The global economy seems to be walking on water, shrugging off soaring oil prices, policy paralysis in Europe, unsustainable borrowing by the United States, and record housing prices. Is it because, as G-8 leaders would have us believe, investors are in a buoyant mood, confident in their leaders’ stewardship of the global economy? Or are we being governed by a pathology of fear, fed by events such as the recent London bombings, that is holding down long-term interest rates thereby covering up a host of simmering problems?
The role of phenomenally low long-term (inflation-adjusted) interest rates in covering up a multitude of weaknesses in the global economy is all too apparent. Soaring house prices worldwide are propping up consumer demand in many countries, and, according to a recent study by the International Monetary Fund, continually falling long-term interest rates explain two-thirds or more of the global price rise. Europe has benefited less, but its economies would be a lot worse off if long-term interest rates climbed back to their 25-year average.
Similarly, Latin America has been booming in recent years, despite high debt burdens and a mixed record of policy reform. Low long-term interest rates have kept the region’s debts manageable, while high consumer demand has helped bid up prices for the region’s commodity exports.
Why hasn’t the huge spike in oil prices cut the world to its knees, as it has on so many other occasions? Again, the answer is low interest rates. Ordinarily, a sharp rise in oil prices quickly translates into higher inflation expectations, followed by rising interest rates at all maturities. But this time, even as the US Federal Reserve keeps hiking its short-term lending rate to keep inflation in line, long-term interest rates – which are far more important – have been magically declining.