The debate over rates is pointless - we're in trouble either way

While there is growing consensus that the global economy is in big trouble, there is an ongoing and very confusing debate about the cause of the trouble, and therefore what central banks should be doing about it.

Broadly there appear to be two schools of thought. In one corner stand the Inflationists which point to the take-off in inflation in China, India and much of the developing world. They see this as leading to higher inflation in the West, perhaps leading to an inflationary spiral which destroys the value of our currency (see e.g. Eric Janzen). These people are often the types to be burying bars of gold in the ground.

In the other corner stand the Deflationists which see the destruction of credit, and mounting bank losses as potentially bringing about a deflationary spiral which could ultimately lead to something like the Great Depression. See e.g. Mish. They think that banks should be vigorously cutting rates in an attempt to prevent this. These guys are buying bonds and waiting for the dust to settle.

These two camps are currently engaged in a lively debate over whether banks should be lowering or raising rates.

The fact is that the debate is pointless. It doesn't really matter whether central banks raise or lower rates. Either way the global economy is going to face a painful period of readjustment which will probably mean a period of recession and lower living standards in both the West and most emerging economies.

If we slash rates, our currencies will fall, imports will get much more expensive, eroding spending power, leading to a consumer recession, falling profits and rising unemployment. On the other hand we can raise rates, which will clobber the housing market further, depress consumer spending and lead to falling growth and unemployment.

Either way the result is basically the same. Central banks can't fight the economic fundamentals.

For the past 10 years the West and China have been stuck in a Faustian pact in which the yuan has been kept artificially low, allowing the Chinese to grow fast, while Western consumers could buy more goods than they could really afford. The large-scale sale of yuan and purchase of dollars by the Chinese allowed this to persist while keeping interest rates low in the West.

It seemed to be the best of all worlds. Continuous growth, low inflation, low interest rates, low unemployment, fast growth in the developing world. But it couldn’t go on forever, for it was built on a lie – the fiction embodied in the artificially low value of the yuan against other major currencies.

This lie allowed the Chinese to expand production and exports without having to worry about bothersome things like productivity or efficiency. And it allowed Western consumers to increase their spending while their wages stagnated.

But of course it couldn’t go on forever. Either the Chinese would be unable to buy dollars as fast as the rest of the World was selling them, or American consumers would be unable to spend as fast as China wanted to produce. In the end it was a bit of both. By 2007 US consumers were maxed out, and could spend no more, while servicing their huge debts. At the same time investors started to dump dollars en masse, sensing an economic downturn.

What we are seeing is the beginning of a gradual and inevitable reversal in the terms of trade. Chinese goods aren’t really getting more expensive, it’s just that they are no longer able to subsidise them as much as they have been. They’ve kept the exchange rate down but inflation is now making that effort pointless. The same goes for oil exporting nations. The lie is finally being exposed, and we are all facing the consequences.

In the longer term the result of this will be lower consumption (but possibly more production) in the West and lower production (but possibly more consumption) in the East. But that shift is going to be neither swift nor painless.

What central bankers and policy makers should be discussing is not how to prevent, or slow down the necessary rebalancing of the global economy, but rather how it can best be effected with the minimum of lost growth and welfare.

Unfortunately, like many things in life, big changes usually only happen as a result of an extended period of suffering. It's going to be unpleasant.