The Central Banks Alone Can’t Save Us

I have been coping with tennis elbow in one arm for most of this year and have had to rely much more on the other — excessively, it turns out. Entering the new year, there are now limits on what I can lift, pull and twist with either arm. Should I fail to do something about this, I could spend 2017 struggling with simple tasks such as carrying a briefcase.

In a way, this is an apt analogy for the global economy's disappointing performance in 2016, pointing to what's needed if we are to fight financial instability and worsening economic and political malaise in 2017.

It was a tepid, strange year for the global economy. An already prolonged and frustrating period of insufficient and scattered growth simply continued as the world remained over-reliant on central banks.

Since 2010, the use of fiscal policy, where the government adjusts its spending and taxation to manage the economy, has been hindered by the perception, especially in the United States and Europe, that such policies represent overreach. This has resulted in concerns about debt and unnecessary interference in the private sector, ushering in a period of excessive austerity, in terms of decreased government spending, in several advanced countries such as Greece, Portugal and Spain. This has also sidelined any sustained fiscal stimulus in those countries with strong balance sheets, such as Germany.

The resulting fiscal paralysis, combined with insufficient progress on pro-growth structural reforms — including revamping corporate taxes, building better infrastructure and training workers — hit those countries' middle and lower classes particularly hard and aggravated the impact of joblessness, especially among the young. As the pressure on household incomes increased, the prospects for consumer spending became more uncertain, and companies became less enthusiastic about investing in new plants and equipment, feeding into the cycle. Economic conditions remained difficult, and the politics of anger gained momentum.

The need for greater fiscal policy flexibility attracted much more support among economists in 2016. But the effort to translate that support into action was frustrated by social and political polarization that essentially precluded any major economic policy initiative.

As growth remained stuck in low gear, falling short of people's aspirations and dimming the hope of re-creating the economy of earlier years, the benefits of this limited growth were perceived to have collected disproportionately in the pockets of those who were better off already. Alarming pockets of under- and unemployment, particularly in Europe, became more deeply embedded in the economy's structure, adding to the headwinds. Popular anger continued to rise, and mistrust of the "establishment" — both of government and the business sector — deepened. Economics, finance and politics became increasingly interlocked in a menacing, self-perpetuating cycle of disruption.

Citizens of the U.K. voted in June to dismantle the country's deep trading and financial links with Europe, which have served it well for four decades. Anti-trade rhetoric dominated the United States presidential election, from Donald Trump's threat of tariffs on China and Mexico to Hillary Clinton's distancing herself from trade agreements with Asia, South America and the European Union that the Obama administration had painstakingly negotiated. Trump's victory on November 8th illustrated the growing influence of anti-establishment movements.

With both fiscal and structural policies impaired — with both arms incapacitated — central banks were the only game in town, in an economy that needed high, sustainable and inclusive growth. Since they enjoy a considerable degree of political autonomy, they felt morally obliged to do whatever they could, even though they lacked the proper tools for the task. For the most part, theirs are limited to monetary measures, where central banks influence the economy by adjusting interest rates and the money supply to change financial conditions and asset preferences.

Despite their willingness to take on others' policy responsibilities, central bankers were unable to deliver on their objectives, and for good reasons: The supply impact of their tools, such as changing interest rates or buying and selling market securities, could not lift structural impediments to growth, such as a lack of infrastructure, fragmented tax regimes and excessive regulation; and the demand influences, like decreasing interest rates to spur consumption and investment, were too weak to power the economy forward in its current state. Yet, since they were the only institution with the flexibility to address the problems, the central banks refused to walk away, continuing to administer their imperfect — even experimental — prescriptions.

The result included policy outcomes that, not so long ago, were virtually unthinkable. The Bank of Japan and the European Central Bank took their interest rates negative — that is, below 0 percent — leaving some investors in the highly unusual position of having to pay, rather than receive, interest income if they hold government bonds. With that, around 30 percent of the total stock of global government debt traded with negative yield during the course of 2016.

During most of 2016, stock markets were unusually immune to the uncertainty that has dominated the economic, financial, institutional and political landscapes. For that, investors had liquidity to thank — that is, the continuous injection of money into the markets, whether from central banks' unconventional measures or the recycling of corporate cash through mergers, acquisitions and share buybacks. But there is a limit to how long this counterintuitive combination of unstable fundamentals and market calm can persist.

While the exact timing of economic and financial turning points is inherently hard to predict, we could experience an important one in 2017. But that need not be a scary proposition if politicians resume their economic governance responsibilities.

A comprehensive policy response would focus on pro-growth structural reforms (including tax reform), greater fiscal activism (particularly in building infrastructure), lifting pockets of over-indebtedness (for example, in Greece and, pre-emptively, for parts of student loans in the United States), and improving cross-border policy coordination (both at the global level and in strengthening the eurozone's regional economic architecture). This would unleash some of the considerable cash idling on corporate balance sheets, thereby turbocharging two critical transitions: from low growth to high and more inclusive growth, and from artificial financial stability to genuine financial instability.

But if politicians continue to fail voters, low growth will risk turning into recession, artificial financial stability will give way to unsettling instability, and the politics of anger could get a lot messier. The alternatives we face are stark, and time is pressing.

The treatment for tennis elbow is rest. Central bankers have been hitting the ball long enough — let's avoid a painful and more difficult 2017.

Mohamed A. El-Erian is chief economic advisor at Allianz, chair of President Obama's Global Development Council, and the former CEO and co-CIO of PIMCO. His books include "The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse."

© 2016 Mohamed A. El-Erian
Distributed by The New York Times Syndicate