Page 1 of 3

Neel Kashkari is a managing director and head of new investment initiatives with PIMCO. This article was written for Morningstar US.

Once per quarter, investment professionals from across PIMCO's global offices gather in Newport Beach [California] for our economic forum. These sessions have been the foundation of PIMCO's investment process for years; we debate and update our short-term and long-term views for the global economy, and, from that, for individual asset classes, such as government bonds, corporate bonds, mortgages and stocks.

Last month, we gathered for our December forum and the topic that dominated the discussion, as it has in recent quarters, was the fate of the euro. Will the eurozone break up? Will European governments impose extreme, deflationary austerity to control their deficits? Will the ECB [European Central Bank] monetize the region's debts and risk inflation in order to preserve the common currency?

This is a debate that has raged within PIMCO for quite a while. There is a wide range of opinions, each supported by relevant precedents and sound economic reasoning. Yet, despite our intense focus, we don't know the answer with certainty.

Here in America we too face a similar question, though markets are not currently demanding an immediate answer. For the last few decades, America has fuelled its economic growth by borrowing and consuming, and, in doing so, has racked up large, unsustainable debt. Families that take on too much debt must eventually cut spending, either to pay back loans, or at least because banks stop lending them money.

They are eventually forced into some combination of austerity and default. But countries with their own currencies have a choice: one, austerity-induced deflation; or two, print money and eventually trigger inflation, which makes their debts easier to pay off, while robbing creditors of the real return they were promised.

Will we find the political will to cut spending? Or will we continue running large deficits? Will the Federal Reserve resume quantitative easing, in effect monetizing our debts? Will it unintentionally trigger inflation?

Listening to my colleagues make their arguments during the forum, I was taken back to my days 15 years ago when I was an engineering graduate student at the University of Illinois. You may wonder what a debate about the global economy has to do with engineering. It reminded me of one of my favourite classes: non-linear systems - the study of natural and man-made systems that, at times, behave very oddly. Allow me to explain.

Most systems we interact with every day are linear: if you change an input to the system by a small amount, the output will also change by a small amount. Think about driving to work. If you leave your house 10 minutes early, you will usually arrive about 10 minutes early. If you turn up the flame on a stove a little, the pot of water will heat a little faster.

But some systems, under certain conditions, behave very differently. These systems are said to have "sensitive dependence on initial conditions" - very small changes of the inputs can lead to enormous variations of the output. Mathematicians have given these systems the label of being "chaotic" and experts in the field are called "chaoticians". (The term "chaotician" always struck me as ridiculous. Could you imagine introducing yourself this way?)

The weather is the best example of a real-life chaotic system. Predicting the weather beyond a few days is impossible because minor variations lead to large changes in the future. Go back to the driving example. If you leave 10 minutes late, rather than 10 minutes early, you might hit rush hour, and the extra 10 minutes ends up costing you an hour.

Chaos theory describes the conditions under which a system changes from linear and smooth to highly non-linear and violent, where minor changes to the inputs will lead to enormous variations of the output.