If we are to make sense of where the world economy is today and might be tomorrow, we need a story about how we got here. By “here”, I mean today’s world of ultra-low real and nominal interest rates, populist politics and hostility to the global market economy. The best story is one about the interaction between real demand and the ups and then downs of global credit. Crucially, this story is not over.
Amazingly, prior to 2009, the Bank of England never lent to banks at a short-term rate below 2 per cent. That had been low enough to cope with the Napoleonic wars, two world wars and the Depression. Yet, for a decade its rate has been close to zero. The bank has been in good company. The US Federal Reserve has managed to raise its federal funds rate to 2.5 per cent, but only with difficulty. The European Central Bank’s rate is still near zero, as is the Bank of Japan’s. The latter’s rate has been close to zero since 1995. Yet the BoJ has still been unable to get inflation much above zero. Weak inflation is not Japan’s problem alone. It remains strikingly low elsewhere, too. (See charts.)
In fact, we should not be that surprised by this world of persistently weak inflation and ultra-aggressive monetary policies, including outright asset purchases by central banks and favourable long-term lending to banks. Ray Dalio of Bridgewater has laid out the logic in his important recent book Principles for Navigating Big Debt Crises. The central point is that governments of countries whose debts are denominated in their own currencies can manage the aftermath of a crisis caused by excessive credit. Above all, they can spread out the adjustment over years, thereby preventing a huge depression caused by a downward spiral of mass bankruptcy and collapsing demand. Mr Dalio calls this a “beautiful deleveraging”. It is achieved by a mixture of four elements: austerity; debt restructuring and outright default; money “printing” by central banks, not least to sustain asset prices; and other transfers of income and wealth. An important element in this deleveraging is keeping long-term interest rates below growth of nominal incomes. That has in fact been done, even for Italy.