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Mohamed El-Erian: THIS dwarfs worries about China

The nosedive in the Chinese stock market and the slowdown in the world's second-largest economy will certainly be front and center for global investors in the near term, but there's a more important shift underway, economist Mohamed El-Erian said Friday.

The bigger issue for financial markets is that central banks are running out of ammo, the Allianz chief economic adviser told CNBC. "Markets are realizing that central banks can no longer repress financial volatility. And they are repricing to new volatility paradigm," he said in a "Squawk Box" interview.

To that end, any shocks to the markets will take longer to reverse themselves, said El-Erian, former Pimco co-CEO. "What we're going to see is every time something happens in the world it's going to take longer to restore stability. That's what we're seeing with China today.

Read MoreJPMorgan: Here's what China needs to stabilize

El-Erian said it's a good thing the Federal Reserve is starting to normalize monetary policy. "They realize that they can't artificially repress financial volatility."

"What's not a good thing," he continued, "is we're not doing the other things that need to unleash the productive capacity of the economy."

The government needs to improve fundamentals to "validate financial assets," El-Erian said.

Read MoreDennis Gartman sees stocks dropping another 10%-15%

He encouraged lawmakers in Washington to start with issues perceived as common ground, such as reforming corporate taxes, reducing debt and fostering public-private cooperation on overhauling antiquated infrastructure.

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