The Risk of a New Economic Non-Order

Mohamed A. El-Erian

LONDON – Next month, when finance ministers and central bank governors from more than 180 countries gather in Washington, DC, for the annual meetings of the International Monetary Fund and the World Bank, they will confront a global economic order under increasing strain.

Having failed to deliver the inclusive economic prosperity of which it is capable, that order is subject to growing doubts – and mounting challenges. Barring a course correction, the risks that today’s order will yield to a world economic non-order will only intensify.        

The current international economic order, spearheaded by the United States and its allies in the wake of World War II, is underpinned by multilateral institutions, including the IMF and the World Bank. These institutions were designed to crystallize member countries’ obligations, and they embodied a set of best economic-policy practices that evolved into what became known as the “Washington Consensus.”
That consensus was rooted in an economic paradigm that aimed to promote win-win interactions among countries, emphasizing trade liberalization, relatively unrestricted cross-border capital flows, free-market pricing, and domestic deregulation. All of this stood in stark contrast to what developed behind the Iron Curtain and in China over the first half of the postwar period.
For several decades, the Western-led international order functioned well, helping to deliver prosperity and relative financial stability. Then it was shaken by a series of financial shocks that culminated in the 2008 global financial crisis, which triggered cascading economic failures that pushed the world to the edge of a devastating multi-year depression. It was the most severe economic breakdown since the Great Depression of the 1930s.
But the crisis did not appear out of nowhere to challenge a healthy economic order. On the contrary, the evolution of the global order had long been outpaced by structural economic changes on the ground, with multilateral governance institutions taking too long to recognize fully the significance of financial-sector developments and their impact on the real economy, or to make adequate room for emerging economies.
For example, governance structures, including voting power, correspond better to the economic realities of yesterday than to those of today and tomorrow. And nationality, rather than merit, still is the dominant guide for the appointment of these institutions’ leaders, with top positions still reserved for European and US citizens.
The destabilizing consequences of this obstinate failure to reform sufficiently multilateral governance have been compounded by China’s own struggle to reconcile its domestic priorities with its global economic responsibilities as the world’s second-largest economy. Several other countries, particularly among the advanced economies, have also failed to transform their domestic policies to account for changes to economic relationships resulting from globalization, liberalization, and deregulation.
As a result of all of this, the balance of winners and losers has become increasingly extreme and more difficult to manage, not just economically, but also politically and socially. With too many people feeling marginalized, forgotten, and dispossessed – and angry at the leaders and institutions that have allowed this to happen – domestic policy pressure has intensified, causing countries to turn inward.
This tendency is reflected in recent challenges to several features of the economic order, such as the North American Free-Trade Agreement, as well as America’s withdrawal from the Trans-Pacific Partnership and the United Kingdom’s renunciation of European Union membership.
All are casting a shadow on the future of the global economic system.
America’s inward turn, already underway for several years, has been particularly consequential, because it leaves the world order without a main conductor. With no other country or group of countries anywhere close to being in a position to carry the baton, the emergence of what the political scientist Ian Bremmer has called a “G-Zero era” becomes a lot more probable.
China is responding to the global system’s weakening core by accelerating its efforts to build small networks, including around the traditional Western-dominated power structures. This has included the establishment of the Asian Infrastructure Investment Bank, the proliferation of bilateral payments agreements, and the pursuit of the “Belt and Road Initiative” to build infrastructure linking China with western Asia, Europe, and Africa.
These dynamics are stoking trade tensions and raising the risk of economic fragmentation. If this trend continues, the global economic and financial configuration will become increasingly unstable, amplifying geopolitical and security threats at a time when better cross-border coordination is vital to address threats from non-state actors and disruptive regimes, such as North Korea. Over time, the risks associated with this shift toward a global economic non-order could have severe adverse effects on geopolitics and national security.
None of this is new. Yet, year after year, top government officials at the IMF/World Bank annual meetings fail to address it. This year is likely to be no different. Instead of discussing concrete steps to slow and reverse the march toward a global economic non-order, officials will probably welcome the cyclical uptick in global growth and urge member countries to do more to remove structural impediments to faster, more durable, and more inclusive growth.
While understandable, that isn’t good enough. The upcoming meetings offer a critical opportunity to start a serious discussion of how to arrest the lose-lose dynamics that have been gaining traction in the global economy. The longer it takes for the seeds of reform to be sown, the less likely they will be to take root – and the higher the probability that a lose-lose world economic non-order will emerge.

Mohamed A. El-Erian, Chief Economic Adviser at Allianz, the corporate parent of PIMCO where he served as CEO and co-Chief Investment Officer, was Chairman of US President Barack Obama’s Global Development Council. He previously served as CEO of the Harvard Management Company and Deputy Director at the International Monetary Fund. He was named one of Foreign Policy’s Top 100 Global Thinkers in 2009, 2010, 2011, and 2012. He is the author, most recently, of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse.

Wall Street's Best Minds

Investors Can Afford to Take on More Risk

Fund flow data suggest that modern investors are “closer to fearful than to greedy,” writes Zachary Karabell.

By Zachary Karabell

Risk. Mention the word, and many investment professionals pause. Traders, hedge funds, and a few quantitative firms and their algorithms may love risk. But these days, the preponderance of investors, advisors, strategists, and their clients—not to mention the individual investor—see risk as a negative to be avoided. And that is why, dear readers, it may be time to consider adding some to clients’ portfolios.

All of the attendant disclaimers should—and must—accompany that statement. Adding some risk wisely does not mean turning a conservative portfolio into an aggressive one, or tossing best interest out the window. It does not mean advising clients to take half of their assets and put them in bitcoin. Nor does it mean ignoring real, actual risks in favor of rank speculation and greed.

It does, however, mean considering investments whose success is predicated on the continued stability of the financial system and the continued evolution of global commerce. In short, considering risk in today’s climate might simply mean investing as if the world is not on the verge of some crisis.

Risk now, risk then

Measuring the market’s appetite for risk is not science. One popular gauge is the level of volatility in the market, measured by a basket of futures known as the VIX ( CBOE Volatility Index), which often is referred to as “the fear gauge.” In spite of global crises, such as North Korea, domestic political sclerosis, and popular sentiment that has been trending negative, market volatility has been remarkably low. In fact, it has been on a steady decline for a few years, after staying elevated in the years following the 2008-2009 financial crisis.

Volatility measures suggest that both investor appetite for risk and investor fear are muted.

One would think that as market players become less concerned, they would behave in the opposite fashion by loading up on risk. It certainly was the case in the late 1990s and again in the mid-2000s, and to some degree it was the case for the years after 2008, when a select number of funds made substantial sums of money trading financial instruments and derivatives keyed to volatility.

Today, however, even though volatility is muted, investors continue to pursue investments that they see as safer. Despite equities having a very strong year, fund flows into them are negative.

While there have been a number of weeks with strong inflows into US equities, almost every week has been positive for US bonds, with billions of dollars flowing into Treasuries, even as rates sag and lag and refuse to budge much above 2.5%.

Fund flows are a decent proxy for investor preferences, and this year they paint much the same picture as in the past years. Even plain vanilla equities—not small caps, biotech, emerging markets—are less in favor than government bonds, regardless of the fact that equities of all flavors have been doing much better for the past few years. The same is true of higher risk bonds: high-yield bond prices have barely budged, which means that demand may be stable but hardly substantial. Compare today’s risk appetite with that of the late 1990s or the mid-2000s, when appetite for return trumped concerns about risk. Investors poured into more and more speculative equities in the late 1990s and into more and more esoteric debt and derivative instruments in the mid-2000s, especially those tied to the red-hot housing market of those years.

In the late 1990s, as many will recall not so fondly, valuations were not just stretched. In many instances, they were non-existent. Given a proliferation of tech companies without discernible earnings, and stocks going up 10X, investors took to new metrics other than price-to-earnings (P/E), because the P/E ratio for many of those issues was zero. Instead, metrics such as price-to-growth were floated as alternatives in assessing possible future earnings. In that sense, one just cannot compare market valuations today with market valuations on the Nasdaq in 1999. The appetite for speculation then versus today was many times greater.

The same can be said for the mid-2000s. Equities were also surging then, but the entire financial system was benefiting from excessive liquidity brought on by lax leverage standards at banks, which had become complacent about risk. Numerous funds as well as traders were allowed to trade 10X or 20X (or more) of their capital, which, as long as it worked, drove up asset prices of homes, equities, and derivatives. In the years after 2008-2009, a combination of intense and even excessive regulation, and a recognition at many financial institutions that excessive risk imperils their survival, has led to much less leverage and much less exposure.

Here too, today is a far less leveraged climate.

None of this is to say that there isn’t risk, especially unknown risk, in the financial system. But on most measures, one just cannot equate today with the late 1990s or the mid-2000s. In fact, one cannot equate today with 2009-2012, when the potential unravelling of the European Union was putting extreme strain on global financial systems, and the massive liquidity being injected by central banks was potentially bolstering asset prices. Now, with modestly rising rates in the United States, along with an unwinding of that liquidity, today looks even more stable than just a handful of years ago.

And yet, appetite for even modest risk is hard to find on a mass scale. Risk itself has been defined down to include almost any investment that isn’t perceived as safe and that could under various circumstances lose value rapidly. When investors contemplated adding risk in 1999, that meant getting a piece of the IPO; today it means putting money in a US small cap fund.

Given investors’ paltry appetite for anything that has a whiff of risk, and given how crowded the “safety” trade remains, it is an opportune time to consider investments that, relative to one’s current allocation, appear riskier. What that means specifically depends entirely on the nature of one’s portfolio and individual needs and goals.

For a 30-year old looking to amass capital, it might mean small caps, high-yield debt, and emerging markets equities or individual investments in newer companies with less tested models. For a retiree, it might mean more exposure to US large cap stocks via a diversified equity index fund. Risk is a relative concept in most cases, and contemplating adding a dollop here and there will have a different complexion depending on one’s age and goals.

It’s an old adage—repeated by everyone from financial advisors to Warren Buffett—that buying when others are fearful and selling when others are greedy is usually a good rule of thumb. From sentiment to actual flows of money, investors today are closer to fearful than to greedy, and at the very least, they are cautious and timid. That may mean that assets considered even modestly risky might be bought for less than they would be otherwise.

In short, with volatility extremely low and markets stable even in the face of global uncertainty, now is the time to assess whether and how much risk to take on. Doing so can be, well, risky, but not doing so could be riskier if long-term returns fail to keep pace.

Karabell is head of Global Strategies at Envestnet, a leading provider of wealth management technology and services to investment advisors.

In Geneva, ‘Dirty Money’ of Another Kind — Flushed Down the Toilet


The European Central Bank plans to phase out the 500-euro note in an effort to curb money laundering and financing of terrorist acts. Credit Andrea Comas/Reuters 

Flushing money down the toilet is usually only a metaphor, reserved for spendthrifts or those casual with their cash. But not in Geneva.

Prosecutors in the Swiss city are investigating the attempted disposal of around 100,000 euros, or about $120,000, at a bank branch and restaurants nearby. The €500 bills had been cut up and flushed, but they clogged pipes and were eventually discovered in a trash can and inside the toilets.

The case, which occurred this summer but became public only after a report last week in the Swiss daily Tribune de Genève, has highlighted concerns about the use of high-denomination bank notes for money laundering and other crimes. The European Central Bank said last year that it would phase out the €500 note — a bill referred to in some criminal circles as a “Bin Laden,” after the former leader of Al Qaeda.

The public prosecutor’s office in Geneva said that the money appeared to have been disposed of by two Spanish citizens, whom it declined to identify, and that unless there was evidence that the cash had been obtained illegally or was destined for criminal activity, no charges could be brought.

“The fact that you put the money into toilets is weird, but not criminal,” said Vincent Derouand, a spokesman for the public prosecutor’s office.

“The only thing you have to check is if it’s of legal provenance or not,” he said, adding that investigators had yet to find evidence of links to criminality.

According to investigators, the money was found in four locations in May and June: in a toilet at the Rue de la Corraterie branch of the Swiss bank UBS, and in the bathrooms of three restaurants on Place du Molard, a square in the heart of the city’s historic center.

At the Café du Centre, a seafood restaurant on Place du Molard in Geneva, cleaners found €500 notes in the toilet and in a trash can. Credit Gaëtan Bally/Keystone, via Associated Press

The area is filled with restaurants and bistros, traditional chocolate shops and international clothing stores. Around the corner is one of the city’s most famous attractions, the Horloge Fleurie, a giant clock made of colorful flowers.

At the Café du Centre, a restaurant on Place du Molard, cleaners found several €500 notes in the toilet and in a trash can, according to Blaise Gumi, the restaurant manager. Mr. Gumi said that several thousand euros had been found, but that he did not know the precise amount. He declined to comment further.

Though Switzerland has its own currency — the franc — many businesses, shops and restaurants accept euros (usually returning change in francs). Finding wads of cash in toilets is not a common occurrence, however, and the story drew attention in the national news media.

UBS, whose Rue de la Corraterie branch is a short walk away, on the edge of a quiet area known as the “Quartier des Banques,” or neighborhood of banks, declined to comment.

The Geneva police said the investigation was focused on damage to the toilets of the restaurants where the money had been found. The prosecutor’s office said a lawyer for the two Spanish suspects had paid for damage to the restaurants’ plumbing, but added it could not provide further information because it was a private arrangement.

The lawyer could not immediately be contacted, and the restaurants declined to comment on the damage.

The disposal of the large sum of cash came around a year after the European Central Bank said it would phase out the €500 in a bid to curb money laundering and combat financing of terrorist acts. The bill will no longer be printed, and, from the end of 2018, central banks in the 19 nations of the eurozone will no longer replace €500 notes that are returned.

The note is an unusually large denomination, worth nearly $600. By comparison, the highest-value American bill now in circulation is the $100. Though Switzerland has a 1,000-franc note, worth about $1,040, supply is limited. According to both European and United States officials, the relatively easy availability of the €500, combined with its high value, has led to its playing a major role for drug cartels, as well as in other illegal transactions like money laundering and terrorism financing.

A Harvard University study last year found that the equivalent of $1 million in €500 notes weighs about five pounds and fits in a small bag, whereas the sum in $100 bills weighs more than four times as much.

South Korea: The Wild Card in the Korean Crisis


Last May, I spoke at Mauldin Economics’ Strategic Investment Conference and made two points on the situation on the Korean Peninsula. I said that the United States and North Korea had entered into a major crisis and that the crisis would likely lead to war. The crisis ensued, but war has not broken out. As North Korea test-fired another missile that flew over Japan late last week, it’s time to review what happened and why the war hasn’t materialized.

North Korea had been working on developing nuclear weapons for years; this was nothing new. But the development that turned this into a crisis was that the North had passed a threshold. There was evidence that North Korea had developed warheads small enough to be fitted to a missile. There was also evidence that Pyongyang seemed to be moving toward a new missile that would be capable of striking the United States.

One of the United States’ top imperatives is to keep the homeland secure from foreign attacks of all sorts. The possibility of a nuclear attack towered over all other threats. Logically, North Korea would not want to fire an intercontinental ballistic missile and endure the inevitable retaliation that might annihilate the country. The problem for the United States was that it could not be certain that North Korea would follow this logic; the fact that it probably would was not good enough in this situation.

Therefore, the US would try to destroy North Korea’s nuclear and missile capabilities just before they became operational. The problem, of course, was figuring out how close North Korea was to developing an operational weapon. The United States was therefore in an area of uncertainty.

“Likely” Isn’t Good Enough

The US had little to gain from a war with North Korea; it wanted only to destroy the North’s nuclear program. The war plan was complex, and though it was likely to succeed, “likely” is not a term you want to use in war. North Korea’s nuclear and missile facilities were scattered in numerous locations, and many were underground or in hardened sites. And the North Koreans had massed artillery along their southwestern border, within easy range of Seoul. In the event of an American attack on North Korean facilities, it was assumed those guns would open up, killing many South Koreans. Destroying those batteries would require a significant air campaign, and in the meantime, North Korean artillery would be firing at the South.

The US turned to China to negotiate a solution. The Chinese failed. In my view, the Chinese would not be terribly upset to see the US dragged into a war that would weaken Washington if it lost, and would cause massive casualties on all sides if it won. Leaving that question aside, the North Koreans felt they had to have nuclear weapons to deter American steps to destabilize Pyongyang. But the risk of an American attack, however difficult, had to have made them very nervous, even if they were going to go for broke in developing a nuclear capability.

But they didn’t seem very nervous. They seemed to be acting as if they had no fear of a war breaking out. It wasn’t just the many photos of Kim Jong Un smiling that gave this impression.

It was that the North Koreans moved forward with their program regardless of American and possible Chinese pressure.

Another Player Enters the Game

A couple of weeks ago, the reason for their confidence became evident. First, US President Donald Trump tweeted a message to the South Koreans accusing them of appeasement. In response, the South Koreans released a statement saying South Korea’s top interest was to ensure that it would never again experience the devastation it endured during the Korean War.

From South Korea’s perspective, artillery fire exchanges that might hit Seoul had to be avoided. Given the choice between a major war to end the North’s nuclear program and accepting a North Korea armed with nuclear weapons, South Korea would choose the latter.

With that policy made public, and Trump’s criticism of it on the table, the entire game changed its form. The situation had been viewed as a two-player game, with North Korea rushing to build a deterrent, and the US looking for the right moment to attack. But it was actually a three-player game, in which the major dispute was between South Korea and the United States.

The US could have attacked the North without South Korea’s agreement, but it would have been substantially more difficult. The US has a large number of fighter jets and about 40,000 troops based in the South. South Korean airspace would be needed as well. If Seoul refused to cooperate, the US would be facing two hostile powers, and would possibly push the North and the South together. Washington would be blamed for the inevitable casualties in Seoul. The risk of failure would pyramid.

With the South making it clear that it couldn’t accept another devastating war on the peninsula, the war option was dissolving for the United States. When we consider North Korea’s confidence now, it is completely explicable. Assuming the South hadn’t told the North its position, Pyongyang’s intelligence service certainly picked it up, given the various meetings being held. I thought these meetings were about war plans, but in retrospect they were about pressuring and cajoling South Korea to accept the plans. Another indicator I missed was a general absence of South Korean preparations for war and an odd calm among the public. The US was leaning forward, and yet there were few practice evacuations, as if the South did not expect war.

The key element I missed was that South Korea’s overriding imperative was the avoidance of war. It wasn’t happy with North Korea’s programs, but it was not prepared to sustain the kind of casualties an attack on North Korea would precipitate in the South, and especially not the possibility that, like other American wars, a quick intervention would turn into a long and limitless war.

Other Options

For the United States, a nuclear North Korea is still anathema, but war is less of an option. One solution would be to increase the isolation of the North, but there is little that can be done to isolate Pyongyang more than it already is. Another solution would be to convince China to bring overwhelming pressure on North Korea. But in exchange for their cooperation, the Chinese will demand massive concessions. Some will be about trade, others about the South China Sea and US forces in South Korea. Trump will be traveling to China, likely in November, to continue negotiations. In the meantime, South Korea remains opposed to war on the peninsula, and that explains why the US is going after South Korea on steel.

We got the crisis I predicted, but the war that seemed so likely has become an enormously more complex issue… though still a possibility. If North Korea appears too immediately threatening, if China is unwilling or incapable of persuading the North, or if the United States simply decides that it cannot tolerate the risk posed by North Korea, then war is possible. But the geometry of that war will be very different than it first appeared to me.