It is time to end protectionist Chinese currency manipulation. This is not free trade.
If the natural balancing of currencies had occurred, we would not have had the extreme excesses that have caused the financial meltdown.
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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.
© 2008
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