Bailout Plan Boosts Stagflation Risk: El-Erian

The financial system bailout plan, which could end up by costing Washington around $1.8 trillion, may increase the risk of stagflation and will probably cause problems for hedge funds and smaller banks, Mohamed El-Erian, co-CEO of bond giant Pimco, told CNBC on Monday.

The plan will also lead to slimmer, less risky and probably less efficient banking management over the long-term, while short term it is going to be "messy".

"View this in the context of massive crisis management response," El-Erian told "Squawk Box." "It came late but when it came, it's big. It's going to be messy, it's not going to be elegant."

Over the next two years the risk of stagflation has increased as the bailout plan needs to be financed, but over the long term the government actually stands to gain, he added. "Here's a prediction: they're going to make money out of this."

(Watch the full interview of Mohamed El-Erian on CNBC above).

Volatility will continue in the stock markets as on Friday investors saw a "technical bounce" in which short-sellers were squeezed by the bans slapped on short-selling across the world, El-Erian said.

"You are seeing a massive change in risk premium, a complete redefinition of the landscape, and first movers are going to have an advance," he said. "The reality is that the world changed very quickly on everybody."

The government opened an umbrella to fight the financial markets storm and investors should look out for that, El-Erian said. "If you have a storm going on, there's an umbrella that's going to protect certain segments that are systemically important. If you're going to go long, make sure that you are under the umbrella, and make sure that you are very close to the handle of the umbrella, so you don't get sprayed."

The market storm will also lead to massive changes in regulation over the next two-three years, El-Erian said. "We're going to go from under-regulation to over-regulation to better regulation."

The system of bonuses for Wall Street dealers and traders and executives in the financial sector will also change from the current, short-term focused, one.

The solution is not capping bonuses, as some have suggested, but making sure decision-makers have a long-term perspective, he said. "Wall Street is like an elevator where people need to decide what floor to get off on. You don't want your guys to get off at the wrong floor."

"What is no longer acceptable… is a system that privatizes the game and socializes the losses. No society will accept this," El-Erian added.

(El-Arian shares investment advice on "Squawk Box.")

El-Arian also cautioned that this is not the time to take on risk or sell everything.

“You do not want to be a seller in this market,” he said. “Don’t get sucked in, because when the market, when it’s unthinkable, it has a way of flushing you out at the wrong time.”

Rather, retail and institutional investors should focus on preserving capital, he said.