A New Normal

Mohamed El-Erian

What Now?

It was clear to us that, despite the very high hurdle that we always apply to such a statement, the world has changed in a manner that is unlikely to be reversed over the next few years. Put another way, markets are recovering from a shock that goes way, way beyond a cyclical flesh wound.

It is not just about the major realignment of the financial system and the extent to which governments have intervened to offset market failures. And it goes beyond the massive increase in government deficits and government debt in virtually every systemically important country in the world (at a time when few countries can credibly pre-commit to the type of fiscal primary surplus required to subsequently reverse the massive deterioration in the debt dynamics).

It’s also about the structural change in how savings are mobilized and allocated, nationally and across borders. It is about the shifting balance between the public and private sectors. And we should not forget the potentially long-lasting consequences of the erosion of trust in such basic parameters of a market system as the sanctity of contracts and property rights, the rule of law, and the robustness of the capital structure. Such trust can be lost quickly but takes a long time to restore.

The result is a prolonged pause, or in some cases, a violent reversal in certain concepts that markets had taken for granted. We referred to it as the demise of the “great age” of private leverage, asset- and credit-based entitlements, self-regulation, policy moderation, and shrinking direct government involvement. Not surprisingly given the extent of the gains that were privatized and the losses that are now being socialized, the demise is occurring in the context of popular anger, confusion and what one of our speakers called “a morality play” in parliaments around the world.

This is not to say that the global economy has no defenses. It has. Policymakers are fully engaged in an effort to avoid another Great Depression. The secular forces of productivity gains and entrepreneurial dynamism will not disappear. And there are pockets of considerable economic and social flexibility, high self-insurance, and even some global policy coordination.

Yet, while these factors help reduce the risk of a deflationary depression, they are not strong enough for a return to the high growth and low inflation that characterized 2002–07. Simply put, there are insufficient demand buffers and fast-acting structural reforms to provide for a spontaneous and sustainable recovery in the global economy. No wonder we have characterized the financial crisis as a crisis of the global system (as opposed to a crisis within the system). Lacking endogenous circuit breakers, the system will not reset quickly and without permanent changes (and some would argue that even if it could, it should not). For markets that are highly conditioned by the most recent periods of “normality,” this will feel like a new normal. Indeed, it will be a major shock to those that are trapped by an overly dominant “business-as-usual” mentality.

The New Normal

For the next 3–5 years, we expect a world of muted growth, in the context of a continuing shift away from the G-3 and toward the systemically important emerging economies, led by China. It is a world where the public sector overstays as a provider of goods that belong in the private sector. (As one of speakers put it, we have transitioned from a world where the private sector provided public goods to one where the public sector provides private goods.) It is also a world in which central banks and treasuries will find it difficult to undo smoothly some of the recent emergency steps. This is particularly consequential in countries, such as the U.K. and U.S., where many short-term policy imperatives materially conflict with medium-term ones.

The banking system will be a shadow of its former self. With regulation more expansive in form and reach, the sector will be de-risked, de-levered, and subject to greater burden sharing. The forces of consolidation and shrinkage will spread beyond banks, impacting a host of non-bank financial institutions as well as the investment management industry.

How does inflation behave in the new normal? For now, it is hard to project any imminent pickup in inflation given the severity of the collapse in global demand and the resulting large output gap. Private components of global demand will not recover quickly and fully. Yet, one should not fixate just on demand when transitioning from a cyclical to a secular mindset. Supply also matters.

In the next few years, the historical pace of growth in potential output will face many headwinds. Excessive regulation, higher taxation, and government intervention will be among the factors that will constrain the growth of potential (non-inflationary) output (Chart 3, prepared by Ramin Toloui, conceptualizes the process). With investment activity subdued for a while, the rate of depletion of the capital stock will rise. There is also the loss of endogenous credit factories that, especially in their overheated 2004–07 phases, fooled people into believing that the increase in leverage-based economic activities was sustainable.

The most animated discussion in our Forum related to another aspect that will govern inflation dynamics in the new normal: whether the massive amount of fiscal and monetary stimulus adopted by the U.S. authorities will erode confidence in the public goods that the country provides to the rest of the world – namely, the dollar as the world’s reserve currency, and deep and predictable financial markets to intermediate excess savings.

In its weakened state, the U.S. can ill afford a reduction in the “implicit rents” it collects for providing such public goods. Otherwise, inflation will take off much earlier than recent history would suggest. Even more consequential, over time the U.S. would retain less control over its economic and financial destiny, thereby slowly assuming the characteristics of what economists label as “small open economies.” This is a fundamentally unattractive possibility not only for the U.S. but also for most other countries. None of them (let alone regions and multilateral bodies) is able and willing to assume the responsibilities at the center of the global system.

In the new normal, bottom up issues will actively compete with top down themes. The power of the convergence magnet – that mystical Anglo-Saxon model of liberalization and de-regulation where a prosperous post-industrialization phase relies on an ever-booming financial system – has weakened. No other model is able to step in at this stage. Accordingly, the partial vacuum will translate into country differentiation relative to what has taken place in the recent past.

Think of the following potential configuration:

• We would look for financial rehabilitation in the U.S. to occur in the context of low growth and an eventual inflationary bias down the road.


• The U.K. would also be stuck in a low growth world, but with greater vulnerability to domestic and/or external financial instability.


• Core Europe will also grow slowly, influenced by its historical inflation phobia and concerns for the integrity of the European Union.


• Japan will continue to face growth headwinds as its economy is too encumbered by fiscal and demographic issues.


• Emerging economies will bifurcate more clearly into two groups. Those with weak initial conditions will return to the old emerging market paradigm that alternates between austerity and financial instability; those with strong initial conditions will maintain their development breakout phase, albeit not at the torrid pace of recent years.

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