Former Pimco CEO Says Global Financial System Is Broken

People often congratulate him on navigating Pimco through the financial crisis so successfully and ask, “How did you know what would happen?” His answer: We didn’t know. On the Friday before the weekend when Lehman Brothers failed, Pimco’s top managers went home leaving three scenarios on the whiteboard:

• Lehman gets rescued. They considered this by far the likeliest outcome.
• Lehman fails in an orderly manner, with thorough plans for unwinding its positions.
• Lehman fails in a disorderly manner. They believed the chance of this was less than 5%.

Pimco developed detailed plans for what to do in each scenario. So when the least likely scenario happened, the company responded confidently and quickly, including sending a lawyer to Lehman’s offices in person Monday morning to deliver critical instructions and documents.

Pimco didn’t try to predict the future; had it done so, it would have been wrong. Instead it imagined different futures and prepared for each one. People often object that this is wasteful, since most of the plans will never be used. But, says el-Erian, “it’s a lot less expensive to prepare plans for events that never happen than to have no plans for events that do happen.”

His larger point is that today’s environment is in many ways as crazy and unpredictable as the environment of September 2008, and we must prepare in the same way. “Secular stagnation” isn’t secular, he argues – it can’t last. Looking across the developed world, he believes the financial system is broken; “negative rates don’t work forever.” Politics are broken; fringe parties and movements can influence but can’t govern. And social systems are broken, as the widespread revolt against immigration shows. Today’s stagnation will end in the next two to three years, he says. But how?

Economists agree on the broad outline of what should be done. The prescription includes comprehensive reform of taxation, immigration, and social insurance across developed economies plus specific steps in particular countries, which together should spark a return to strong growth and more normal interest rates. But maybe none of that will happen, in which case “low growth becomes recession and artificial financial stability [maintained by aggressively easy monetary policy] becomes financial instability.”

If el-Erian is right, we’re headed for one of two starkly different futures, and soon. Which will it be? He has learned not to guess. “Our only hope,” he says, is to “think in scenarios, get cognitive diversity” into our discussions, and plan now for multiple futures – even the ones we think are highly unlikely.

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