Life After the Financial Crisis

It is amazing how often I am asked a question along the lines of, "What inning is the crisis in?" I was on the verge of formulating an answer at a panel recently when the courtroom scene from the 1992 film My Cousin Vinny flashed in my mind. Drawing on Marisa Tomei's brilliant performance as a blunt-spoken car expert on the witness stand, I replied: "It's a bogus question." Because we won't be going back, anytime soon, to business as usual—what financial analysts like to call mean reversion. We're in the midst of a regime shift, a hard transition into what my colleagues and I at global investment management firm Pimco call "the new normal."

I know: Once they are disrupted, systems overwhelmingly tend to revert to their previous states. But the evidence suggests that, for economies and markets conditioned by the recent experience of "normality," the future will feel quite unfamiliar—even when the sharp edge of the crisis recedes.

This is not to deny that the government is doing all it can to "normalize" things. Nor is it to ignore the power of productivity and flexibility. Both are in play but insufficient to fully offset the economic and political disruptions wrought by the financial meltdown.

So the post-crisis U.S. will differ quite a bit from its 2003-07 predecessor. That period delivered a rare combination of sustained high growth and low inflation that helped power the global economy to a remarkable 4.5% average annual expansion. More later about just how different our future will be. Let's first consider the chain of events that has created that future.

On the eve of the crisis, the U.S. economy had reached a point of leverage, credit, and entitlement exhaustion—most obviously in the housing sector. By now, we can all recite this part of the story: Using exotic mortgages and packaging them into even more exotic structured financial products, banks lent billions to Americans buying homes they previously could not afford. The old ideas of restraint and affordability yielded to the notion that house prices could only go up. That led to homeowners using their houses as ATMs, withdrawing any equity buildup to finance even more consumption.

When this super-debt cycle reached its limit, the U.S. economy found itself at a dead end. Overstretched, it was extremely vulnerable to what Pimco's co-chief investor, Bill Gross, labels DDR dynamics, the combined forces of deleveraging, deglobalization, and re-regulation. When gravity pulled down home prices, consumption plummeted, banks stopped lending, and cross-border activities slowed markedly as U.S. institutions scrambled to get their own houses in order first. What's more, to prevent a highly disruptive domino effect, policymakers were forced into action with limited information and inadequate tools. They resorted to bold "unconventional" policies. Experimentation became the rule. And as with a trial for a new drug, this inevitably brought some unpredictable results and potentially nasty side effects.

We will be telling our kids and grandkids about this exceptional period, when economic behavior changed and the delicate balance shifted between the market's invisible hand and the government's fist. In adulthood, they may wonder why they ended up carrying so much of the burden of adjustment.

And adjustment will be necessary. Tomorrow's U.S. economy will have a lower speed limit. Forget about the 3% annual trend growth rate of the past 15 years. Start thinking 2% and under. Unemployment? It will stay stubbornly high in the next three to five years, with 6% becoming a floor rather than what many recently regarded as an unpleasant high point. The financial system will look more like a utility, shackled by politically driven overregulation that limits volatility at the cost of fewer productive activities.

Indeed, look for politics to dominate economics. Political feasibility, rather than technical desirability, will define too many policies. In the process, some basic anchors of the market system will come under pressure. It has already happened in Chrysler's bankruptcy filing, where contractual principles of debt seniority have been disregarded.

Internationally, the postindustrial Anglo-Saxon model, which gives finance a preeminent role in a deregulated landscape, will be discredited as too crisis-prone. The model will no longer be a global magnet. And with no alternative to take its place, the shift of wealth and economic dynamism from the U.S. to such countries as Brazil, China, and India will accelerate, albeit in the context of lower worldwide growth.

Finally, if the U.S. is not careful with its already precarious public finances, other nations may be less willing to maintain their deep faith in the dollar as the global reserve currency and in the U.S. financial system as the best vehicle to intermediate savings and investments. Since the U.S. will emerge from this crisis with larger debt and deficits, any material erosion of trust will make it harder to attract the required funds from abroad, complicating an already challenging policy picture.

In short, the world's economies are in an era whose troubles will go well beyond "just a flesh wound," to quote from another movie—Monty Python and the Holy Grail. And like the film's Black Knight, who insists on that diagnosis after getting his arms lopped off in a sword fight, some may want to deny the new reality. That's a mistake. Companies and government agencies should be testing the robustness of their strategic and structural underpinnings against the challenges they'll meet on the road to the new normal. Retooling is difficult. But being caught in a regime shift with backward-looking beliefs and operating models, is much worse.

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