other two risk hypotheses. It would not surprise me if, in the next year or so, the world wakes up to the problems created by the rigid differentiation between core and headline inflation. Core inflation is the indicator that guides the U.S. Federal Reserve, and because oil and food prices have been rising, perhaps for the long term, it is increasingly misleading. Headline inflation, which includes food and energy and thus reflects the real-life experience of most consumers, is the one most often reported in the newspapers. The difference between headline and core inflation has been large and persistent for several years, with the core-inflation figure running low, and the headline figure running higher and higher. If this continues, it is conceivable that both the public and private sectors will be forced to move back to measures of headline inflation, with important policy and pricing implications—the Fed would face growing calls to raise the policy interest rates, while the market would drive other rates higher.

It is also conceivable that such a shift would occur in the context of an important historical realignment of the U.S. financial system, driven by the consequences of an understandable emergency decision on March 16 to provide investment banks with access to a financing window at the Federal Reserve. It is likely to prove extremely tricky for the Federal Reserve to credibly roll back such a facility. More likely, the Fed will start regulating investment banks more like commercial banks, also encouraging the investment banks to go out and secure cheap funding in the form of bank deposits that benefit from federal guarantees. The result will be a flurry of mergers and acquisitions.

As investment banks move away from riskier deals, private equity and hedge funds will take up the slack. To do so, the funds will need to raise more permanent capital through stepped-up IPOs and issuance of term debt.
 
Where does all this leave us? The Black Swan scenarios illustrate the importance of analyzing factors that don't fit comfortably into conventional wisdom. The experiences of the past 10 months, including the damage to the standing of global financial institutions and the unintended consequences of policy reactions, illustrate how little of this discipline prevails. The longer this remains the case, the more unsettling the future will be for some institutions and governments.

El-Erian is co-CEO and co-CIO of PIMCO.