Last week, something important happened.
Two days after the US presidential election, the International Monetary Fund’s chief economist issued a warning.
He said the global economy was in a “liquidity trap”.
“For the first time, in 60 percent of the global economy – including 97 percent of developed countries – central banks have pushed policy rates below 1 percent. In a fifth of the world, they are negative,” warned Gita Gopinath.
“With little room for further rate cuts, the central bank has adopted an unconventional method.
“Despite these efforts, persistently low inflation – and in some cases intermittent deflation – has raised the specter of further monetary easing to hit real negative levels should another shock strike.
“This has led to the inevitable conclusion that the world is in a global liquidity trap, in which monetary policy has limited influence.
“We have to agree on the right policy to get out,” he said.
Ms Gopinath’s memorial is published in the Financial Times, the 132-year-old organ of the world’s financial elite.
A day later, the Reserve Bank of Australia cut its target interest rate from 0.25 percent to 0.1 percent – the lowest in our history.
Too launched a $ 100 billion “quantitative easing” program to lower interest rates across the structure of the Australian economy, and to depress the value of the Australian dollar.
The day after that, the US presidential election took place and much of the world’s attention has been on the historic election results since then.
But we have to take Ms Gopinath’s warning to heart – because if she’s right, the implications for Australia could be huge.
So what is a ‘liquidity trap’? And how does this affect Australian households?
Basically, a liquidity trap is a situation where interest rates are so low that monetary policy has limited influence.
We have seen evidence of this phenomenon here.
Over the past nine years, the RBA has consistently cut interest rates.
The target interest rate was 4.75 percent in 2011, now 0.1 percent, but inflation has been weakening over the years.
And last week, the RBA announced it would start buying hundreds of billions of Government bonds to lower interest rates, and weaken the currency.
This is another sign of a liquidity trap.
“There is … a greater risk of currency wars in the global liquidity trap,” Ms. Gopinath warned in her Financial Times article.
“When interest rates approach zero, monetary policy works to some extent by weakening the currency to support domestic producers.
“[But] with a pandemic that has tested the boundaries of multilateralism, the world cannot bear the increasing tensions that competitive devaluation is likely to generate. “
How does the government get out of this situation?
Ms Gopinath said it would require a coordinated global effort.
He said governments must work together, use their purchasing power, to revive demand on a global scale. They must avoid currency wars.
“It’s time for a global synchronized fiscal push to lift the prospects of all,” he said.
Of course, he wasn’t the first to say that.
In October last year, in a speech to the IMF, the former Bank of England governor, Mervyn King, criticizes the current generation of policymakers for failing to acknowledge how much the world has changed since the global financial crisis.
He wanted them to recognize that the world’s developed economies (including Australia) had been caught in the “low growth trap” for at least a decade.
He said policymakers are sticking to certain models of how monetary policy operates, and that leads them to misdiagnose our current economic problems.
He believes the global economy is suffering from a continuing demand shortage, and countries must work together to reallocate resources around the world to revitalize demand.
“Escaping this low growth trap is a different proposition than getting out of the Keynesian slump and requires a different solution,” he said.
Other economists has also taken care of this problem.
In fact, Larry Summers, former secretary of the US Treasury, started the conversation in 2013 when he asked the public why developed countries have struggled to grow since the GFC, and why inflation is so low, when interest rates are near zero and the world is flooded with savings.
“All of this requires new thinking and new policies, much like the rapid inflation of the 1970s forced a reset at that time,” he later argued last year (also in the Financial Times).
“The core problems of the macro economy today are very different from the problems experienced by living policymakers before.
“What needs to be done? To begin with, it would be helpful if policymakers recognized … that policy problems do not fluctuate cycles or prevent waste.
“Rather, the fundamental issue is ensuring that global demand is sufficient and fairly distributed across countries.”
If their combined analysis is correct, there will be implications for Australia.
This means that interest rates will be closer to historical lows for many years, and the government will shoulder a greater part of the burden of inflating the economy – rather than the RBA.
The federal and state and territory governments will be able to borrow at the lowest interest rates in history, but they still have to spend wisely, otherwise they could do more damage to the economy in the long run.
“Fiscal policy must play a major role in the recovery,” said Gopinath.
“The importance of fiscal stimulus may never be greater because the spending multiplier – the result in economic growth from increased public investment – is much bigger in the lingering liquidity trap.”
But there is a problem here.
See how the government deals with the problem of collective action?
We have the chief economist of the IMF, the former governor of the Bank of England, and the former US Treasury Secretary who all say that global leaders need to work together to pull the world economy out of this low growth, low interest rate, high debt trap.
But last week, the RBA initiated a multi-billion dollar bond purchase program to drag Australian interest rates lower, to keep the Australian dollar’s value down.
It pursues the same strategy as other countries: competitive currency devaluation.
That’s the opposite of what was suggested.
But there is no choice (at this time).
In a world of open trade and interest rates are close to zero or negative, if other countries drag their interest rates lower and Australia doesn’t follow them, the Australian dollar will strengthen and that will hurt our domestic producers.
So what’s the end game?
Australian policymakers haven’t made it clear.