Lunchtime Must-Read: Mohamed El-Erian: US Midterm Elections Offer Limited Prospect for Economic Change

I think Mohamed El-Erian makes two analytical errors:

1. He argues that a faster American recovery requires that the private sector “decouple even more from Washington” and undertake “longer-term investments… [to] unleash underused resources and expand longer-term potential… [at the] scale and scope… need[ed] to validate the current level of excessive risk-taking by financial markets lest that, in itself, becomes a consequential headwind to economic growth and stability…” This morning’s earnings yield is 5.1%. This morning’s 5-year TIPS yield is 0.1%. That five percentage-point spread does not suggest a financial market in which demand for risky assets has outrun supply and pushed risky-asset valuations to levels that are inviting a crash and subsequent financial crisis triggered by the potential bankruptcy of institutions with normal equity cushions. And are there an unusually large number of institutions right now with normal or subnormal equity cushions whose business model is to sell unhedged out-of-the-money puts on a large scale, pocket their winnings until the strategy goes bust, and then declare bankruptcy and walk away? I’m watching. I don’t see any concentration of such institutions…

2. El-Erian assumes that Washington can do nothing. That is not true. Washington may do nothing–it probably well do nothing. But it could do a lot. FHFA head Mel Watt has the power to offer every homeowner in America a refi at conforming-loan rates with an equity-option kicker attached to mortgages that do not have the 20% equity cushion or exceed appropriate conforming-loan limits. Federal Reserve head Janet Yellen has the power to do a Paul Volcker and undertake a regime change to the Federal Reserve’s operating procedures and so alter the expected and actual future path of nominal GDP. Either or both of those could powerfully jumpstart the economy over the next two years. The FHFA and Federal Reserve regime change options should be on the table. El-Erian should not overlook them…

Mohamed El-Erian: US midterm elections offer limited prospect for economic change: “The main question is not whether the midterms will change the gridlock in Washington…

…that undermines economic growth, accentuates inequalities, and holds back prosperity; it is whether companies and individuals can decouple even more forcefully from yet another ‘do-little’ Congress…. There is little chance of change in the polarisation and dysfunction paralysing Congress…. The fiscal stance would not be altered to provide for higher and better balanced aggregate demand; supply responsiveness would not be enhanced by stepped-up investments in infrastructure, education, labour market strengthening and other areas that improve productivity; medium-term operational uncertainty would not be reduced by greater clarity on corporate tax reform; and damaging debt overhangs would not be lifted…. For stock markets to continue to prosper, the private sector would have to decouple even more from Washington…. It would require much bigger emphasis on longer-term investments in areas that, notwithstanding the continued shortfalls in Congress, unleash underused resources and expand longer-term potential. And the scale and scope would need to validate the current level of excessive risk-taking by financial markets lest that, in itself, becomes a consequential headwind to economic growth and stability…