Top economist Mohamed El-Erian says we’re not just headed for another recession, but a ‘profound economic and financial shift’
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Investors and economists are sounding the recession alarm. But a prominent economist, who has been seeing warning signs for many months, says this potential recession is different than what we are used to.
That economist is Mohamed El-Erian, previously the chief executive officer of massively influential bond market player PIMCO. He was also Chairman of former President Barack Obama's Global Development Council and has written several best-selling economics books. Put simply, he's one of the best Fed and market watchers alive and hasn't liked what he's seeing for a while.
There is a tendency to view economic challenges as "temporary and quickly reversible," El-Erian wrote in an op-ed for Foreign Affairs, citing the Federal Reserve's initial thought that high inflation was temporary or the consensus that a recession could only be short-lived.
"The world is not just on the brink of another recession," he continued. "It is in the midst of profound economic and financial change."
He was referring to the economic theory that a recession occurs when an economic cycle reaches its natural endpoint and before the next cycle really gets going, but he said this time around will not be another turn of the "economic wheel" like he's seeing World is experiencing major changes that “will outlast the current business cycle”. He highlighted three trends that suggest a transformation in the global economy is underway.
Three major trends are changing the global economy
The first transformation trend, says El-Erian, is the shift from insufficient demand to insufficient supply. The second is the end of limitless central bank liquidity. And the third is the growing fragility of financial markets.
These help "explain many of the unusual economic developments of recent years," he wrote, and looking ahead sees even more uncertainty as economic shocks "become more frequent and severe." Analysts aren't waking up to it just yet, he added.
The first shift was driven by the impact of the pandemic, beginning with the entire system shutting down and government stimulus or what El-Erian called "tremendous handouts," which "made demand surge well ahead of supply."
But over time, El-Erian said, it became clear that the supply problem "rose from more than just the pandemic." It is linked to Russia's invasion of Ukraine, which led to sanctions and geopolitical tensions, along with widespread labor shortages brought on by the pandemic. These disruptions in supply chains gave way to "nearshoring," a more permanent relocation of companies moving production closer to home, rather than a reconstruction of the 2019-era supply chain. This essentially reflects a change in the "nature of globalization." .
"To make matters worse, these shifts in the global economic landscape are occurring at the same time that central banks are fundamentally changing their approach," El-Erian said. As he has been doing for months, El-Erian primarily criticized the Federal Reserve for being too slow to recognize the inflation taking hold of the economy and then to make up for lost time with steep interest rate hikes.
As inflation soared, the Fed switched to aggressive rate hikes - with the last four hikes all being by 75 basis points, lifting the federal funds rate to a range of 3.75% to 4%. But this fundamental change in approach led to the third problem, writes El-Erian. “Markets recognized that the Fed was struggling to make up for lost time and began to worry that it was keeping interest rates longer than was good for the economy. The result was financial market volatility.”
Markets have been trained to expect easy money from central banks, he said, and the "perverse effect" of this has been that "a significant chunk of global financial activity" has flowed into wealth management, private equity and hedge funds, among others - regulated companies. The volatility in the markets since the end of the easy money era this year can be understood as the significant hunk looking for a new home in terms of investment. It's fragile at this point.
"The fragility of the financial system also complicates the work of central banks," he said. "Instead of confronting its usual dilemma - how to bring inflation down without hurting economic growth and jobs - the Fed now faces a trilemma: how to bring inflation down, protect growth and jobs, and ensure financial stability?"
El-Erian is not alone in citing multiple threats to the future of the global economy. Veteran economist Nouriel Roubini and financial historian Adam Tooze are two other prominent voices warning of linked threats. Roubini has just authored a new book entitled "MEGATHREATS" about no fewer than 10 huge economic problems facing the world, while Tooze has popularized the term "polycrisis" to describe a group of related and worsening problems .
Roubini himself recently told Fortune that he and Tooze describe a similar set of phenomena, though he didn't address El-Erian's criticism. However, like El-Erian, Roubini explained the numerous factors at play, and because they are so interconnected, there is a domino effect that contributes to a possible recession.
"If you raise interest rates, you can also have a crash in stock markets, bond markets, credit markets and asset prices in general, causing further financial and economic damage," Roubini told Fortune. Still, he explained that raising interest rates would help fight inflation, even if it risked the possibility of a hard landing, all of which would be triggered by "negative shocks" in the supply chain.
Looking ahead, El-Erian concluded, these changes mean economic outcomes will be more difficult to predict. And it doesn't necessarily mean a simple outcome, but rather reflects a "cascading effect" - in that one bad event could likely lead to another.
This story was originally published on Fortune.com
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