The extraordinarily easy money policies pursued by most of the globe's central banks also helped pump up the U.S. credit and housing market. Fallout from 9/11 and the U.S. invasions of Afghanistan and Iraq had hit the global economy hard early in the decade. Europeans were still absorbing the formerly Communist states of the East into their economic community and adjusting to their newly adopted currency, the euro. Much of Central and South America had recently reformed those national economies, and Southeast Asia was still recovering from its late-1990s financial crisis.
China's rapid economic ascent created new challenges for nearly everyone. Although the burgeoning mainland economy lowered prices for global consumers, it also destroyed the profits and jobs of its competitors. Not only were higher-cost developed economies such as the U.S. and Germany losing market share to China, but so were developing economies such as Mexico or Poland, where production costs were low but not as low as in China.
Central bankers tried to ease the pain of all these adjustments by cutting rates. With a flood of cheap Chinese goods helping to lower inflation, policymakers had the latitude to reduce borrowing costs dramatically. The U.S. Federal Reserve led the way, but most other central banks soon followed.
The Bank of England, the fledgling European Central Bank, the Mexican Central Bank, and the Bank of Canada all lowered rates. The average global central bank target interest rate declined from a peak of 5% in late 2000 to a low of 1.5% in 2003, where it stayed throughout much of 2004.
Even more telling was the negative real central bank target rate the difference between the stated rate and inflation. (If the benchmark interest rate is 1.5% but inflation is 2.5%, the real rate is –1% a condition at least theoretically attractive to borrowers.) Central bankers have historically reserved negative real rates for times of economic crisis or recession. The global real rate went negative in 2002, and it didn't turn positive again until well into 2006.
A speculative bubble had developed in Japanese asset markets in the 1980s; as it unraveled during the 1990s, bad loans piled up in the country's banks. The banks took years to recognize their mistakes, refusing to write off their bad loans and tying up what capital they had.
A long, painful credit crunch ensued, making it hard for even healthy businesses to expand their operations or for households to spend. With the Japanese economy moving sideways and deflation a persistent fact of life, the Bank of Japan steadily lowered rates. By the early 2000s, the rate targeted by the Japanese central bank was nearly zero 0.10%, to be more precise and Japanese policymakers insisted it would stay that way for as long as it took to revive their economy and rid themselves of deflation.
Global investors quickly devised a way to take advantage of Japan's zero-interest-rate policy: They borrowed yen in Japan and then traded the yen for dollars, euros, or Australian dollars any other currency that seemed safe and offered better returns when invested. This became known as the yen carry trade.
The trade was profitable as long as the yen stayed weak; investors could trade their higher-yielding dollars or euros back into yen, repay their loans, and pocket the difference. The Bank of Japan's steadfast promise not to change its monetary policy made a weak yen a safe bet.
Trillions of yen poured out of Japan and into investments across the globe; U.S. credit markets and housing received a fair share.
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