A Crisis to Remember

Author:Mohamed A. El-Erian
Position::Co-Chief Executive Offi cer and Co-Chief Investment Officer of PIMCO

A crisis in the making. The circuit breakers. The decoupling angle. The IMF: initially missing in action. Prisoners' dilemma.


    The case for modernizing the multilateral framework

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This is a defi ning moment for the global financial system and, by implication, for relationships between countries. The institutional and policymaking landscape is changing in a rapid and unpredictable manner. The changes are not being driven by a master plan but by a series of separate reactions to the global fi nancial crisis. As a result, market accidents and policy mistakes have become largely inevitable. In the process, the inadequacy of today's multilateral coordination is there for everyone to see.

Looking ahead, there is a need for introspection in the countries worst affected by the crisis and for a vision on how to move forward. The financial system will not reset to what it looked like just a year ago, and the longer-term impact of the crisis on the real economy-including on productivity and employment trends-will change the fundamentals of the world economy. All this accentuates the need for urgent and bold modernization of the multilateral framework.

A crisis in the making

How did we get here and who is to blame? At the risk of oversimplifying, the crisis was caused by two factors amid long-standing structural weaknesses: fi rst, the simultaneous and large deleveraging of three major segments of the global economy-the housing sector, the fi nancial sector, and consumer demand in the United States; and, second, the inability of both markets and policies to quickly accommodate such intense deleveraging at both the national and the international levels.

The housing sector. The first major segment to experience a downturn was housing, starting in 2006 (see Chart 1). The immediate damage was felt in the most highly leveraged sector of the economy, a sector that also had the weakest capital support, least transparency, and poorest due diligence: subprime mortgages in the United States.

Initially, the majority of policymakers and market participants felt that the damage could be isolated and contained. This partly reflected unfounded confidence in the host of modern risk management techniques that had been enabled by the proliferation of derivative and structured products.

And it partly reflected inadequate information about the extent to which subprime exposure had infected a number of balance sheets.

The financial sector. The financial sector was the second major segment to experience a downturn, starting in 2007 (see Chart 2). At first the process was orderly. Institutions sought, and largely succeeded in mobilizing, new capital to support their strained balance sheets. And as they raised capital, they recognized their losses and looked to move forward.

But with the housing downturn accelerating and its impact spreading, banks had to run faster just to stay in place. The resulting repeated dilution of shareholders became apparent to all, and was quite costly. As a result, most providers of capital ended up saying "no more"...

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