Mohamed El-Erian

Are you tired of all the stories on Europe’s financial crisis and American politicians’ endless bickering about debt and deficits? Are you tired of weekends of hectic negotiations as policymakers rush to cobble together some agreement before markets open? If you are, you are not the only one.

Millions of people, including stressed-out policymakers on both sides of the Atlantic, wish to put these issues behind them. Unfortunately, despite many announcements, they are unable to do so decisively, and for good reason.

So we better understand why, if we want to minimize the risk of collateral damage and unintended consequences.

To do so, you need only remember one rather clumsy phrase: “safe de-levering” (also known to some as “safe de-leveraging”), or the lack thereof. Consider please each word, starting with the second one.

De-levering refers to the rehabilitation of balance sheets that have gotten over-indebted to such an extent that they are unsustainable going forward. The contributing causes are usually numerous and many years in the making.

In Europe, three peripheral countries face immediate and significant de-levering pressures. Greece and Portugal are two of them. They had too many years of irresponsible government spending, inadequate taxation, weak public administration, and insufficient economic growth. The third, Ireland, was fiscally responsible but made the big mistake of using what was a relatively healthy public balance sheet to assume the massive losses of its irresponsible banks.

These three countries now face a buyers’ strike. Lenders have been resisting the renewal of their credit lines and, needless to say, have no appetite whatsoever to provide incremental funding. No wonder interest rates have soared and financing has dried up, other than official bailouts from neighboring countries, the European Central Banks and the International Monetary Fund.

The result is not just a liquidity crisis; but also a solvency one. With government gross debt burdens ranging from 100 percent of GDP in Portugal to 156 percent in Greece, these countries are now embarked on an unpleasant, forced de-levering process.

America’s case is different. Yes, it has a high budget deficit (over 10 percent of GDP) and has experienced a dramatic increase in its debt-to-GDP ratio since the global financial crisis. Yes, the fiscal outlook gets cloudier as a result of a structurally weak budget. But unlike peripheral Europe, it is nowhere near an immediate liquidity crisis.

America’s creditors are more than willing to fund the country at historically low interest rates. Rather, it is political squabbles that have dramatically brought forward medium-term fiscal challenges, and have done so through the use and misuse of the debt ceiling, an arcane but, as we have all found out, a rather lethal legislative weapon.

We should all accept that Europe and America — the former for fundamental reasons and the latter for self-inflicted ones — are now in a de-levering cycle whose consequences will be with us for many years.

The actual process of de-levering can play out rather quickly. Indeed, too fast a de-levering can be catastrophic in terms of its impact on growth, employment and poverty. So you can be sure that policymakers will do their utmost to deliver a safe, gradual process.

The best way to do so is through high economic growth. This maintains living standards and generates incremental income to pay off debt, thus providing an orderly path to medium-term debt sustainability. Unfortunately, this option is not available today to either Europe or the US as both are stuck in what PIMCO has been describing for over two years now as the bumpy journey to a new normal.

Other than some short bursts, Europe and America are unable to sustain the sort of economic recovery that would make a meaningful dent in their debt dynamics. They will remain in this regrettable situation until policymakers become more serious about a comprehensive and coordinated set of measures to remove structural impediments to sustained economic activity — including steps to improve the functioning of the housing and labor markets, better worker retooling and retraining, enhanced education systems, even more bank lending, improved productive infrastructure, etc.

If they are unable to grow out of their debt problems, countries have four other options. Two of these are also available to us as individuals: we can default, and let restructuring lower our debt burdens, albeit in a rather disorderly fashion; or we can implement austerity, spending less in order to generate cash to pay off our debt.

Because countries control the printing presses and write regulations — things that the rest of us do not have or cannot do — they have two additional alternatives. They can try to inflate their way out of the debt, or they can reduce it through years of “financial repression,” that is, paying millions of depositors and creditors much less than they deserve in order to divert funding to debt payments.

Judging from what we have seen so far, governments are opting for different mixes.

The three peripheral European governments are imposing harsh austerity on their populations — remember the riots in Greece? — and also benefiting from the willingness of their European neighbors to financially repress their citizens in order to provide additional official funding. At least one (Greece) is having to go further by also partially restructuring its debt.

America is talking about austerity, including this past weekend’s compromise fiscal framework, but using financial repression. So far, this has taken the form of the Federal Reserve maintaining interest rates at extremely low levels for an exceptionally long period of time — so much so that savers and creditors are paid interest rates that are below inflation, and in some cases, well below inflation.

This will not suffice. Look for America to intensify financial repression through regulations that forces banks and other regulated entities to hold low yielding government securities. Also, it will attempt to generate unanticipated inflation. Ultimately, it will be forced into more painful austerity involving both spending and tax measures.

The de-levering pressures will be with us for years, and governments will mix and match from the menu of options. Accordingly, periodic debt dramas and crises will not go away any time soon. Debt is simply too high and there isn’t enough economic growth to painlessly de-lever.  Each response that governments decide to adopt has different implications for us, as savers, investors, debtors, home owners, and business people (the topic of a future piece).

Unfortunately, none of us have the ability to fully insulate ourselves from the collateral damage and unintended consequences. The best we can do is to understand the process, including what governments will do. In this way, we can try to minimize, though never eliminate, the adverse impact of de-levering.

By Mohamed A. El-Erian
The opinions expressed are his own.

With its high unemployment and stretched balance sheets, today’s US economy can ill-afford a negative shock from abroad. Yet, this is what it is experiencing. And it explains why markets go through bouts of nervousness about the debt crisis in Europe, and why American policymakers are worried about a foreign financial situation that is getting worse by the day.

Europe’s debt problem is indeed a headwind for what remains a disappointing US economic recovery. It dampens America’s export prospects, can raise the cost of borrowing for some American companies and diminishes an already low enthusiasm among banks to lend to households and small companies.

Having said that, it is unlikely, though not inconceivable, that Europe’s debt crisis would constitute a “Lehman Moment” — a situation that totally paralyzes American economic activity, puts the country on the verge of a depression and triggers yet another round of extreme crisis management measures.

There is now broad-based recognition of America’s persistent economic weakness. Most recently, the Federal Reserve has been forced again to revise downwards its growth projections for both 2011 and 2012. Moreover, with refreshing candor that speaks well to the uncertainties felt by the average American, Fed Chairman Ben Bernanke acknowledged in his second ever press conference on June 22 that only part of the economic weakness is due to transitory factors such as higher oil prices and supply disruptions associated with the Japanese tragedies.

As Bernanke hinted, and as PIMCO’s analyses have demonstrated for a while, the US unfortunately faces four structural headwinds that are yet to be addressed properly by policymakers.

First, and nearly three years after the global financial crisis, the US housing market is still unable to find a firm enough footing. This undermines confidence and limits labor mobility.

Second, joblessness remains worrisomely high, and to make things even worse, is increasingly structural in nature. Witness the 9% unemployment rate, declining labor participation and an alarming 24% unemployment rate among 16-19 year-olds and a 40% rate for African-Americans.

Third, credit is yet to flow properly in the economy. With bank lending still hampered, it is small companies and poorer households that suffer the most.

Fourth, there is a problem of debt and leverage. Coming off a “great age” of debt and credit-entitlement that went way too far, balance sheet rehabilitation has been uneven and generally insufficient. Yes, some sectors, led by multinational companies, have recovered strongly. But far too many in the private sector are still over-indebted. Meanwhile, public balance sheets, be they of the Federal Reserve or the fiscal agencies, are contaminated to such an extent that they now constitute a source of medium-term uncertainty.

Policy responses have been too timid in the face of the economic challenges, and for too long, lacking a central vision. Instead, they have been ad hoc, too reactive and lacking sufficient structural underpinnings.

In the absence of a credible alternative, the role of the country’s main economic spokesperson has fallen to President Obama who, understandably and correctly, is extremely busy with many other national and international priorities. Meanwhile, the other arms of government — Congress in particular — are hostage to extreme political polarization, posturing and bickering. And the recurrent drama associated with budgetary legislation discussions — including the continuing budgetary resolution of a few months ago or today’s debt ceiling debate — adds to the uncertainties facing the nation.

In sum, this is not an economy that is well positioned to deal with a shock from abroad, let alone a major one. Its ability to absorb a systemic shock has been worn down by persistent internal economic weaknesses and the agility needed to sidestep, or at least minimize the impact of the shock, has been eroded by slow economic policy responses and stretched balance sheets.

All this helps to explain America’s concern about Europe’s debt crisis, which has led to periodic selloffs in capital markets and warnings from policymakers. It also speaks to why some commentators have gone as far to suggest that the country faces another “Lehman Moment” — a devastating shock that totally paralyzes the economy, disrupts the functioning of the financial system and pushes the country to the verge of a great depression.

This situation was last faced in the fourth quarter of 2008 following the disorderly collapse of Lehman Brothers, the investment bank. As illustrated by various recounts of those nervous months, policymakers came very close to losing complete control of the situation, despite all the firepower at their disposals.

Indeed, if it weren’t for the aggressive use of what was at that time a relatively healthy public sector balance sheet (especially that of the central bank’s), the US would have been forced into temporarily shutting down its financial system (including by declaring a “bank holiday”) and experiencing an economic depression which, according to some, would have been worse than that of the 1930s.

The question of the “Lehman Moment” becomes even more important now that policymakers have less firepower at their disposal to counter a huge shock. So what should we expect in the months ahead?

To be sure, the European debt crisis is a serious political, economic and financial engineering predicament that is hard to solve. As such, it will likely get worse before it gets better. In the process, it will slow global economic growth, increase risk premiums and darken the cloud over the health of the financial sector in Europe.

None of this is welcome news to an American economy that urgently needs to create jobs. But it need not result in a repeat of the total Lehman paralysis provided three conditions are met: a banking system that remains robust, no disruptions to money market funds and limited blockage to the plumbing of the country’s payments and settlement system.

Chairman Bernanke has spoken publicly to all three. Noting the Fed’s focus on these issues, he has indicated that the US does not face a new Lehman Moment.

Published data, to the extent that they are comprehensive and accurate, support his view; as do the actions taken by certain institutions. But risks remain, particularly within a money market complex starved for yield, and where certain firms appear to have stretched far and wide for extra returns.

A small risk of a catastrophic event should never be ignored. Accordingly, there is no room here for any complacency among policymakers whose economic management to date has fallen far short of what is needed to create jobs and put the country back on the path of high and sustained economic growth. Indeed, Europe serves to amplify warning sirens that have been ringing for a while.

Let us all hope that the increasing volume of the alarm will finally push America to design and implement the type of holistic measures that are desperately needed and long overdue. In the meantime, risk-averse companies, households and investors are justified in taking some extra precautionary steps.

Note: Mohamed El-Erian will be doing a live Q&A on Reuters.com on Thursday, July 7 at 9 a.m. ET. He will be answering your questions and responding to your comments about this piece along with his other previous pieces.