Three Signals We’ve Entered a New Economic Era

“From the U. S. Federal Reserve’s initial misjudgment that inflation would be ‘transitory’ to the current consensus that a probable U. S. recession will be ‘short and shallow,’ there has been a strong tendency to see economic challenges as both temporary and quickly reversible,” writes the economist Mohamed El-Erian. “But rather than one more turn of the economic wheel, the world may be experiencing major structural and secular changes that will outlast the current business cycle.” There are few people who understand financial markets or central banking as deeply as El-Erian. He is the chief economic adviser at Allianz, the president of Queens’ College, Cambridge, and the author of multiple books, including, most recently, “The Only Game in Town: Central Banks, Instability and Recovering From Another Collapse.” Until 2014, he was the C. E. O. of PIMCO — which under his leadership was the largest bond manager in the world. In recent years, markets have been roiled by significant shocks — from a global pandemic that snarled supply chains and disrupted labor markets to a Russian invasion of Ukraine that sent global commodities markets into a tailspin. But El-Erian believes we’re also witnessing a deeper structural shift in the very nature of the global economy. Economic policymakers today are trying to bring the economy back to that of 2019, but in El-Erian’s view, there is no going back. We’ve entered a new era that demands a different kind of response. So I invited El-Erian on the show to help me understand the economic era he thinks we’re entering and how policymakers can respond. We discuss whether the United States is experiencing a permanent decline in labor force participation, why modern supply chains could continue to experience difficulties well beyond the pandemic, how changing U. S.-China relations could unleash inflationary pressures throughout the world, how the Fed’s efforts to stabilize financial markets may have ironically opened the door to the financial collapse, why El-Erian believes a decade-plus of easy money was a colossal mistake, what lessons developing countries learned from the 2008 financial crisis, the parts of the global financial system most at risk of melting down today, El-Erian’s scathing critique of the Fed’s communication strategy and more. Mentioned: “Not Just Another Recession” by Mohamed El-Erian The Only Game in Town by Mohamed El-Erian Book Recommendations: Invisible Women by Caroline Criado Perez Bad Blood by John Carreyrou The World For Sale by Javier Blas and Jack Farchy Thoughts? Email us at [email protected]. (And if you’re reaching out to recommend a guest, please write “Guest Suggestion” in the subject line.) You can find transcripts (posted midday) and more episodes of “The Ezra Klein Show” at nytimes.com/ezra-klein-podcast, and you can find Ezra on Twitter @ezraklein. Book recommendations from all our guests are listed at https://www.nytimes.com/article/ezra-klein-show-book-recs. “The Ezra Klein Show” is produced by Emefa Agawu, Annie Galvin, Jeff Geld, Rogé Karma and Kristin Lin. Fact-checking by Michelle Harris and Mary Marge Locker. Original music by Isaac Jones. Mixing by Jeff Geld. Audience strategy by Shannon Busta.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:06Ezra Klein?

  I'm Ezra Klein. This is the Ezra Klein Show.

• 0:23Ezra Klein?

  So here's a question, and a lot actually rides on the answer. What's a great story to tell about the economy right now? Is the economy and its fundamentals a lot like it was in 2019, but we're just still working out the kinks and the traumas of the pandemic? Or has something changed more fundamentally, where there's no going back to the economy in 2019? That we're now instead in a new era, and what normal could look like, will look like now, is not what normal looked like then? Mohamed El-Arian thinks we're in the new era. El-Arian was, until 2014, CEO of PIMCO, which was the largest bond manager in the world. And he's still chief economic advisor at Alliance, PIMCO's parent corporation, and president of Queens College at Cambridge, and a columnist at Bloomberg View.

• 1:08Ezra Klein?

  So he's a guy who knows markets really deeply, particularly knows bond markets really deeply, which is important for thinking about inflation, for thinking about responses to Federal Reserve initiatives. He's very close with many of the world's key central bankers. And over the past year, he's been a very consistent voice, arguing the Fed is doing too little, in part because it thinks the economy of 2019 is still possible, when it isn't, and in part because it doesn't understand market psychology. In a recent piece for Foreign Affairs, El-Arian explained that the ways in which he thinks the economy has changed, and gave in particular three ways in which the new era will be different than the previous one. And so I asked him on the show to walk me through the argument. As always, my email, [email protected].

• 1:56Ezra Klein?

  Mohamed El-Arian, welcome to the show.

• 1:58Speaker 01

  Thank you. Great to be with you.

• 2:00Ezra Klein?

  So you have a new foreign affairs article where you argue that this is actually the cusp of a new era and that a mistake that forecasters and commentators are making is to think the Fed could just chart us back to pre-2020 territory. So I want to talk about the three economic foundations you say are changing. And I want to begin with your first one, which is you say we're dealing with a shift where the big problem in the economy, the global economy, was insufficient demand and now is insufficient supply and it will remain that way. Why?

• 2:31Speaker 01

  A number of reasons. First and foremost, the labor market is changing and we're getting confirmation of this every day. Labor force participation is not going back up. There's all sorts of rigidities. We're seeing massive vacancies, relatively unemployed, and the labor market is simply not functioning the way it used to be. That is only one part of a bigger supply story. Supply chains are being rewired. Part of it is driven by what's happening in China. Part of it's being driven by national security and part of it is being driven by significant change in the way companies think of how they operate. It is no longer solely a focus on

• 3:14Speaker 01

  efficiency. Resilience has become important. And then finally, globalization is changing. So when you put all these things together, the supply side becomes less responsive and it becomes the binding constraint that plays out on growth, that plays out on inflation, and that is what we're seeing.

• 3:32Ezra Klein?

  I want you to unpack a bit of that. When you say the labor market is changing, it isn't working the way it used to. How did it work? And how is it working now?

• 3:42Speaker 01

  So the indicators are very clear. They suggest that there's a problem with people being in the labor force. They also suggest that there's a problem in matching the unemployed with the jobs that are available and where companies want to hire. I think labor force participation has to do with pandemic effects that are still in force.

• 4:09Speaker 01

  Have to do with changing preferences about life, work balance, and critically have to do with the lack of child care and support in general for certain segments of the population to engage into the labor force. The second one, the mismatch of skills, is harder to solve. That has to do with the evolution that we're seeing in terms of tech. And this distinction that's getting bigger between the service industry and the goods industry. And these are structural changes that we have to take seriously. You know, we have a tendency to think that the world is mean reverting.

• 4:53Speaker 01

  Last year, that played out with inflation. The minute people started worrying about inflation, they were told not to worry. It is transitory, meaning it's temporary, it's reversible. We can quote, "look through it." And therefore, don't change behaviors, don't change policies. This year, as we look at the risk of recession, the same people who dismissed inflation as transitory and were wrong are saying, "Don't worry, it will be short and shallow." And again, a concept of mean reversion. What we really are seeing is structural and secular changes that have to be taken seriously by governments, by central banks, and by companies.

• 5:32Ezra Klein?

  Let me cop to a bias here. I'm always pretty skeptical of arguments about labor market matching. I mean, I remember after 2010, we were hearing a ton of that as we were in the slow recovery from the financial crisis. "Oh, the workers just don't have the skills, we need to upskill, we need to retrain." And then as the economy heated up and job markets got better and wages began going up, it turned out we could find work for those folks. Here, it seems maybe a little bit more likely to me that there are pandemic reasons, that there are, as you said, values reasons. But what makes you think we have suddenly after the pandemic a skills shortage as opposed to something else?

• 6:12Speaker 01

  So first, it's important to make the distinctions you made because we are not waiting for the economy to heat up and to be in a better place. The economy has been in a better place. We've had a ton of liquidity injected from both the fiscal and monetary side. The economy, if anything, has been deemed to be, quote, "too hot." I don't necessarily agree with that, but that's how it's been characterized. And wages are picking up, but wages are picking up at a time when inflation is a problem. So the endogenous solutions that you refer to should have played out or cannot play out to the extent that they've played out. What about the impact of the pandemic?

• 6:55Speaker 01

  So we know that the pandemic has altered some of the supply of labor. What about the demand for labor? I think the nature of the demand for labor has also changed because the way we do things has changed. And that's where the issue comes in. Now, we don't know for sure. I remember being told a year and a year and a half ago, "Don't worry about labor force participation. It will come back. It all has to do with the extra unemployment and benefits that we're paying." Well, they stopped last September, and we haven't seen labor force participation come back up. It may take some time. It will take some time, but we don't have as much time as we'd like to have. We have an inflation problem.

• 7:40Speaker 01

  We don't want to get stuck with high inflation, and you get stuck with high inflation or sticky inflation if the supply side doesn't become more responsive.

• 7:47Ezra Klein?

  How much of this is really just a function of aging or maybe aging plus pandemic risk fears? Because something I think is interesting about looking at the labor force participation numbers is when I look at prime age labor force participation, that's back up. It's back up to where it was in 2019. Nobody, I don't want to say nobody, but I don't think we understood there to be a crisis in labor force participation in 2019. But as you say, when you look at the overall numbers, which includes workers beyond prime age, beyond that 25 to 54 group, that is quite a bit down from pre-pandemic. So how much are we looking at? We knew the workforce was aging. The pandemic was a shock that led to older workers disproportionately leaving the workforce

• 8:32Ezra Klein?

  because being in it is more dangerous. And the problem is we don't really know what to do about that.

• 8:39Speaker 01

  You've said it very well. It's definitely a factor. It is not just that labour force participation has remained below where we were on the eve of the pandemic. It continues to go down. The last jobs report, people expected labour force participation to edge higher. It went down. That's the second month in a row it goes down. So there is a dynamic that goes beyond the pandemic. The pandemic may explain why we are at a lower level overall, and I think it is part of that explanation. But if you look at the changes month on month, you still have negative signs. So I, I think there is something beyond the pandemic.

• 9:22Speaker 01

  We don't fully understand, and labour economists are looking very hard at this because it's such a consequential issue. But then why isn't it hitting prime age workers? The bottom line is we don't quite know the exact reasons other than we have a problem. If it were just the pandemic, and we have exited from the pandemic, and we have indications that the economy is running hot, that we don't have a problem of demand, you would have expected to see labour force participation go up. Wage growth, just to put it into context, year on year, it's 5%. The last three months, it's 6%. Wages have picked up and are still going up. And yet, labour force participation is coming down.

• 10:04Speaker 01

  So there's some structural issue that is in play here. Hopefully, it will get solved by time and by the recognition that as wages go up, it makes sense to re-enter the labour force. That's my hope. But we've relied on hope for too long. I think we have to take seriously issues like childcare, seriously issues like retraining and retooling of the labour force. And these are public-private partnerships that are yet to gain any traction.

• 10:33Ezra Klein?

  I think that's well put. I mean, I think my question that I keep running around is I wonder if we have a bifurcated end of the pandemic, which is, I see this in my own life, that the pandemic has ended for the young people in my life, like the middle aged people in my life. And then the older someone gets, the more the pandemic is still present for them. That's very true for people who are more elderly, but but people in their 60s are just at a different risk or feel a different risk than people in their 30s. And I wonder if something we don't quite know how to think about here is that the pandemic has ended for enough people, but in part because of that, because it has ended for those people. So they're now exhibiting riskier behavior. It really is not ending

• 11:15Ezra Klein?

  for a pretty significant portion of the older workforce, which is partially why they're not coming back or they're leaving the labor force. But I want to move on to supply chains, which you you mentioned as well. I think people had a sense a couple, you know, over the past couple of years, Russia, China, America has become interested in friend shoring. We're trying to bring more supply chains domestically. Obviously, a lot of supply chain fragility was exposed by the pandemic. What are the enduring changes here? What has snapped back? And what do you think will simply not snap back?

• 11:47Speaker 01

  So most of the pandemic effects have snapped back. And what do I mean by that? Containers in the wrong place. You know, when we shut down the global economy, economists call it a sudden stop, when everything stops, you don't just switch it back on. When you try to get the global economy going again, you find that the ships are in the wrong place, the containers are in the wrong place. It takes time to reorder the global economy. And we saw that. And because of that, shipping costs soared, container costs soared, all these now have come down. So the first effects of the supply chain disruptions were completely

• 12:25Speaker 01

  dominated by pandemic effects. But there are two deeper forces at play. One is geopolitical fragmentation. It has to do with tensions, particularly China-US tensions.

• 12:43Speaker 01

  And the friend shoring, the near shoring, is basically saying, for national security reasons, let's increase the resilience of our supply chains. And the Inflation Reduction Act is a perfect example where governments get involved in order to encourage what is de facto near shoring, onshoring, friend shoring. Then you have what companies themselves are doing. For a very long time, just in time, approaches were governing how people thought of their supply chains, and for good reason. Inventory can be expensive. If you can run very efficient supply chains, there's a tremendous amount you gain.

• 13:30Speaker 01

  But this focus on efficiency came at the cost of resilience. And when you have jurisdictions that are behaving in ways that disrupt your supply chains, as is happening repeatedly in China with the COVID zero policy, you start thinking about resilience much more seriously. And that's not a geopolitical issue, that is simply cautious management. And we have seen companies look to diversify their supply chains. Now, you cannot diversify your supply chains overnight. This is something that takes a long time and is inherently inflationary. We then have one major other

• 14:14Speaker 01

  reorientation, that's energy. The critical energy transition

• 14:21Speaker 01

  is inherently inflationary. So when you take all this back, you have supply chains that are less responsive in terms of quantity and more responsive in terms of price. And this is beyond the pandemic. This is just the reality of an economy that's being rewired for better resilience and for the realities of climate change.

• 14:49Ezra Klein?

  I was going to come to China later, but I think we should do it now, actually. Because when you think of a premise on which the global economic order we've been in for the past couple of decades was built, I think China is just itself a premise. Its predictability, the role it's going to play in global manufacturing, the primacy that the Chinese Communist Party is going to give to economic growth. And then a bunch of things have changed in China. Xi is running China with much more dictatorial control and at the same time making very different trade-offs around economic growth. You have zero COVID policy, you now have mass protests in the streets, you have the China-Russia semi-alliance, which has led to more skepticism with the US.

• 15:34Ezra Klein?

  You have rising levels of American hostility and antagonism towards China. How do you understand what has changed in the role China could be or was relied on to play in the global economy, you know, five years ago? And the role it will be playing or can only be relied on to play in the coming years?

• 15:57Speaker 01

  So let me answer that question by first thing, I'm abstracting from the short-term issues that have to do with the zero COVID policy. And I'm looking at longer-term issues. And there are three that absolutely dominate. One is China has been so successful that its growth model is no longer fit for purpose. Its growth model was the same as we've seen in other countries, Singapore, Korea, basically leveraged the global economy to achieve domestic goals. But China is very large. And the more it climbed up the development ladder...

• 16:39Speaker 01

  The bigger it got relative to the global economy. So China needed a transition from an externally driven model to an internally driven model. And that's going to dictate whether it also falls into the middle income trap that other countries like Brazil have fallen into, or whether it's able to achieve what the smaller economies were able to achieve. Second issue is that there was an implicit contract associated with allowing China into the global system. And that is that China would take on global responsibilities, especially as it got bigger.

• 17:21Speaker 01

  And there's a fundamental difference in how China is viewed inside China or outside China. When we are outside China, we say, look, China, you're the second largest economy in the world, and you may well become the largest economy in the world. You need to take up your global responsibilities. Look from within China, China would say, we were a low-income country. We're still a middle-income country. We still are relatively far away from being a top 10 or top 20 in terms of GDP per capita. Wait for us to get up that league, that per capita league,

• 18:05Speaker 01

  and then we will play to the global responsibility you think we should be. Now, the world is no longer patient. The lack of patient was, of course, very visible under President Trump, but it hasn't changed because there's also a national security element to it. And then third is the internal change. China used to dictate the overall direction of where it's going. Mid-course correct is needed, but then allow its private sector to operate under these parameters. And what we've seen in recent years is a much more top-down directed economic approach. So you put these three things together,

• 18:48Speaker 01

  and not only is China no longer the powerful engine of global growth, but it can be disruptive, both on the supply side and on the demand side.

• 19:00Ezra Klein?

  We tend to talk about China in terms of its growth model. But how big a part of, say, Western countries' pricing model was China? When we talk about this era of changing supply, of higher inflation, and you think about it persisting, how much of that is that we relied on China and its manufacturing prowess to create enough stuff at a low enough price point that we could keep this kind of consumer economy going? And a lot of the turbulence is simply that we are not sure we can rely on that or want to rely on that anymore.

• 19:39Speaker 01

  That's part of the resilience argument. No, you're absolutely right. Part of it is that not only are we not able to rely on it anymore because China shuts down every once in a while, because China's wage levels have gone up, and because there's now a domestic market in China for what China produces. That's all true, and that is certainly in play. But we also don't want to rely as much as we've relied on before. And as I said earlier, when you try to rewire your supply chains, it is inflationary. This is like trying to change an engine on a plane in flight. It's going to be bumpy.

• 20:23Speaker 01

  You're not going to be able to maintain the same altitude. And if you're not careful, you may lose a lot of altitude. So yes, you're absolutely right.

• 20:55Ezra Klein?

  So let me then go to your point number two, which is that we have been in this era of boundless easy money from central banks. That era was unusual, and that era looks to be over. Tell me about that.

• 21:09Speaker 01

  So coming out of the global financial crisis, where central banks played an absolutely critical role in avoiding a multi-year depression that has damaged the well-being, not just of the current generation, but of future generations. They looked around, and they wanted to hand off the responsibility for inclusive high growth to governments. This is 2010. Central banks had fixed malfunctioning markets, and now we're looking to step back. The politics didn't allow that handoff to happen. Look at the United States. It was the emergence of the Tea Party.

• 21:51Speaker 01

  It was the November 2010 shellacking of the Democrats. It was when we shut down the government. So central banks did what any doctor will do, even if the doctor doesn't have the right medication. They provided painkillers. So they continued and we oriented what's called QE, which is this exceptional period of injecting liquidity in a predictable fashion into the economy and maintaining very low interest rates. They kept it longer. And the hope was very simple, that they would push up asset prices, financial assets, that we, when we open up our statements, would feel richer.

• 22:36Speaker 01

  It would trigger what economists called the wealth effect. We feel wealthier, therefore we'll go and spend more. As we spend more, companies invest more, and then growth is boosted, both by higher consumption and high investment. That was the theory. But the financial asset channel proved to be very leaky. It did a great job in boosting asset prices. We had this incredible period where every asset price went up. It didn't matter if it was a risky asset, if it was a risk-free asset. Everything went up because central banks were boosting liquidity by so much and so predictably that they encouraged everybody else to take on more leverage and more debt.

• 23:18Speaker 01

  But the trickle down to the real economy proved to be very weak. And the longer it persisted, the more two things happen. One, you conditioned markets to think of central banks as their BFF, their best friend forever. That whenever there's any turbulence in markets, they're going to come in and just buy more. There were examples of that, the 2013 taper tantrum. When Chair Beneki at the time announced that he was going to stop QE. And the markets forced him to reverse course six weeks later.

• 24:00Speaker 01

  And the fourth quarter of 2018, when Chair Powell tried the same thing and then had to undertake a very embarrassing U-turn. Because the markets had gotten so unsettled. So markets were conditioned that they had their back covered all the time by the Fed, which means you take on more and more risk. You start moving into more and more exotic asset classes. You start going beyond your natural habitat and expertise and you over lever. Then the second thing that happened is we started seeing misallocations of resources. And we started seeing all sorts of unintended consequences and collateral damage.

• 24:44Speaker 01

  Then put this whole regime on turbocharge during the pandemic. When understandably, understandably, governments and central banks stepped in. But continued providing exceptional support. Combine that with what we were talking about earlier, supply problems, and you end up with high inflation. And the minute you have high inflation, you can no longer continue with the monetary policy regime we had. You have to start, quote, "normalizing," unquote, monetary policy. And that's where we are, but you're doing that with a financial system that was conditioned.

• 25:26Speaker 01

  To optimize a regime that it thought it would last forever. And that's why this process has proven to be bumpy. That's why we've seen small, very small financial accidents. And that's why we have to keep an eye on the unintended consequences of a change in regime. That is inevitable because we need to bring inflation down.

• 25:51Ezra Klein?

  So one of the trade offs that we were always told of the QE era, the quantitative easing era, is that the Fed was putting, and other central banks too, were putting all this money into the asset markets. And yes, that was going to raise inequality because people who owned assets were going to be the first beneficiaries of that. People could borrow a bunch of money, were going to be the first beneficiaries of that. But it was going to increase growth. We had an economy where, far from not having enough supply, we didn't have enough demand, and that seemed to be a consistent problem. And as you mentioned, actors like Congress, which could have stepped in in a more targeted way, were out of the game. And so it's going to be worth it. It would increase inequality.

• 26:32Ezra Klein?

  It would maybe to some degree addict financial markets to easy money, but it was going to help solve an economic problem that there wasn't really another good way to solve. When you look back over the past 10-ish, 15-ish years, do you think that was true? Do you think the trade off was worth it?

• 26:49Speaker 01

  No. In fact, I've written a book on it back in 2016, warning that to the extent that that trade off existed, it was turning more and more negative. And at some point, it would turn critically negative. This was 2016. And the reason why is you cannot push on a string. You cannot fool people. For you to believe that your wealth gets translated into higher spending, a few things have to be true. First and foremost, what economists call your marginal propensity to consume, meaning your willingness to buy more things, has to be high.

• 27:29Speaker 01

  Ironically, the rich, the ones who benefited most from the increase in asset prices, have a low marginal propensity to consume. So you don't get much bang for your buck, simply on that account. Second, as I said earlier, markets got conditioned. I entered financial markets late, and I was always struck by how financial markets rely on moral hazard. Rely on the notion that authorities will have no choice but to bail them out at some point.

• 28:10Speaker 01

  And the more you reinforce that belief by intervening whenever there's some market volatility.

• 28:20Speaker 01

  The harder it is to exit. So I was really worried that we would have that process continue. And then third, it allowed governments to step back and basically allow, let central banks be the only game in town, because central banks seemed willing to continue doing so. You know, we had an interesting line drawn by the Bank of England. Some of you may know that the United Kingdom went through a very interesting political exercise, where a new government came in and tried to go to quote the Prime Minister Liz Truss, too fast and too far in providing unfunded tax cuts.

• 29:02Speaker 01

  And that created a major market problem. The currency collapsed, borrowing costs went up, the mortgage market got disrupted, and the pension system was on the verge of, to use the Bank of England's, the central bank's word, a meltdown. And then the Bank of England came in, in a method that's very similar to what we had seen earlier, which is QE, saying, don't worry, I will buy the securities that the others don't want to buy, and in doing so, I'm going to encourage others to buy them. But then the Bank of England did something very, very different. A few days later, it came out and said, look, I am serious.

• 29:46Speaker 01

  This is a temporary operation. I am stopping it on Friday, and I'm warning you that I'm stopping it on Friday. By doing that, it was seeking to do two things. One, resist what's called fiscal dominance, resist being the one that's always there when the governments are not doing their job. And second, it wanted to make it very clear to the marketplace that mal-hazard wasn't going to work this time around. Unfortunately, other central banks have not done that. And that is why exiting QE is proving so problematic. That's why every time the marketplace hears Chair Powell say something that is even slightly dovish,

• 30:30Speaker 01

  it takes off because behaviorally you're reinforcing something that's been there for a long time.

• 30:36Ezra Klein?

  I want to explore a word used a couple of times a couple of minutes ago, which is conditioned. That markets became conditioned to this era of easy money, of infinite liquidity. Tell me what you mean by conditioned. Give me some examples of how, when markets begin to expect that money will be this easy to come by, they change their operations or their bets or their structures to accommodate it or profit from it.

• 31:05Speaker 01

  So let me take you into the investment committee room of a sophisticated investor. And you are there presenting the case to invest in a certain company or to buy the bonds of a certain country. And you are grilled on financial resilience, on balance sheet, on management. How good is the management team on business prospects? And you convince everybody in the room that this is an investment that is resilient because the balance sheet is strong. It's a well-managed country or well-managed company and the prospects are very positive.

• 31:46Speaker 01

  That is necessary, but not sufficient to convince people in that room that they should put capital at risk. You need to convince them of something else, that there's going to be a subsequent buyer. And the subsequent buyer plays two very important roles. First, they validate your purchase. Think of you buying an apartment in a building in New York. The minute you buy it and you own it, you love the idea of five other people coming in trying to buy in the same building because it validates your purchase and it pushes up the price of your asset. That's what a subsequent buyer does. But a subsequent buyer does something else that's really important.

• 32:28Speaker 01

  They provide liquidity in the event you have to change your mind. You can change your mind for many reasons that have nothing to do with the underlying investment. Maybe an even better investment comes up, an even better apartment comes up. So this notion of subsequent buyer is really important. Now suppose I tell you, Ezra, don't worry. The subsequent buyer is a central bank with a printing press in the basement. A seemingly limitless willingness to use it and they're non-commercial. They don't care about the price that they are paying. They're non-commercial because they're fulfilling some other objective. They're not fulfilling a strictly commercial objective.

• 33:11Speaker 01

  So they're going to overpay over and over again. The minute you hear that, not only do you buy whatever investment you are considering, but you buy many more and you leverage many more because you've got a subsequent buyer who is predictable, who's non-commercial and that who has a printing press in the basement. That's how the conditioning happened. That's how excessive risk-taking ends up by occurring. And that's how moral hazard deepens in the system. And we have seen this happen. And it shouldn't come as much as a surprise if you understand the behavioral aspects of markets.

• 33:51Speaker 01

  One of the tragedies of central banking is not only has there not been enough market experience, but there hasn't been enough behavioral science applied to policymaking.

• 34:06Ezra Klein?

  So that implies then that we've had a long period where all kinds of different market actors have made a bunch of investments that are not going to pan out in this new era. They have a bunch of things on their books or they were used to buying a bunch of things that as the central banks back off a bit, it's no longer going to work out for them. And I think that opens up to the third plank for you, which is that this is going to be an era of much more fragile financial markets. Which sounds a little bit weird, honestly, to read because the financial crisis was a very fragile financial market. That was only 15-ish years ago. We had a lot of financial turmoil during the pandemic. So it feels to me, as somebody who's covered this period,

• 34:49Ezra Klein?

  like the financial markets, on the one hand, seem to keep going up, but they're also constantly fragile or constantly either in crisis or almost in crisis. So tell me what kind of fragility you're talking about here. What about this era of threatening looming financial crisis is different?

• 35:10Speaker 01

  So would you have imagined that the UK pension system could collapse?

• 35:14Ezra Klein?

  I'll be honest, I almost never imagined anything about the UK pension system.

• 35:19Speaker 01

  Well, those who who who spend a lot of time imagining that, okay, were surprised. Would you have imagined that the real estate fund provided by a very established manager would have to apply limits on redemption because it has provided a liquid, a relatively liquid instrument on a relatively liquid asset class because it never had to worry about liquidity? Well, that happened. Look at crypto. Look at how we've had an asset class emerge, get turbocharged by liquidity, and we find out that even the most basic

• 35:59Speaker 01

  elements of risk-taking weren't implemented. These are little fires, but the risk here is that these little fires start spreading and start becoming something bigger. What we've seen since the financial crisis is a morphing and migration of risk. The financial crisis was ultimately about the banking system and about the payments and settlement system, and that is crippling.

• 36:26Speaker 01

  We understood what the problem was. We applied high capital requirements. We limited the sort of activities that banks can take. And we basically de-risked the banking system. And we congratulated ourselves on doing it. But we didn't pay attention to the fact that the risk didn't just disappear. It migrated. It migrated from banks to non-banks. And non-banks are less well-understood by regulators, less well-regulated and less well-supervised. So every single one of the examples I cited to you came as a surprise to regulators. And that is the reality. We now have risk residing more among the non-banks,

• 37:11Speaker 01

  a lot more in the non-banks than in the banks. And it is a much lighter regulated sector. I'm hoping that we don't get too many of these financial accidents. Look, I don't fundamentally care about the financial accidents. You know, if people take too much risk, let them have an accident. Let them lose money. They'll learn. What I worry about is when these financial accidents spill back into the real economy and hurt people that have nothing to do with risk-taking, whose companies suddenly cannot borrow money, whose companies has to lay them off and who don't have much savings to be able to navigate that world.

• 37:53Speaker 01

  And we saw how bad that world could get in 2008 in the banking system. I don't think it gets that bad, but I worry that this is yet another headwind to high durable and inclusive growth. And we desperately need high durable and inclusive growth.

• 38:12Ezra Klein?

  I don't want to take away anything from people who have lost a lot of money that they needed in crypto. There's a lot of just human tragedy there. But systemically, I've wondered if crypto isn't strangely almost an unsung hero. Because it took a lot of this risky financial behavior and the incentive to engage in very risky, high reward financial behavior and pushed it all at once, a lot of it anyway, into this weirdly self-contained market. It wasn't a market that was well-integrated into broader markets. It was a pretty unregulated market, so a lot of big players didn't enter it. I almost wonder if it had been in another asset class or if crypto had been better regulated.

• 38:56Ezra Klein?

  So it was seen as safer, safer for big institutional investors to get into it. If things like the FTX collapse wouldn't have been a lot more dangerous for the system. I mean, I've actually been a little surprised by how little spillover the crypto collapses have had. I could imagine it as having gone a very different way.

• 39:15Speaker 01

  So first, we should be happy that the spillovers were limited. It's early still, but so far it's comforting that the spillover have been limited. Now, if you assume there was a fixed amount of irresponsible risk-taking and it was all channeled into crypto.

• 39:35Ezra Klein?

  Right, I don't want to say all. I take that point.

• 39:37Speaker 01

  Okay, that a good part of it was channeled into crypto and therefore it's contained. Yes, that was a good thing. But what if the irresponsible risk-taking that we see in crypto was also taking place elsewhere? Because it was encouraged by very low interest rates. It was encouraged by a notion that markets only go up because central banks have their back covered. And that crypto simply happened to be the structurally most fragile of that, of those cases.

• 40:08Ezra Klein?

  Right, so it's a canary in the coalmine.

• 40:10Speaker 01

  Correct. And we've seen, you know, other, there's been areas in, and I'm going to get a little bit technical, I apologize, in ETFs that are offered on path of the high-yield market. We've seen that in fragile emerging markets. We've seen other similar evidence, okay, of financial fragility. Now, none of them have been systemic, which is a good thing. But what I worry about... Israel is that they are simply canaries. And they're not the, you know, good thing where you want, you want to bring all the excessive risk takers in a room, lock them up and say, well, you know, as long as you don't impact anybody else, then I don't really care about you. I wish it were there, but I worry that it's not that.

• 40:55Speaker 01

  You know, what I repeat to people is that we don't live in an orderly world anymore. We don't live in a, in a world that's determined by a bell shaped distribution of potential outcomes, where there's a very like high likelihood of one outcome. And there are tails, but the tails are thin. We live in a world where there are many potential outcomes, none dominate in absolute terms. And therefore we have to do three things. One is have an open mind and plan for several possible outcomes and not become hostage to just one. Let's not repeat the transitory inflation mistake is, it's an example of that.

• 41:39Speaker 01

  Be open to the possibility, yes, it could be transitory, but it could be something else. Two is have action plans for different outcomes. So we're not surprised. And then three is recognize that cognitive diversity is absolutely critical if you're going to navigate this world and take cognitive diversity much more seriously, which means taking gender diversity, education diversity, culture and experience diversity much more seriously. Unless we do that, unless we open to the possibility that we're living in a much more

• 42:15Speaker 01

  fluid world, we may end up on the shooting on economic, social and institutional objectives that are really important, not just for this generation, but the future, for the future one. And if we do that, it will be the most vulnerable segments of the population that will get hurt most.

• 42:35Ezra Klein?

  I recognize that one of the difficult things about systemic risk is that if it emerged where we think it is, it would be much easier to stop it from blowing up the, the system. But when you look at the system and you think about the spaces that have a lot of systemic importance and could be badly disrupted as low interest rates come to an end.

• 43:02Speaker 01

  Where do you look first? What are you most worried about? I look at two things. One is where is leverage? Because even in areas that seem to be safe, the pension fund, I mean, when you think of it, the UK Pension Fund was investing in UK government bonds. That seems so safe. It's boring. Okay, but there was so much leverage in the system that we almost had a meltdown. So the first thing I look at is leverage and how much leverage has been taken. And then the second one is how much liquidity give up has occurred? Those are the two things that I pay a lot of attention to. And where do those signals point you to pay attention?

• 43:44Speaker 01

  So they first point to structurally weak asset classes, asset classes that are dominated not by residents, but by tourists. You know, there's a fundamental difference in the way residents and tourists behave. Residents, when they go through volatility, don't suddenly abandon their homes, don't want to somewhere else. They stay in them and try to sort it out and try to navigate it. Tourists head to the airport. And we have various financial asset classes that are full of tourists that were attracted by what seemed to be hot weather and everything else, you know, high returns, et cetera. And that I haven't really thought about the risks they were taking on.

• 44:29Speaker 01

  And the minute these risks start being visible, they try to head out. And of course, they cause what's called contagion. Now, we've seen it in crypto. We've seen it in certain loan products. We've seen it in emerging markets. We've seen it in distressed selling. And we've seen it parts of venture. So we already started to see it in a small way, but that's where it's evident so far.

• 45:21Ezra Klein?

  We've been talking here about financial actors and investors, that kind of class of agent. But what about countries? What about smaller or poorer countries? And maybe not smaller or poorer countries, whose fiscal position or whose politics or whose trade was built on this era of easy liquidity, of more expansive globalization, of more expansive trade and supply chain flexibility? Geopolitical risk is always real, and there's certainly been a lot of fear that the Fed is exporting pain as it tries to bring down inflation out into the rest of the world. Do you worry that one of the things happening here

• 46:03Ezra Klein?

  is not just an increase in the structural financial instability risk, but structural geopolitical risk as countries begin to fall into economic crisis because of this sort of confluence of factors?

• 46:16Speaker 01

  That's another thing that has changed. In the old days, you could give a general response to that. And the general response used to run as follows: that the minute you have tightening global financial conditions, the minute you have a sharply stronger dollar, the minute your global economy is slowing down, then you will get problems in developing countries. And you may well end up having a crisis. The Latin American lost decade, the Asian crisis, the Russian default. And that was the sort of general story. But 2008 was an interesting one, where we had a major, major shock to the global economy.

• 47:01Speaker 01

  And yet, it is developing countries that led the global economy out of the Great Recession.

• 47:08Speaker 01

  Again, in 2020, we had a pandemic and we had the sudden stop. But we didn't have massive damage in the developing countries. And the reason why is developing countries learned. I think of it as if you have a small heart attack and change your behavior, you reduce your risk to a large heart attack. And a lot of countries built up their international reserves, adopted flexible exchange rates, had fiscal responsibility, steps taken, and therefore were able to navigate that. So you can no longer make the general comment. However,

• 47:47Speaker 01

  you need to differentiate and differentiate significantly. There's a bunch of countries, the highly indebted countries in particular, they tend to be have fragile institutions that are at risk of default in the world that are described of higher borrowing costs, less abundant liquidity, and a stronger dollar and slower global growth. And those also pose geopolitical risk. And we need greater focus on them. Now, to be fair, the IMF and the World Bank has identified the set of vulnerable economies.

• 48:25Speaker 01

  And there's been some attempt to try and secure some proactive debt rescheduling. But unfortunately, it hasn't gone far enough. Now, why does that matter? Because in the journey to a default, a few things happen. First, you starve the social sectors of funding in order to meet debt service payments. It means education, health, public services. So the social cost of the journey is very high. And second, typically, you also start getting political fragility. So it is an important thing, and I'm glad you've raised it. But I want to stress, this is not a general developing country problem.

• 49:08Speaker 01

  This is concentrated in a number of countries. And therefore, and that's the good news, it's easier to address than if it was a generalized developing country problem.

• 49:20Ezra Klein?

  So you're the former CEO of PIMCO, which is a giant bond trader, among other things. And one thing that has happened over the past year, and has been a distortion or an ongoing question in how to read the economy, is that bond markets and markets in general seem a lot more sanguine than, say, you have been or some other people have been. Why is that?

• 49:44Speaker 01

  I think there's a few reasons for that. One is conditioning. You know, the trend is your friend is what you often hear in the marketplace. And we've had a decade of incredibly supportive financial conditions and the belief that, yes, we may be subject to temporary interruption in that regime, but they will be temporary and they will be reversed.

• 50:11Speaker 01

  Second, the policy narrative hasn't helped. I cannot tell you how problematic the transitory inflation narrative has been because that basically told people not to worry, not to plan for higher prices, not to plan for the consequences of high prices. Remember, when I tell you something is transitory, when I tell you something is temporary and reversible, I'm encouraging you to look through it and therefore don't change your behavior. So there was reaffirmation coming from outside that there was no need to change things. And then finally, the mindset.

• 50:51Speaker 01

  A lot of people in finance have grown up in an era of abundant liquidity. Most of them don't remember the late 70s and the 80s when we had inflation. They haven't experienced that. And therefore, that tends to be one of the three big behavioral traps that we fall into whenever we're taken out of our comfort zone, whenever there's a regime change, whenever uncertainty becomes unusual uncertainty. One is you get blind spots. You simply don't see it. The other one is you reframe. You get told something and you immediately reframe it. Today, the minute you mention recession to a typical market participant,

• 51:36Speaker 01

  you will get, oh, but it's going to be short and shallow.

• 51:40Speaker 01

  That is reframing something that's uncomfortable into something that's more comforting. So if you don't get blind spots, if you don't get reframing, you get the third behavior, which is active inertia. You know you have to do something differently, but you end up doing the same thing. The sort of simple example is of an American tourist in Paris asking someone something in English. The French person either doesn't understand English or doesn't want to understand English. The most likely reaction of the American is to say the same thing in English, but louder. The louder bit is the active part, knowing that you have to do something different. But the inertia is so strong that you end up doing the same thing.

• 52:25Speaker 01

  Don Saul, now at MIT, has done amazing work on why successful companies fail. And he's shown that active inertia is one of the main reasons. The world changes on them, but they continue doing the same thing. One of the examples is IBM on the eve of the PC revolution, by far the brand and technology, very big R and D budget and profitable. Research has shown that management recognized how disruptive the PC would be, recognized that needed to migrate from simply mainframe to also occupying the PC space. And to do that, they had to take their mainframe upstream

• 53:10Speaker 01

  and charge premium pricing to maintain profits. The absolutely right approach, it was endorsed by the board. So you had the right strategy, you had recognition of the disruption, you had a willingness to do things differently. And yet, middle management went back to doing what it was doing. And a few years later, IBM almost went bankrupt. So I never underestimate these behavioral traps that become very important in a world that has been conditioned to just follow the trend. And when the trend is supported by central banks, that's a really strong process. And I think that's why you've seen markets take such a long time

• 53:54Speaker 01

  to recognize that we are in a different operating regime.

• 53:58Ezra Klein?

  So we're talking here at the end of a week that has been very, I think, whiplashy in terms of people's inflation expectations. When it started, it seemed like various pieces of data had people thinking the hope for a soft landing where we bring inflation down and don't get a recession or don't get a big recession was seeming likelier than it had in previous months. And then we got this wage revision data that suggested wage increases have been higher than we thought by quite a bit. And that really, really whiplashed people into feeling that we are not going to be successful in easily getting inflation under control. So given where we are now, what do you think Jay Powell and the Fed should be doing that they're not doing or saying that they're not saying?

• 54:42Ezra Klein?

  How far from the course you'd like to see them take, are they?

• 54:47Speaker 01

  So let me answer that by taking you to Chair Powell's piece at Brookings, which contributed to sort of the market volatility. He did a very good job in trying to come across as balanced. He pointed out that we're not good at inflation forecasting these days. He pointed out that the Fed had a lot more to do.

• 55:11Speaker 01

  He pointed out that the worst thing would be to repeat the mistake of premature loosening. But he also said the few things that the marketplace really wanted to hear and ended up having a situation where the market completely ignored all the other things he said. And what did he say? He said that it is likely that we will downshift on wage increases in December. He decided to do that two days before the wage data. So everybody assumed that he must know something about the wage data.

• 55:51Speaker 01

  Otherwise, why would he be so explicit about something that is in two weeks' time and has a CPI report before it? So they assumed he knew something that the marketplace didn't. And then he didn't say anything. He didn't lean against what had already been a significant loosening of financial condition. I say this because it's a lesson. When the market only wants to hear one thing, be careful when you say it. Because what can happen is that the market doesn't hear all the other things that you are rightly saying. And the result of that is undue volatility.

• 56:32Speaker 01

  It is way too early to go for what I call spurious accuracy in terms of what policy will do. There's too many things we don't know about. You want to maintain optionality. You don't want to pre-commit. Every time this Fed has pre-committed, it has had to eat its words. That is true in terms of forecasts that have proven to be horribly wrong and repeatedly so. That is true when Chair Powell said that we are at neutral interest rates. We weren't, and we're not. So what I would advise to the Fed is be more humble, be more open-minded,

• 57:13Speaker 01

  and recognize the conditioning of markets because that will impact how they hear your message. And if markets loosen financial conditions too quickly, your job is even harder.

• 57:27Ezra Klein?

  Do you think we're headed in the US for a recession? And if so, do you think it will be deep and long?

• 57:32Speaker 01

  I do not know whether we're heading into recession. I think the probability is uncomfortably high, but it's not 100% as some have suggested. We can still avoid one, and hopefully we will. What I do know is that if you are convinced we're going into recession, there isn't enough evidence to say it will be short and shallow. It could be long and deep, it could be long and shallow, it could be short and deep. We simply do not know, and we should not suggest that we have enough evidence to be comfortable about a particular shape of a recession. I'm very tempted to take you to an example, if I may, of something that happened within PIMCO.

• 58:15Ezra Klein?

  Please.

• 58:16Speaker 01

  So on the weekend in which Lehman Brothers failed, we were sitting in the investment committee room, and we were trying to predict what was going to happen.

• 58:30Speaker 01

  The history books keep on saying that PIMCO predicted the disorderly failure of Lehman because most of PIMCO's clients made money after the financial crisis.

• 58:44Speaker 01

  As Bill Gross, the founder of PIMCO, and I have gone out of our way, that is simply the wrong interpretation. We never predicted a financial crisis. Let me explain to you what happened. We had three scenarios on the board, and we had voted on the probabilities that we individually attached to each of those scenarios. And here was the outcome. Scenario A, 85% probability. That's the combined probability, given that Lehman would not fail, that Lehman would be a repeat of Bear Stearns, a stronger bank would come in, take over the weak Lehman Brothers, and there would be no counterparty risk on Monday morning.

• 59:27Speaker 01

  It had happened with Bear Stearns, JP Morgan had taken, and we knew that Lehman was in discussion with at least two banks. Scenario B, 12% probability. Lehman fails, but fails in an orderly fashion. Why? Because no regulator would put the PMS and settlement system in play. That is paralyzing to the real economy. That is destructive to livelihoods. Surely, if they allow Lehman to fail, it will fail in an orderly fashion. 3% was the probability we gave to Lehman failing in a disorderly fashion, the outcome. So the notion that we predicted Lehman was completely wrong. But why?

• 1:00:12Speaker 01

  Why is it that we were able to completely reposition ourselves? Because we had a very detailed action plan for each of these scenarios. We knew who would be doing what, when. Simple things, like delivering the notice of failure, so that you can re-establish positions, to other things like informing clients and trying to change your portfolio postures before others work out their own action plan. And I say this because when you face unusual uncertainty, it doesn't mean you get paralyzed.

• 1:00:52Speaker 01

  Know what does it mean you stick to one outcome that may happen, but you ignore everything else? It means that you do the hard work of saying, here are possible scenarios. And let me try and figure out what I would do if these scenarios materialized. And let me keep open minded and know what data I'm supposed to follow, rather than get stuck to a baseline that ends up to be wrong. It's a lot of work, yes. But the cost of that work pales in comparison of the cost of not being ready for an outcome that you did not plan for.

• 1:01:30Ezra Klein?

  I think that is a great place to end, and I thank you for sharing that story. Always our final question. What are three books that have influenced you? You would recommend to the audience?

• 1:01:38Speaker 01

  Let me give three books. Invisible Women is a book that I've read and reread. It reminds you of what a world made by men for men discriminates against women, and it provides you examples and stories when you're trying to convince people about the importance of diversity that are very powerful. The second one that has impacted me is Bad Blood. It's the story of Elizabeth Holmes, and it just shows you how people can get carried away, both in pursuing a certain venture and investing in that venture. And then the third one is The World For Sale.

• 1:02:22Speaker 01

  It's about the commodities market. It's about an area that has massive geopolitical, as well as economic and financial consequences. And that's not as well understood as it should be.

• 1:02:35Ezra Klein?

  Mohamed Al-Arian, thank you very much.

• 1:02:38Speaker 01

  I thank you.

• 1:02:50Ezra Klein?

  Yes, The Clinch is produced by Emma Pa Agau, Annie Galvin, Jeff Geld, Raji Karma, and Kristin Lin. Fact checking by Michelle Harris, Mary Marge Locker, and Kate Sinclair. Original music by Isaac Jones, mixing by Jeff Geld, and audience strategy by Shannon Busta.