Comments Mohamed El-Erian’s Remarks at the ALOUD Business Forum – Los Angeles Public Library

Mohamed El-Erian’s book “When Markets Collide” made quite an impression on me last year.  I’ve had the utmost respect for Bill Gross and PIMCO since I read “The Bond King: Investment Secrets From PIMCO’s Bill Gross” a number of years ago.  Both Bill Gross comments and PIMCO’s general position on market conditions were well received and well circulated back in Chicago amongst the commodity traders I know.

Although I’m about a year slow on uncovering El-Erian’s talk at the ALOUD Business Forum, by no means am I late.  The topic is one of mega-trends; the secular shifts that he is framing are one’s that will distinguish generations.  From my viewpoint, this is a must hear/watch/read.  I believe it is so worthwhile that I have gone to the effort to type up the unofficial transcript of what was said.  At the root of why I think this talk is so valuable is the relatively clear and simple presentation of the global financial crisis.  Not only that, but also the perspective.  PIMCO is often viewed as the third branch of government.  To have such a candid, simple, and thorough framing of such a massive life changing event is invaluable.  All of us can take something from Mohamed’s presentation.

I’ll summarize the simple model of the financial crisis that El-Erian presents.  Specifically, he describes four large forces– the four horseman of the financial crisis: 1) housing, 2) banks, 3) U.S. Consumer, and 4) China / emerging markets.  He claims that they are all simultaneously trying to de-lever.  In reality, this can’t all happen at once.  So, there are curious feedback loops.  Finally, there is one force that is counter-acting the effect of the four horseman.  Specifically, the U.S. government is the sole counter-acting force, attempting to try and inflate what the others are naturally deflating.

In addition to that really simple model, El-Erian offers the final certainties about the dynamics of such a situation:

• increased unemployment,
• decreased production,
• increased role of government over 3-5 years, as government finds itself in greater control of modes of production
• transformation of banks into utilities
• and shift in global consciousness from an age of entitlement to an era of thrift.

The un-official transcript is here.  Please notice that the transcript does NOT include the introduction, nor the actual question and answer session which are a substantial portion of the presentation.  You are still urged to hear the actual talk.

“Good morning.  Let me say upfront it’s a huge honor for me to be here.  I’d like to thank the Lowry foundation.  I’d like to thank Andy Knox and Tom who convinced me to be here.  I’m a nervous wreck. i don’t like enjoy doing these things.  But, they were persistent and I’m glad they were.  So, I thank you very much

I’m going to say a few comments before I sit down and get grilled by David, who is standing there because he doesn’t want to divert attention from me.  He is being very kind.  Let me tell you one thing that Tom didn’t say.  There is a term that has stuck with me since I was about twelve.  My first attempt at a girlfriend had said this to me and it stuck: "You are a nice guy BUT…"

(laughter from crowd)

and the “BUT is… you are boring and unimaginative.”

and I say this because if my wife were here… and I’m sorry she can not be.  But, if she were here she would tell you about a year and a half ago I started coming home almost every day and saying to her "You won’t believe today what happened in the markets" or "You won’t believe today what happened in the global economy."  And she would humor me.  She would listen to me and think he really is boring he keeps repeating this thing.  She would change the subject.  Then we went through a period where I would wake her up at 2:30 in the morning when i was going to work and I said “Janie… get up… turn on CNBC… today is going to be a day that we are going to talk about for the rest of our lives.”  She looked at me and smiled and went straight back to sleep.

(laughter from crowd)

Two days later I called her and said “Janie, go to the ATM and take cash out.”  She said “Why?” and I said  “I don’t know if the banks are going to open tomorrow now.”

The situation is completely reversed now that the financial crisis has completely hit main street.  She is the one who asks me when i get home “What happened today?”  And not only that, but all my in-laws ask me that question too and I find myself not wanting to talk about it any more.

And the reason I am starting that way is just to convey to you that we are living NOT just a crisis WITHIN the global system but a crisis OF the global system.  That is a very important distinction.  Because the minute you have a crisis OF the global system, opposed to WITHIN the system, the circuit breakers do not work.

The circuit breakers are not made to be triggered when the whole system is in a crisis they are made to be triggered when elements of the system are in a crisis.  Which means that anybody who gets up and says to you with any degree of confidence “the bottom of the economy is this quarter”… or “the bottom of the market is that quarter”…  That person is not being intellectually honest.  The reality is that we do not know.  The reality is that there is no reset button.  It is not as if you drop your phone and you just reset it.

We are in what economists call a multiple equilibrium where the crisis will continue to move.  So what I’d like to do in my introductory marks is just three things.

• One, is convey to you what is driving this
• Two is to tell you what to look for to tell you whether we are reaching some sort of turning point and
• Three leave you with the notion that every single person whether you are an individual a company, a foundation, a government has to navigate both the journey and the destination.

We are on a very bumpy journey to a new destination.  Everybody has to ask what are my journey strategies and what are my destination strategies.

[Part I: Why we are in a financial crisis]

The reason we are here is complex but basically boils down to three issues.  We had a number a number of long standing weaknesses, structural weaknesses.  If you go back many people have been writing about the global imbalances.  This notion that the poor were lending to the rich.  It was unsustainable; people knew that. Many people were talking about the failures of risk management; but, like anything that is important but not urgent, the tendency is not to do anything about it.  So these structural weaknesses, while well identified, were allowed to persist.

The second.  As important, is the world had a massive innovation.  A massive financial innovation.  It was called structured finance the ability to take an activity and split it into multiple activities, re-bundle them, and change the characteristic of the activity.  It’s actually a very efficient innovation.  But remember what happens with innovations in history.  Human nature is to overproduce and over-consume an inn
ovation before we understand it.  We fall in love with what an innovation allows us to do.  But we do not ask the question are we able to sustain it.  And most innovation end in tears in the first round.  People actually loose money in innovation in the first round.  Not all; but, most.

And the third issue is that there was a feeling that it doesn’t matter because often times you can control the process.  There wasn’t enough recognition I talk about it in the book: the difference between noise and signals.  There wasn’t enough understanding that there was signals being sent up that required the public and private infrastructure to catch up. 

So when you have these three issues [global imbalances, massive innovation, and complacency], it is inevitable, it is inevitable that you will have market accidents.  It is inevitable that you will have politics.  That is the world that we are living in today.

[Part II: What to look for… Where are the turning points in the global financial crisis.]

Second issue is that how do we recognize that things are going to change.  At PIMCO we tend to look for simple frameworks.  Simple frameworks are very powerful because you don’t get diverted by too much complexity.  So if you can get to a simple framework your live gets a lot easier.  And that’s why we tend to use simple examples.

The simple framework is that you have four massive vacuums right now sucking oxygen out of the room all operating at the same time.  And when you have that happening, the question is first not only how does the weak react [but]…  how does the strong react.  Everybody is going to feel the oxygen getting sucked out.  So there are no sectors that are immune to what is going on.  Whether you are profitable, whether you are loss making, whether you are the United States, or whether you are China, everybody will feel this oxygen effect coming about.  And secondly, it doesn’t stop until the new machine comes in to put oxygen in [the room].

So what are the four elements?  They are four sectors that are now all shrinking at the same time.  We know about them.  We read about them every day.  We write about them. 

• The first one is housing housing– turned in the summer of 2006.  It is still on the way down.
• The second is finance– the banks started turning in the summer of 2007
• The third is the US consumer– because of pressure from unemployment, wealth destruction… he or she started "turning" in the summer of 2008
• and then after the failure of Lehman brothers– which truly made a US centric disease a global disease, the rest of the world started turning.

These are four massive sectors all looking to de-lever.  The result is you can’t do it all at the same time.  And you get these negative feedback effects that make it so critical.

So you need a new balance sheet.  You need a new source of oxygen to come in.  Of course, there is only one source.  You may like it.  You may not like it… [it] is the government.  And that is why we read about fiscal stimulus packages.  That is why we read about housing programs.  That is why we read about banks. 

And you should feel sorry for the policy makers. I would hate to be in politics right now.  If you are a policy maker right now, you are flying a plane with instruments that don’t cover everything, with engines that are stalling, and with a co-pilot that is arguing with you, which is congress.  Do you really want to be a policy maker? 

…

[Part III: Journey to a new destination]

These lead me to the third issue. .. which is ultimately… what does it mean?  Let me give you [this].  It is not often in our business [that] I can tell you this is unambiguous.  I’m going to tell you what is unambiguous.

• It is unambiguous that we are going to continue to see unemployment go up.
• That we are going to continue to see unfortunately production going down.  These are all short term effects.

2009 is spoken for.  There is very little upon it before it is over.  More critically… and I was telling David that I look at my daughter every day and I say “Wow!  What world are we leaving you?”  And she is five and half years old.

• It is unambiguous that we are changing the structure of the world in the following ways first the next few years… and [you] put a gun to my head and say “What do you mean by ‘few’ years?”  And I’ll tell you, at least five. It’s going to see a very dramatic shift between the private sector and the government.  The government will be a much bigger owner and controller of the modes of production.  Not because it wants to, but because the alternative is worse.  That has tremendous implications for the long term growth the potential of this economy.  The potential implications of exit mechanisms that no one is quite sure of.  But that is the reality.
• The second unambiguous reality is that we are seeing a massive consolidation of Wall Street.  Wall Street is being de-risked.  For those of you who play monopoly, which I am teaching my daughter because chess is providing to be be too hard.  But, those of you who play monopoly will remember the very expensive properties on the monopoly board, the dark blue the dark green.  Very expensive to buy, but once you have buy, you can build hotels and houses.  You can basically collect a lot of money.  That is what the banking system used to do.  That is what wall street used to do in normal mode.  The banks are now being turned into the utilities.  Remember the utilities on the monopoly board?  Very cheap to buy… you can’t build anything on it.  i.e., you can’t lever it very much and you can make a living but it is going to be nothing compared to what you used to make.  The consequences for society of suddenly de-risking and de-levering Wall Street are very large. You are going to cause a number of other consolidations that are going to be large.
• The last thing we are changing is the attitude of people.  We are going from what I call an age of entitlement– where the average person felt entitled to consume today on the basis of income that was uncertain in the future, to an age of thrift– where the destruction is so large that people are going to become very cautious.  In fact, one of the things we are doing at PIMCO today is to play defense in order to play offense tomorrow.  Not because we have to play defense; but, because, we recognize that the world is changing so much. 

Which leads me to my final comment: which is everybody out there in society has to ask the question: “Do I have a way to navigate the journey?” and “Can I position myself for the destination?” which is the message you hear us saying all the time… it is different this time around.  It is ugly.  It is very ugly.  And it requires a retooling.  It requires to ask the question: "Am I still doing the right thing"  Because this is not a reversion to the mean.  This is something that is we hardly ever see, which is a massive cyclical dislocation in the context of a massive secular realignment.  And, I leave you with a thought before I get grilled by David that there is nothing easy about a retooling.  It is hard to design.  It takes you out of your comfort zone.  It is not automatic.

60; And it is totally not risk free.  But, if you believe in anything I just said… the alternative of not doing it is even riskier.  So, let me stop here and have David ask any questions…

(applause)”