Economists are concerned about the failure of the price mechanism in international capital markets. Governments are highly indebted, it is said, and interest rates and bond yields are not rising to the occasion.
As long as they do not respond, the profligacy will continue and the correction, when it comes, will be all the more dramatic. The US is the worst offender with its current account deficit stretching ever deeper and yet its real bond yields are below those of Japan’s and more or less the same as those of the euro area.
Currently, the blame for the malaise is placed in three quarters: on the shoulders of Asian central banks, whose buying of low-yielding US treasuries apparently defies logic; the massive production of cheap goods in China, which holds down inflation; and the single monetary policy in the eurozone, which stops yield spreads properly reflecting differences in economic health.
It is easy to see how any one of these benign conditions could quickly be brought to a screeching halt. China’s July decision to partially reform its currency regime, basing the value of the renminbi on a basket of currencies and not only the US dollar, must surely push the investment of its reserves into a broader range of instruments. That’s possibility one. Possibility two is that the low inflation environment is wrecked by higher oil prices. A third possibility is that a spat between two major eurozone countries – Germany and Italy, for example – over rates could knock yields back into line, even if it did not break up the single monetary policy.
Markets always overshoot in both directions. When they are eventually called to account, the results can be dramatic. Policymakers then learn how to deal with the same conditions better. The challenge would be to find the solution, and be brazen enough to implement it, without first experiencing the full crisis. Economic policy has come a long way in the past few decades but it is doubtful whether it has travelled that far.
