RETURN OF THE NERVOUS WEEKEND / THE WALL STREET JOURNAL OP EDITORIAL ( VERY HIGHLY RECOMMENDED READING - A MUST READ )

OPINION

MAY 22, 2010.

Return of the Nervous Weekend .

By MOHAMED A. EL-ERIAN

With global financial markets volatile once again, we're back to what I call the "weekend policy watches." For many years, weekend policy watches were confined to struggling developing countries. But beginning in 2008, the phenomenon burst onto the American scene as government officials scrambled to contain the financial meltdown. It's hard to forget those "Sunday night specials"—long hours spent anxiously waiting to hear from Washington on topics like Bear Stearns, Fannie and Freddie and Lehman Brothers.

Now, it's Europe's turn. The focus these weekends is on Berlin, Brussels and Frankfurt, with observers wondering how policy makers will react to the generalized disruptions in global markets, and particularly to the mounting pressures facing the European banking system.

It is absolutely critical to understand how we end up in the midst of these unsettling weekends. It's a failure of both crisis prevention and crisis management. It happens because structural problems like excessive budget deficits are allowed to fester. Policy makers quickly fall behind in terms of their understanding and ability to respond. And the crisis morphs into a highly disruptive, multidimensional affair.

This is the case in Europe today. What started as a Greek debt problem, mistakenly viewed by too many as containable, has gone regional and now global. The already difficult debt challenge has now assumed complex economic and technical dimensions.

The immediate consequence of Greek contagion is heightened market volatility, violent, across-the-board sell-offs in equities and other risky assets, a drying up of market liquidity, and cascading blockages in the plumbing of the global financial system. All of this will have a negative impact on the real economy through tighter credit, lower consumption, postponed investment, and higher unemployment.

In assessing Europe's various responses—and there are still many to come—we need to keep three key questions in mind at all times:

First, is the Greek problem being treated for what it is (namely, a solvency problem) as opposed to what people wish it to be (a liquidity problem)?

Second, are appropriate circuit breakers being put in place to limit the collateral damage for European growth and the global economy more broadly?

And finally, how much have we done to prevent violent market selloffs that aren't driven by economic fundamentals but are motivated by investor overleverage and market illiquidity?

I fear that markets may not get sufficiently reassuring answers any time soon to these questions.

There is still a deep hesitancy among European policy makers to acknowledge that the approach to rescuing Greece is incomplete. But few outside observers are fooled by a strategy that results in a further increase of the country's already excessive debt-to-GDP ratio, relies too heavily on a blunt and draconian fiscal policy instrument, and sustains a debt overhang that will deter new investments and amplify an already painful drop in GDP.

The emphasis on circuit breakers is there, but badly targeted. Rather than focus on a defensible and sustainable fire break, too much effort and money are being deployed to defend the indefensible, like Greek over-indebtedness. This also muddies the political narrative.

The unwind of unstable investor positions is still in its early stages. Having over-romanced the cyclical bounce, some investors are now scrambling to reposition their over-extended portfolios now that structural problems are undeniable. The resulting unwinding of overleveraged trades will inevitably disrupt a very wide range of other assets as the good gets contaminated by the bad.

The bottom line is simple yet consequential: The disruption in financial markets is not a garden-variety market fluctuation. Instead, it's an overdue recognition that the global economy faces an uncertain future that involves slower growth and greater government regulation.

Structural problems require structural solutions. The question is whether those at the weekend discussions will acknowledge this, or remain hostage to hope for an immaculate recovery.

Mr. El-Erian is CEO and co-CIO of PIMCO, and author of "When Markets Collide" (McGraw-Hill, 2008).

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