Laurence Siegel: I’ve read your book, "The Only Game in Town," which is principally about the Federal Reserve and other central banks. I had an overriding question while reading it: How did we, meaning the American people, let the Fed get so powerful? According to the Fed’s own website, the Fed was originally established to prevent banking panics, yet its mandate grew over time to include price stability and full employment and now seems to involve stewardship of the entire economy. What happened, and is this good?
Mohamed El-Erian: We didn’t let the Fed get more powerful, nor did the Fed go for a power grab. What happened is that we inadvertently limited our policy responses and created a huge vacuum, and the Fed felt that, in order to buy time for the system, it had a moral and ethical obligation to step in.
Siegel: Where did we limit our policy responses? What did we do that was wrong?
El-Erian: It’s what we didn’t do. We made three basic mistakes. In the runup to the global financial crisis, we overinvested in the financial services sector as an engine of growth. We wrongly believed as a society that finance was the next level of capitalism. You can see this in the way that countries were competing to become the global financial center; even smaller countries such as Switzerland, Ireland, Iceland and Dubai opted to grow their financial system to sizes bigger than their GDP. And regulators believed that they could reduce their oversight and regulation of the financial sector because, after all, it was the next level of sophisticated capitalism. So we stopped investing in industries that create growth, and we excessively embraced the financial sector. In fact, we changed its name from financial services to just “finance” – again the notion that it is a stand-alone. So that was the first mistake.
The second mistake we made was that, when we were coming out of the financial crisis, we didn’t understand that it was much more than a cyclical shock. Importantly it was also structural and secular and, as such, it required a different mindset. Policymakers focused too much on the notion that Western economies operate only in cyclical space and that secular and structural issues were the domain of emerging economies. They didn’t understand that we were also facing structural headwinds so we got an insufficient policy response.
The third mistake was the overreliance on central banks. And awaiting a policy handoff that hasn’t materialized as yet – to a more comprehensive policy response that deals with the real impediments to growth and genuine financial stability – these institutions had no choice but to venture ever deeper into experimental policy terrain and to stay there a lot longer than they anticipated. As such, the benefits of their policy interventions have come with heightened risks of collateral damage and unintended consequences.
Siegel: Let me reflect for a moment on the idea of overinvesting in finance. In retrospect, of course we did, but in a market economy each industry, or each corporation, sees it as their job to grow as big as they can. So in the 1950s we probably overinvested in cars, and then in the 1990s we overinvested in technology and telecom. I don’t think finance is any different. People in financial services companies want big profits and big bonuses, so who is going to stop them from trying to expand?
El-Erian: You’re absolutely right. Capitalism has a tendency of going too far on certain activities. The only difference – and this is an important difference – is that overinvesting in cars doesn’t mean that you risk the payments and settlement system of an economy, whereas finance is an integral part of the payments and settlement system. I think of finance as being the oil in your car. If it breaks down, then no matter how good your engine is, no matter how good your brakes are, you simply are not going to be able to drive the car. Other sectors are different; you can still drive a car if your bumper falls off. Finance, unfortunately or fortunately, speaks to the payments and settlement system, which is a necessity. And what happened in 2008 is that the payments and settlement system was threatened.
Siegel: I agree. I think of finance as a type of infrastructure, and it has to function. As John Stuart Mill said about money, it is only important when it doesn’t function. Can you elaborate a little on the third mistake we made?
El-Erian: While central banks stepped in to fill a void, they did so based on the understanding that there would be a policy handoff.
Fed chairman Ben Bernanke’s speech in August 2010 at Jackson Hole, Wyoming, really identified the moment when the Fed started using unconventional policies to pursue broad economic objectives, as opposed to pursuing market normalization. He said that it’s about “benefits, costs and risks.” It was understood that, the longer the Fed remains unconventional, the lower the benefits and the greater the costs and risks. I don’t think anybody imagined, at that point, that the Fed wouldn’t be able to make the handoff from unconventional monetary policy to a much broader policy response. So the third mistake was the absence of a handoff, and that speaks to political issues.
Read the rest of the interview here.
