Don't wait for the US to sort itself out, because it has a longer runway to be fiscally irresponsible. It's the global currency. It has the biggest financial markets. You will continue to import bond market instability, and you have to deal with it at home. The cooperative approach is of course the best approach, but I see the middle powers losing trust in the multilateral system and looking for an alternative, but you can't build an alternative overnight.
Hello and welcome to One Decision, conversations about intelligence, statecraft, and the forces that drive world politics with people who've been in the room and on the ground. I'm your co-host, John Rain.
Hi, John. And I'm Sir Richard Dearlove, the former chief of MI6, British Intelligence. And today, actually, I'm sitting in a hotel rather unusually in Arizona. In fact, in the Arizona desert, but it's a rather lovely spot.
Great. Very good to see you, Richard. You're guaranteeing a transatlantic perspective today. Let's hope that the line holds. We have an insightful and topical interview for you today. To keep up with all our content, subscribe wherever you get your podcasts, like this episode or drop us a comment on YouTube. That will help others find the show. Let's get on with the business of the day, which is the global economy. How is the global economy weathering the long and growing list of largely geopolitical headwinds that it faces against a worrying backdrop of not just the US-Iran war, but also Russia's war in Ukraine. Energy prices and inflation are on the rise. The economic models of the Gulf States are being threatened. Government borrowing costs are surging around the world. The Trump administration's tariff policies are continuing to disrupt international trade. So where is this lethal-looking combination of geopolitical events, conflict and economic statecraft? Where is it all going? Joining us today to help make sense of both the visible and the invisible hands that are shaping the global economy is Mohamed El-Erian, Hauser School professor and chief economic advisor at Allianz. Mohamed's previous roles include CEO of the bond giant PIMCO, deputy director of the International Monetary Fund and chair of President Obama's Global Development Council. Mohamed, I'm going to ask you a few questions about the bond markets because it's so topical. But just before I do that, could I ask your help in scene-setting what is going on on the grand scale? And we were all of us struck by the coincidence of global conflicts, real economic challenges, some economic models themselves, and they are fundamentally challenged. And I wonder, in your long experience of commentating on financial and geopolitical crises, how bad is this one? Is there something special about this set of challenges that sets it apart? Or should we take confidence that we've ridden out worse before?
I think what makes this period different is two things. One, the uncertainty is structural. It's in the system itself. And the second is that we've shifted in my world of economics and finance to a world of geoeconomics where increasingly geopolitics, domestic politics and national security determine economic policy, determine economic outcomes. And in turn that feeds back to geopolitics. That is clearest in the United States but is also evident in Europe.
You've spoken and written very eloquently on the perma-crisis, where one of the memorable conclusions seems obvious enough: none of us can solve this on our own. Are we in an age where the dependencies that are generated by a global economy are now outweighed by the vulnerabilities?
Certainly how it feels like much of economics and much of finance, in game theory terms, has to be done as a cooperative game, as people participating for their good and for the greater good. The minute you turn this into an uncooperative game, which increasingly has happened, you get very strange outcomes. We see this across the board and the solution lies in going back to a cooperative game. Now there's two types of cooperative games. There is the old-style globalization multilateralism, but there's little appetite for this, and there's a new emerging proposal which is called minilateralism. Let's depend on smaller coalitions of the willing. The middle powers are particularly interested in doing this. But you see it also when it comes to how do you solve or how do you address the AI risks. You see it there, you see it in trade. So this notion of we can't go back to a world of globalization or multilateralism. Can we settle in a world of minilateralism to avoid total fragmentation?
Mohamed, on that theme, the new style of economic statecraft, protectionism that we're seeing, America has under President Trump certainly played a leading role in that. I mean, could you help us understand the current bond market selloff? And this seems to have come about quite suddenly. What was the path, the series of decisions or events that took us to this apparent decline in American creditworthiness?
It's a global phenomenon and I'm surprised when I hear people say they're surprised that it has happened so quickly because the drivers behind it have been evident for a long time. Think of the four major drivers. The first and most important one, and the one that's least talked about, is there's a fundamental imbalance between those who want to buy long-term bonds and those who need to sell long-term bonds. So, governments and increasingly the hyperscalers, the tech companies, are major issuers of bonds. They need funding. On the other side, your traditional reliable buyers are less. So, I'm talking here about China that wants to buy fewer US treasuries for geopolitical reasons. Norway that announced it was reducing its holdings. Japan that has things at home that it needs to deal with and cannot buy as much. And of course, the Gulf countries that are spending more money at home and in fact are no longer buyers. They're now sellers of bonds. So you have this fundamental imbalance that has been well telegraphed. The second thing, and Richard can speak to that, is the uncertainty about the end point as to what's happening in the Middle East and therefore what's going to happen to oil. I can argue for an oil price of 120. I can argue for an oil price of 80. I just don't know which is more likely. The third issue is inflation and the fact that with governments having difficulty on the fiscal side, central banks are going to have to hike more. And finally, the biggest players in this market have become the hedge funds. So it tends to overshoot on the way up and it will overshoot at some point on the way down, but not for a while.
Mohamed, what do you think the consequences are going to be in the US domestic economy of all this? A US carrying an enormous amount of debt. Does it have to take out more debt in order to service the current debt? What are its options? Where do you think they're going to come out?
So, there are economic, social, and political consequences. The economic one is that the interest-rate-sensitive sectors are being hit hard. It's housing. People find mortgages more expensive. If you have to refinance your mortgage, it's a different world right now. And it adds to the affordability pressure, which is real. The second is car loans. People don't think about this a lot, but many Americans fund their cars either through a lease or through a bank loan. And that price is going up. So what's going to happen is you're going to hit these traditional sectors hard to make room for the hyperscalers and for governments to be able to raise the funding they need. They are interest-rate-insensitive. So it's the interest-rate-sensitive element. The social element is this hits the low-income household the hardest and this notion of a K economy where the rich are doing better and the less fortunate are doing worse is going to continue, which then has a political aspect to it. The US bond market is the deepest in the world. And to hear the US Treasury Secretary wanting to intervene in that market to artificially lower the yields just gives you a sense of how much of a political debt issue this is as well as an economic and social issue.
But Mohamed, what you're describing, you know, is a let's say a sort of economic and political bind and there is no obvious route out of it at the moment. And obviously there are governments sort of struggling. If you look at France and you look at the UK, despite the sort of projection in the UK with a new prime minister of feel-good factor, there's no apparent solution being offered. And you've mentioned the need for maybe a cooperative approach to the problem, but it seems that we're miles away from that at the moment. And so much depends on what the Trump administration chooses to do next. Is there an obvious route that you would recommend? And even if you had that, how long is it going to take to unlock this situation and find a sort of sweet spot that is going to improve outlooks for national economies?
Those are great questions and let me deal with them sequentially. First, the international effects, and secondly, what about the US? What should it do? You know, back in 1971 the Treasury Secretary in the US famously said, 'Our dollar, your problem.' Today the US is basically saying, 'Our yields, your problem.' You mentioned the UK, you mentioned France, I would add Japan. You have three G7 economies that are very vulnerable to the yield instability that the US is exporting. And it's important to stress these are G7 economies. These are economies at the core of the global system. These are not the peripheral economies. These are the core economies. You're right, Richard, to raise the global issue. As to where to solve it, I like the positive spin on this. The US is lucky to have financial markets that are willing to fund a massive innovation that has the potential, if we can risk-manage the bad aspect, has the potential of delivering higher productivity, higher growth. The US is unique in having these capital markets but you have to make room for it. There's two ways of making room for it. One, you leave it to the market and the market in making room for it will hit the most vulnerable segments of your society and in the process will turn a financial and economic issue into a social and political issue. The other way is you smartly make room for it and that speaks to the US fiscal policy. It speaks to a 6% deficit at a time when the US has full employment. This is a time for fiscal containment. Otherwise, we're going to get a crowding out that's going to be really problematic. I was taught early on in my career in markets, what you think should happen matters less than what you think will happen. So, what will happen? We're not going to have the sort of fiscal adjustment we need. It's not going to come for a few years and we're going to have a crowding out effect that's going to polarize the country even more. And I'm sad to say that, but that's the most likely outcome. And that should be a very clear message to other countries. Don't wait for the US to sort itself out because it has a longer runway to be fiscally irresponsible. It's the global currency. It has the biggest financial markets. So you will continue to import bond market instability and you have to deal with it at home. The cooperative approach is of course the best approach, but Richard, I don't see it happening right now. I see the middle powers losing trust in the multilateral system and looking for an alternative, but you can't build an alternative overnight.
But Mohamed, supposing there is, let's say, a trigger crisis in one of the medium economies. Actually, I'm thinking specifically of France. We've got a presidential election coming up and we've actually got Melenchon, the left-wing candidate who could win. Okay, he's not necessarily the front runner, actually advocating a policy of burning French debt. And you know, this has caused a huge dispute in the EU now and across Europe and politically in France. Is that significant enough, as it were, to knock the global economy in a profound way in terms of what the reverberations would be through the system, or is it not, as it were, sufficiently large to alter the picture you've just painted?
It's significant for Europe. Europe's decision-making process, Europe's economic stability always relied on two core countries, France and Germany, with a few around them, the Netherlands being an example, and that holds the system together as others converge in a positive way to something better. Now you have France, as you pointed out, having economic, financial, and political uncertainty that's really high. Germany has its own issue. Germany is dealing with a China shock and has its own political issue. So for Europe, the ability to make decisions quickly, the ability to follow leaders has been undermined. Is it a problem for the world? No. Because they are part of the Eurozone. The ECB provides a form of collective insurance that certainly could help France deal with this issue. It's not going to be pretty, but it can deal with this issue. Richard, I worry much more about the UK and Japan when it comes to the G7 economies than I do about France. I find it interesting that French spreads are now more risky than Italy's. Who would have thought that a few years ago? So I find that interesting. But if you're looking for systemic effects, it is more the Japan and the UK among the G7.
Mohamed, I just want to go back to your comments on fiscal containment and your smart observation, lesson well learned, that what you think should happen is probably not what is going to happen. So fiscal containment may seem unlikely, but the big challenge on fiscal containment certainly for the economies you've mentioned in Europe is the new defense burden. So the defense commitments, how do you see a way through that? Because whilst the social implications of not meeting those wouldn't be immediately high, the reputational national security implications and implications in terms of your reputation could be very high indeed. Do you see that defense spending commitments in the end naturally being shaved in order to meet other commitments, or do you think in fact they might rise because most defense budgets do?
So I really can't speak to what should happen on the defense side other than we should modernize the way we do defense. I think that's obvious to many, many people. Is that going to mean a bigger budget, a smaller budget? I don't know. What I do know is there are some very difficult choices that need to be made on the fiscal side and these are political choices. They will need leadership. We're not in a world where your initial conditions are what you want them to be. You know, there's the old joke, how do you get somewhere where you don't start from here? Well, we have to start from here. So, we're going to have to make some really difficult choices. It's doable. There's a difference between the engineering issue. Can you come up with an engineering solution? And the answer is yes, you can. And can you minimize the collateral damage and the unintended consequences? Yes, you can. But then you need implementation. And that requires leadership. You know, I have this discussion with my daughters all the time. They complain about the legacy that my generation is leaving behind. And it's not something to be proud of. They say, 'Dad, you're leaving us with high debt, high inequality, low growth, a climate crisis, a defense deficit. Thanks. Your generation really messed it up.' And I say we did, but your generation has tools that we never had. And if you manage these tools properly, and there's many aspects of that simple phrase, but if you manage these tools properly, you can address all these issues in a way that we could never address them. And when I look at what's happening on technology, when I look at what's happening on life sciences, when you look at robotics, quantum, these are really exciting developments that can fundamentally change the paradigm and make the engineering solution easier to implement. It requires leadership.
Do you think, Mohamed, that those assets that you have listed, which your children's generation have, do you think that they're part of the core strengths of the US economy, or are they currently, the way that they're structured and capitalized, are they actually huge risks?
They are 80% assets, 20% liabilities, and let me explain. And the rest of the world recognizes this. Data was just published in terms of foreign investment flows into the US and what you see is investment in the private sector is at a record high. Investment in government bonds is coming down really quickly and the rest of the world, to quote again my daughter, is saying we are willing to go long US innovation, long US private sector entrepreneurship, we just want to short the mess, the sovereign mess. That is how they see it. So yes, 80% of it is good. It is fundamentally good. You can either look at what I call small AI, what it can do to health, what it can do to education, it can fundamentally transform both and has a very positive social impact. Or you can look at big AI, which it can fundamentally move the productivity needle and therefore the growth needle. Are there risks to be managed? Absolutely. And we're seeing them very clearly. There are risks to be managed and they can be managed. A friend of mine puts it really succinctly. He says we are witnessing not just the industrial revolution, which was a notion of a general-purpose technology coming in and changing how things are done. Electricity is a general-purpose technology. But also the enlightenment, because AI is not just a GPT, a general-purpose technology, it's also an invention machine. An invention machine is like bringing in the microscope and suddenly you're seeing new things that you've never seen before. So this is really transformational but we need to manage it and managing the 20% downside is critical while at the same time unleashing it. You know, the US tends to focus on let's unleash the 80% and the other stuff will take care of itself. Go to Brussels, they want to regulate for the 20% and they forget about the 80%. You've got to embrace both and if we embrace both, I think we can turn the legacy issues around.
Mohamed, one I think crucial aspect of the AI revolution, or whatever you like to call it, and you've described it so beautifully, seems to me, I mean now we look through the geopolitical optic, is the relationship with China on this issue. Now we've just seen Xi in Washington, strong on visuals, empty on content, or at least that's my opinion, but the mere fact of the meeting and the fact that these two, you know, competing but also conflicting economies can meet, you know, does sound a note of optimism. And it seems to me that the AI revolution is intimately connected with what happens in this economic relationship between China and the US that will largely dictate the global shape of the AI revolution. And without that arrangement, the framework is lacking. And I think at the moment the nervousness about AI is it has no framework, it hasn't reached that point of development although it desperately needs it. You're a sort of, you know, economic commentator but I mean you can't avoid here a geopolitical judgment as to how is that relationship likely in your opinion to evolve?
You know, Richard, you can speak to that much better than I can.
Well, I'm so concerned about it because the negative aspects of the relationship seem so predominant and you know, I'm actually very vociferous on that issue as regards the UK's relationship with China. On the other hand, I would like to feel that there is a sweet spot somewhere that can be established without getting into, you know, a direct confrontation and conflict. But at the moment, it doesn't seem that the United States in particular is working hard to achieve that.
Yeah. I worry that this sweet spot you talk about is what I would call an unstable equilibrium. That it's there simply because both countries want it there but don't trust each other. The Economist had a wonderful phrase for it called strategic stalemate. You get to a strategic stalemate where your interdependencies are both your strength and your weaknesses. So they can either be weapons or they can be vulnerabilities and you just freeze there. But you know deep inside, you being US and China, that whoever wins, quote unquote, the AGI, the artificial general intelligence race, will have not only an economic advantage but a fundamental national security advantage. I think the reality is both countries are going to continue doing what they're doing. They're using completely different models. So it's going to be interesting to see which models. And at some point you would hope just like happened in the nuclear world that there would be an agreement but for now I see, you know, let's first build domestic coalitions and then let's build coalitions among allies before we try to build coalition with an adversary. So it's going to be sequential and hopefully we'll get there. And the question to you, Richard, is you saw it happen with nuclear weapons. It was the same sequence. Do you think it happens here or do you think it's just too far to happen? It's gone too fast here for it to happen.
Well, if you look at the later stages of the Cold War, you had the SALT agreement, you had the MBFR talks. I mean, you had a whole range of discussions and relationships which ultimately were designed to, let's say, mitigate the risk of a thermonuclear war. And they've worked reasonably successfully. And I mean funny enough I was just writing something yesterday in which I said that, you know, the model for AI if you take a longer term view has to be some sort of maybe disarmament negotiations is the wrong phrase to describe them but some sort of high level talks which develop over time into not necessarily a balanced relationship but a relationship which avoids crisis. I mean, I guess I'm looking at a minimalist outcome, but something that the motivation on both sides is that humanity doesn't destroy itself. I'm sorry to put it so fundamentally as that. And I don't think the Chinese view of that is different from the American view. But on the other hand, finding that spot, particularly if you're in a crisis over, let's say, Taiwan, makes it that much more difficult. I mean game theory I always find very illuminating when it comes to things like this. You know if you think of the three conditions you need, you have two of them. One you just stated, a common objective, and I think both countries will buy into the common objective at some point. The two is the perception that you both win. Cooperative outcomes don't happen when one side believes that they're losing in a big way. You could probably formulate it as both sides win. The third one is the one I worry about, is trust. And you brought Taiwan into this. You need trust for it to solve. So you have two of the three conditions and the question is how do you get that third condition and like you I think it's going to take time. And you know we had a modicum of trust with the Soviet Union in that we expected them not to do certain things. Okay, that was a limited concept but it actually served its purpose. And if you look at something like the biological and chemical weapons agreement, there were violations, but essentially it has over time delivered what it was intended to do. So there are models out there which meet your three criteria, which I think is fascinating.
