By Nina Easton
October 4, 2012

NINA EASTON:  My final guest is somewhat of a man of mystery.  As CEO of PIMCO, he oversees investment policies and strategies for one of the world’s largest bond investors, with over $1 trillion — that’s with a T, trillion — in assets under management.  Please welcome to the stage Mohamed El-Erian.  (Applause.)

So, we don’t usually have men on stage, but I have to tell you something, disclose a little secret about our guest, he’s intimidated.  This is a man who grew up in Egypt, his father was ambassador to France.  His name has been put out this summer as potential prime minister to Egypt, which he’s been trying to shoot down.  His name has been out there as potentially running the IMF, potentially running the World Bank, and yet he’s intimidated by you guys.  (Laughter.)  Tell us why.

MOHAMED EL-ERIAN:  First, I’m intimidated — now intimidated and humbled.  Intimidated for a number of reasons.  First, the person who did this last year is Warren Buffett.  I’m not Warren Buffett.  Second, I go to many events, and I can tell you I’ve never been to an event where the collective achievement and the achievement per capita is so high.  So that intimidates me.  And then before I actually sat through the panels, and then I got intimidated and humbled because of what people have done in terms of changing lives.

So I’m up here intimidated, humbled, and just counting the minutes until I can get off the stage.  (Laughter.)

NINA EASTON:  Well, we’re not going to let you go that easily.  Let’s first talk about your relationship with Bill Gross, founder of PIMCO.  He’s known as a trader — T-R-A-D-E-R.  You’re somebody who’s considered a conservative macro-economic thinker.  And yet, you’re potentially in the line of succession.  Talk about your partnership in the firm.

MOHAMED EL-ERIAN:  First, I don’t think of myself as a successor.  I don’t think Bill is going anywhere, not should he go anywhere.  He’s really brilliant.

I think of myself as a small complement, maybe 80/20.  Okay?  And I’m the 20 part.  And Bill and I work closely together and sit next to each other — we sit this far.  We e-mail each other, we don’t talk to each other, but we e-mail each other.  And it’s important because we respect each other’s space in terms of allow the person to finish what they’re thinking.

So we are different.  Bill grew up as a trader.  His famous story is he paid for college playing blackjack.  I was very fortunate.  I had a father who sacrificed everything to send me to the best schools.

So I came up the policy side, the macro-economic side in the public sector, he came up in the private sector.  And everything that you’ve discussed so far today, we are in a world where private and public are coming together.  Public institutions play a much greater role in the private sector today.  Think about what the Fed is doing, think of everything that we’re talking about, regulation.  But the private sector is also impacting a lot how the public sector is thinking.

For PIMCO and Bill and myself, that works really well.  Plus, Bill is one of the very few brilliant people that I’ve met.  I’ve met three in my life.  Three people I’ve met that I can call brilliant, and he’s one of them.

NINA EASTON:  And who are the other two?

MOHAMED EL-ERIAN:  The other two are Mike Spence, a Nobel Prize winner in economics who I’ve gotten to know really well.  And Seth Plauman (ph.) who is someone who is not very well known in Boston, but a brilliant, brilliant financial mind.

NINA EASTON:  Interesting.  So you started to talk about sitting next to Bill in PIMCO.  We talked earlier about equity of space inside the firm, how you try to bring voices to the fore, and how you actually believe in talking about making mistakes.  Take us inside.

MOHAMED EL-ERIAN:  So what attracted me to PIMCO, it is that I came into a firm that took very seriously its responsibility, which is to protect the assets of retirees, of savers, but to do so with a very clear view as to what is coming up and what we should do about it.

And in order to fulfill that mission, you need a few things:  First, you need to level the playing field every single day.  There will be no entitlement in this firm.  You do that not only on how you conduct yourself, but the fact that every office is exactly the same.  It doesn’t matter whether you’re CEO or whether you’re an associate, you have the same size office.

NINA EASTON:  And the corner office is for conferences?

MOHAMED EL-ERIAN:  Yeah.  No corner offices.  Just a conference room.  And then I knew that I had made the right decision when my very first outing with PIMCO, I had come from the IMF, 15 years working on emerging markets.  I had a swagger, I thought I knew what I was talking about.

I put forward my view, and this summer intern felt safe enough to get up and say, “You know what?  Mohamed is wrong and this is why he’s wrong.”  The fact that PIMCO had created this safe zone where a summer intern could get up and question someone who was supposed to be an expert confirmed to me that I was in the right place.

NINA EASTON:  And you guys, it turns out, you were wrong about Lehman, even though the history books are suggesting you were right.  But you tell us the real story is that you were wrong.

MOHAMED EL-ERIAN:  Yes.  So the history books say PIMCO navigated Lehman really well.  They saw it coming, they positioned their clients’ assets accordingly, and we as a firm have benefited enormously because people have trusted us since then enormously, our assets under management have doubled since Lehman.

The real story is we predicted Lehman wrong.  So I remember the weekend of Lehman Brothers, we were in the investment committee room.  We had three scenarios on the wall.  Scenario one was everything would be fine.  Lehman would be a repeat of what had happened six months earlier when JP Morgan took over Bear Sterns.  We gave the highest probability to that scenario.

Scenario two was Lehman would fail, but fail in an orderly fashion.  The second highest probability.

Scenario three, Lehman would fail, but fail in a disorderly fashion.  We gave that the lowest probability, that’s what happened.  Why did we navigate it well?  Because for each scenario, we had an action plan.  For every single one.  So even though the probability was low, we had spent the time figuring out what is it that we’re going to do if it turns out that we’re going to be wrong?

So we had our lawyer at Lehman at 3:00 a.m. in the morning giving the notice of failure in order for us to reestablish and protect our clients well before anybody else reacted.

And this is important because I think today as we heard, we live in unprecedented times, unthinkable times, and having an action plan for different scenarios is the key difference between success and failure.  It’s not about predicting right, because most us will not be able to do that, it is about reacting once things happen.

NINA EASTON:  So you now have an action plan for five potential global economic risks.  Tell us what the risks are and then we’ll go through each one of them.

MOHAMED EL-ERIAN:  So we are worriers, okay?  We always wonder what can go wrong, and we worry about more things than actually happen.  Right?  So that explains why we’re paranoid by nature.  Our culture is to be constructively paranoid.  You’re paranoid, but you’re constructive about it.

So as you heard this morning, there are a set of things that can go well.  Most people don’t want to talk about those, but there are a set of things that go well.  And there are a set of things that can go badly.  Two of them come from Europe.  So it’s not enough to say, oh, Europe is scary.  You’ve got to concentrate what in Europe is scary, and two things in Europe are scary:  Greece and Spain.

In the U.S., we have a self-inflicted threat, which is a significant one, which is the fiscal cliff.  The first one is whether China soft lands, and finally, what happens in the Middle East, particularly what happens in Iran.  Each of these can completely change the outlook, completely.  So it’s really important to figure out what these threats are and how you will respond to them if they were to materialize.

NINA EASTON:  Okay.  Let’s start with fiscal cliff.  Potential scenario, impact on GDP and the bond market, because it’s not necessarily the same.

MOHAMED EL-ERIAN:  Right.  So the fiscal cliff is very simple.  If Congress doesn’t take decisions, then we will get a fiscal contraction of 4 percent of GDP.  Why is that important?  Because that unambiguously will throw us into recession.  If it throws us into recession with an unemployment rate that’s so high, with inequality that’s such a problem, we will suffer enormous feedback effects.  So much so that you get close to a situation where for the first time in a very long time, our kids’ generation will be worse off than ours.  So this is really important.

NINA EASTON:  So that’s the “do nothing” scenario.

MOHAMED EL-ERIAN:  That’s the “do nothing” scenario.  Our own baseline — and I’ll give it a 60 percent baseline — is that Congress gets its act together, it does something, doesn’t completely eliminate the cliff, nor should it, but the fiscal contraction is at 1.5 percent of GDP, and that’s something that our economy can absorb.  That is our baseline.

The up-side scenario is a grand bargain.  And if you get the grand bargain, unleash the $3 trillion that was talked about this morning, and the impact on the economy is significant, and of course the negative tail is we go into recession.

NINA EASTON:  So the grand bargain, what happens to GDP and the bond market?

MOHAMED EL-ERIAN:  So the grand bargain starts putting together the solution to a lot of our problems.  The most frustrating thing for an economist, and I’m an economist by training, is that what the U.S. faces is not an engineering possible, it’s a political problem.  It’s about politicians not able to agree because, A, they don’t trust each other, and B, they’ve made all sorts of commitments that make less sense in today’s world.  They have the legacy of the past that they can’t get rid of.

So our problems are not engineering, they’re political.  So if we can get the politics right, the engineering is such that we can then grow at 3-4 percent, we can again lower unemployment to something acceptable, and we can deal with two really big problems that all of us would worry about, especially if we’re parents.  And I have a nine-year-old, I worry about this a lot.  Youth unemployment is 24 percent.  24 percent of 16 to 19-year-olds are unemployed.  When you are unemployed at that age, you risk becoming unemployable.  And then you talk about a lost generation.

And then long-term unemployment is at record highs.  We need to deal with this issue because it’s structurally embedded in our economy, we find it very difficult to overcome.

NINA EASTON:  Just going back to the grand bargain.  If Congress does come up with a grand bargain, A, what would that look like?  B, you know, what would be the effect on the economy?

MOHAMED EL-ERIAN:  So as much as the narrative will sound different, including tonight, any solution requires simultaneous movement on the tax side and on the entitlement side.  You can’t get there mathematically in one way because if you tried to get there mathematically either just on spending or on taxes, you’re going to break something.  And what you break, the collateral damage will be greater than what you’re trying to solve.

So you need compromises and we need both tax reform and entitlement reform.  It’s feasible.  We have time.  You know, it’s a great thing that we issue a currency that everybody else wants.  Right?  So we have time to get it right.  We just need politicians to compromise and move simultaneously on both things, and combine that with fixing the labor market, the credit market, and the housing market.  That’s a lot.

NINA EASTON:  So you think that will boost the economy, but the bond markets won’t be happy?

MOHAMED EL-ERIAN:  The bond markets won’t be happy because the bond markets right now are pricing two things, first the very sluggish economy, and rightly so.  We’re growing at 1 percent per annum.  And second, we are pricing in a very activist Fed that’s buying lots of bonds.  So you always want to have something that someone else wants.  So valuations of the bond market are up here, okay, and the fundamentals are down here, right?  So if the fundamental starts moving, you’re going to get an interest rate adjustment that’s going to impact the bond market.

As a citizen, that’s what I want.  I’d like our economy to pick up.  Yes, it’s going to have an impact on our business, but it’s much better to live in a healthy society than to just have a good business.

NINA EASTON:  Greece and Spain.

MOHAMED EL-ERIAN:  Real problem.  There, it’s more than politics, it’s engineering too.  Greece is like the infection in your toe.  If you don’t pay attention to it, it’s small, and then the next thing you know, it’s spread to your leg, and the next thing you know it’s affecting your vital organs.  You’ve got to deal with it.  And Europe has not dealt with the problem of Greece.

What Europe has been trying to do is to buy time to sort out other parts of the body.  Now, there’s a problem with that, which is that the Greek people are suffering greatly.  Greatly.  Youth unemployment in Greece is 50 percent.  Overall unemployment is 24 percent.  People see absolutely no light at the end of the tunnel.  They’ve gone through four years of austerity and there’s been no payoff whatsoever.  So what do you get?  You get total economic, financial, political, and social rejection by society.  The economy implodes, people take their money out, they don’t trust the political system, and you get social unrest.

That is where Greece is today.  That is a really unstable situation.  And if we’re not careful, that no one will no longer be in control of what Greece’s outlook looks like.  It will be left to a very disorderly outcome, and that in itself would have an impact on Europe.  So Greece is important, even though it’s small.

NINA EASTON:  So where are you putting odds on what’s going to happen?

MOHAMED EL-ERIAN:  I’m really worried about Greece.  I don’t think people quite realize what happens when the population simply rejects the system.  It happened in Argentine.  Any of you who lived through Argentina in 2001 will know how quickly things can get out of control, and how at that point the all-powerful policymakers cannot regain control.  So I really worry about Greece and I really worry that that in itself can cause — now, Europe knows.  It’s building firewalls, that’s the good news.  But no one wants to take an active decision.

It’s a very simple decision.  Either you say you want Greece in the Euro zone and you just write checks for a very long time, what West Germany is still doing to East Germany today, 22 years later.  So you say this is not an economic decision, this is a political decision and I’m committed to writing checks for a very long time.  Or you find a way for Greece to exit the Euro zone.  But this muddled middle where you don’t do much of this and you don’t want to talk about this is really problematic.


MOHAMED EL-ERIAN:  Spain needs to apply for financial aid.  So Spain is in the situation where the Euro zone is willing to give it to money through the European Central Bank, unlimited amounts, but Spain doesn’t want to apply.  And why doesn’t Spain want to apply?  Two reasons:  One, internal politics; and two, the stigma.  Internal politics, it has elections coming up.  It has regions looking for autonomy.  The regions feel that the center is weak, so there are a lot of political games going on.  So that stops the government from looking forward.  And stigma, it’s a bit like what they call the roach motel, once you get in, you can’t get out.  Like Hotel California, if you’re an Eagles fan, right?  You can check out, but you can never leave, right?

But it needs to overcome this.  You need Spain to have a vision and say, “I need help right now to get there and I’ll take the political cost of getting there, but I need to go forward.”  And the longer they hesitate, the harder it gets.

NINA EASTON:  So what is PIMCO’s most likely scenario on the Euro zone?

MOHAMED EL-ERIAN:  So our most likely scenario is the Euro zone survives.  Most people say that that makes sense.  But our second element of that, which is more controversial, is the Euro zone shrinks in size.  It becomes less imperfect, more homogeneous in terms of the politics, and therefore it is not a Euro zone of 17 member countries, it’s a smaller Euro zone.

NINA EASTON:  Of how many countries?

MOHAMED EL-ERIAN:  Probably somewhere between 14 to 16.

NINA EASTON:  You’re just saying Greece — who’s out?

MOHAMED EL-ERIAN:  At the minimum, Greece.  And then there are going to have to be some decisions to make about some other countries that have to decide whether they can live within the Euro zone or not.  The Euro zone imposes tremendous discipline on you by reducing your flexibility of movement.  So you’d better be able to deliver on that discipline, otherwise your citizens are worse off.

NINA EASTON:  Give us your scenarios on Iran.

MOHAMED EL-ERIAN:  You know, I worry about that because that economy is imploding.  Any of you who saw the news yesterday would have seen that the sanctions are working, and the west is putting pressure on Iran to abandon its nuclear initiative.

The problem is that Iran doesn’t trust right now the west to deliver once it abandons its nuclear initiatives.  If you are a game theorist, there’s something called a non-cooperative cooperative game.  So we all know what a cooperative game is, a bit like a family.  Everybody needs to cooperate, share the burden, get things done.  And why does that work?  Because we trust each other or you have an enforcer, right?

If you try to run this game without trust, and trust doesn’t exist among the three parties — Israel, the United States, and Iran — and without an enforcer, there is no enforcer, there is no incentive to cooperate.  And when there’s no incentive to cooperate, bad things can happen.  So, that is why this is one of our five big risks.

NINA EASTON:  So, are you putting a percent likelihood on military action?

MOHAMED EL-ERIAN:  Again, it’s one of these things where we don’t think we’re smart enough, nor do we have the expertise of saying exactly how this can evolve.  We just know that if something happens, then these are the consequences, this is how we want to protect our clients.

So, if something happens in Iran, you know oil prices are going to shoot up.  Tom Friedman from the New York Times always reminds us that there are societies that implode when they get destabilized, others explode, explode in the sense that they destabilize other things around them.  Iran explodes.  It destabilizes Syria, it probably destabilizes Lebanon, it probably destabilizes Bahrain.

So, we think of the consequences, we play scenario, what happens to oil prices, what happens to risk appetite, and how do we want to protect our clients in that world.  That’s what we do.

NINA EASTON:  And finally China.  Will there be a hard landing?

MOHAMED EL-ERIAN:  We don’t think so.  We think China soft lands to 6.5 to 7 percent.  For the rest of us that’s great, for China that’s a low growth rate.  But we’re humbled by what Mike Spence who I mentioned earlier reminds us, and we should always remember this:  Only five countries have succeeded in what China is trying to do, and China is trying to navigate what’s called the middle income transition, when you go from a developing country to an advanced economy.  It’s a bit like your teenage years for your kids.  They’re tricky.  Things change very, very quickly.

So, China is trying to do that and trying to do it at high speed of growth, and only five countries have managed that in history, five, and none was as big as China and none was as complex as China.  So, this is a very complicated transition, and all of us have to be humbled by not just what China has achieved but what China is trying to achieve.

NINA EASTON:  And do you know the five countries off the top of your head?

MOHAMED EL-ERIAN:  Yeah.  They are two small ones, Singapore, Hong Kong, Taiwan, Korea, Japan, the only five countries that have done it historically.

NINA EASTON:  All much smaller.

Well, unfortunately, we’re out of time.  That’s what you’ll learn about the Fortune conferences, too.  They go — we always try to stick to the clock and we’re fast paced, but thank you so much.  This was so enlightening and frightening on some level, but very enlightening.  Thank you so much

MOHAMED EL-ERIAN:  Thank you.  (Applause.)

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