John Rapley

Something odd is happening in United States financial markets. In Washington for some meetings, I was having lunch with some economists at the International Monetary Fund. We could agree on one thing: When it pays a bank to borrow money for 30 years and then park it in a two-month deposit, the omens suggest that something unpleasant lies around the corner.

But when it came to explaining the anomaly, agreement ended. One fellow said China was continuing to plough money into the U.S., and thereby keeping interest rates persistently low. Another argued that the world economy had entered a century-long period of deflation. I said that even if that were so, I suspected the short-term prospect was for rising inflation.

Real long-term interest rates stand near zero. When you subtract the inflation rate from the interest rate on a fixed-income security, you get the real rate of return. In effect, banks are paying depositors next to nothing to borrow their money. It makes more sense to spend it. Nevertheless, banks, governments and other borrowers are having few problems attracting investors.

The conundrum

That is the conundrum, and it indicates one of two things. One possibility is that the risk premium has become unusually low. That means that savers believe there is virtually no risk of default or rising inflation over the period for which they are lending. That seems unlikely. Thus, some analysts are concluding that we are going through a period of exceptional complacency among investors.

Historical studies suggest that periods of high complacency usually precede market crashes. Pride goeth before a fall. Bolstering this interpretation is the evidence that spreads between U.S. interest rates and those in riskier markets like our own are also at unusually low levels. Everyone seems to be taking Bobby McFerrin's advice not to worry and just be happy.

There is, however, another school of thought - that one typified by my colleague who believed in a deflationary world. He suggested that real rates remained low because markets had correctly anticipated that deflation would resume, restoring real rates of return. There might be a brief inflationary spike, after which inflation would drop until prices in the U.S. actually began to fall. That would make real rates of return attractive again.

If that view turns out to be correct, investors who look complacent or even foolish today will appear pretty clever in a year's time. But if that is so, it also means that the U.S. economy could be headed for a recession in the short term. That might not be so bad for the world economy, since Europe and Japan are looking healthier than they did a few years ago, and could pick up some slack.

It might not be great news for us, though. Moreover, if deflation really sets in, it will be bad for everyone. Falling prices depress returns, which depress investment, which depresses spending. Then we could be in for a long and painful slog.

Last scenario

This last scenario seems the least likely. But it does appear safe to say that unless financial markets are being manipulated by China's central bank - I have my doubts they are, though almost anything is possible in a globalised world - something unpleasant does indeed wait around the corner. Either the first school is correct, and we are headed for a market crash of possibly global proportions; or the second school is correct, and we are headed for a period of slow growth and possibly recession.

In effect, the option is to pay now or pay later. But an 'adjustment' of some sort seems highly likely before too long.

John Rapley is a senior lecturer in the Department of Government, Mona.