In the first half of the book review, we analyzed the general implications of Central Banks' policies. In the second section, we will look at how the author thinks the future could play out.
The developed world is now sitting on a vast amount of savings that are not being put to use in the real economy. Companies, flushed with cash because of the Central Banks’ dovish policies, are just buying back their own shares, thus making their shareholders richer and increasing wealth inequality further. This development, together with shifting demographics towards an older population with a high propensity to invest in fixed-income, has the potential to push the developed World in a perennial slow-growth scenario, similar to what happened to Japan after the Asian Financial Crisis of 1997.
The author Mohamed El-Erian identifies four of the most important issues that developed economies are facing, namely:
Lagging structural reforms to revamp growth engines;
The mismatch in aggregate demand between the ability and willingness to spend;
Persistent debt overhangs that undermine existing and new productive capacity;
Europe’s incomplete regional integration project.
At the same time (2016), many emerging economies were embarking into comprehensive “self-insurance” programs to weather potential future difficult times. The author brings about the case of Brazil, which even after having elected a populist far-left politician like Lula da Silva, managed to overcome some of the issues of the 2002 crisis.
This particular part of the book did not age well, as Brazil went into a deep recession in recent years, Luiz Inácio Lula da Silva was arrested and Dilma Rousseff closely followed him in jail. Indeed, most of Brazil's growth in this period was coming from a boom in commodity prices, which was hiding deep inefficiencies and corruption in every stratum of the Country's inefficient bureaucratic apparatus.
All in all, emerging economies like the Philippines can self-insure themselves by:
Building up financial buffers in the form of ample international reserves (to this date, only East-Asian developing countries seem to follow this path);
Adopting more flexible exchange rates;
Reducing the currency mismatch between debt issuance and assets/revenues (known as 'original sin' by the Economist);
Paying off some debt obligations and refinancing at longer terms and lower rates (easier said than done).
Yet another issue highlighted in the book, which is now even more evident than at the time of writing, is the widespread loss of credibility of institutions across the Western World. This credibility inarguably took a hit with the bank bailout programs of 2009 and subsequently with the embarrassing prediction failures of polls for the 2016 US Elections (at least for what concerns the Media as an institution).
While Western institutions maintain greater credibility than many of their Developing World counterparts, this credibility stems more from the dismal conditions of the developing World's institutions, rather than on their own merit.
In financial markets, the void left by retreating financial institutions (banks) after the financial crisis of 2008 and the subsequent over-regulation of the banking sector, is being quickly filled by new financial players, mainly hedge funds and private equity firms. This shift has the effect of moving systemic risk from one sector of the financial world to another, with consequences that are not yet predictable. The biggest risk impacted by this shift of capital to the asset management industry is likely to be liquidity risk, especially in the credit segment of asset management, with funds now extending credit to increasingly shaky companies in the search of higher yields.
Indeed, Howard Marks of Oaktree Capital has been credited with saying: “The impact on the liquidity of ETFs, liquid alternatives, and the Volcker Rule are yet to be tested in tough times. We’ll see what happens in the next serious downturn.” As the roles of intermediaries between asset managers and providers of capital, usually banks have shrunk after the financial crisis, liquidity risk has become even more important in financial markets.
The problem is that it is banks, not asset managers, which have (for now) access to funding windows of Central Banks. This means that the effects of a liquidity crisis could be potentially even more severe with this kind of market structure.
Another pressing issue that the World is facing nowadays is the mismatch in volatility between financial markets and the real economy. Clearly, the stabilizing effect of Central Banks has translated in a period of extended low volatility for financial markets regardless of real economic and political conditions.
The famous “Short the VIX” strategy (and internet meme) became very crowded recently given the considerably low volatility of the last 6/7 years. More often than not, bad economic news has translated in good economic news for markets, also given the expectations of a prompt stabilizing intervention of Central Banks in case of turmoil.
It seems that investors have been conditioned to expect Central Banks to deal successfully with any hiccup along the way. A consequence of this mitigating action by Central Banks is the closure of many hedge funds, which usually thrive in high volatility environments. Possessing “permanent capital” and a highly elastic balance sheet, Central Banks can stick with a “losing trade” much longer than most hedge funds can bet against it. Moreover, as Central Banks are not profit-driven, market mispricing and irrational correlations among assets are not a short-term concern for Central Banks.
To cope with coming problems, El-Erian suggests increasing the reach and rationalize the IMF while making it more inclusive, for example by removing the tradition that the President should be of European nationality.
Overall, this book does a good job of explaining some high-level dynamics of Central Banking, and it is particularly relevant now that Central Banks find themselves dealing with the unprecedented times of the Coronavirus Crisis.
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