HERE is a very common narrative about the American economy (or, for that matter, the Anglo-American or Atlantic economy):

Our current episode of deleveraging will eventually end, which will shift the IS curve back to the right. But if we have effective financial regulation, as we should, it won’t shift all the way back to where it was before the crisis. Or to put it in plainer English, during the good old days demand was supported by an ever-growing burden of private debt, which we neither can nor should expect to resume; as a result, demand is going to be lower even once the crisis fades.

That's Paul Krugman, by the way. Before the crisis, he reckons, the only way to get enough demand to manage full employment was to induce ever more private-sector borrowing. If we then limit borrowing through financial regulation (as we should), we cannot help but suffer a permament demand shortfall: "secular stagnation". What is more likely to occur is a return to high levels of indebtedness (which, many people suppose, is precisely what rich-world central banks are trying to achieve).

I don't get this. I don't understand why we would assume that pre-crisis demand was supported by or in any way dependent on higher levels of indebtedness.

I have a sense for what the story is (or one story is). Imagine (if you can) that America has experienced steady growth in income inequality, which has effectively concentrated an ever larger share of income in the hands of households with a lower marginal propensity to consume. Other things equal, such a shift in the income distribution will reduce demand and require a lower real interest rate to match desired saving with desired investment. The Federal Reserve, conscious of the need to keep demand near potential, dutifully pushed down its policy interest rate in an effort to reduce real interest rates (and was successful). This encouraged non-rich households to take on ever more debt, the better to generate higher levels of investment, mostly in the form of single-family homes. It simultaneously encouraged yield-conscious rich households to seek ways to channel their savings, via new financial products, into higher yielding debt instruments. Desired saving and desired investment balanced through the magic of Wall Street wizardry and everyone made out like bandits until the world nearly ended. Now, the Fed is trying to balance desired saving and desired investment once again, but it is finding it difficult to do. In part this is because deleveraging continues, but it may also be because new financial rules are blocking the flow of credit from rich households to non-rich, which is necessary to restore adequate demand.

Does this story make sense? I'm not so sure. Part of the difficulty is in knowing what is driving what. But let's consider one thing. The trend in private-sector indebtedness moves very closely with the trend in America's current-account balance.

I've taken the private-sector indebtedness figure Mr Krugman uses and shown the quarterly change in liabilities alongside the quarterly current-account figure (both are in billions of current dollars). There is a rather pleasing symmetry between the two series. (In a new post, Mr Krugman adds that this might be relevant.) Here's another thing to consider:

At least where Treasuries are concerned, the driving force behind sustained low interest rates is not short-term interest rates, at least not by early 2003. From then on expected short-term rates are moving up. The big downward pressure on interest rates comes from a declining term premium. Now as Ben Bernanke explained in a speech earlier this year there are several potential explanations for the falling term premium. Here are a few:

[D]uring periods of financial turmoil, the prices of longer-term Treasury securities are often driven up by so-called safe-haven demands of investors who place special value on the safety and liquidity of Treasury securities. Indeed, even during more placid periods, global demands for safe assets increase the value of Treasury securities. Many foreign governments and central banks, particularly those with sustained current account surpluses, hold substantial international reserves in the form of Treasuries. Foreign holdings of U.S. Treasury securities currently amount to about $5-1/2 trillion, roughly half of the total amount of marketable Treasury debt outstanding.

So we can tell another story. In that story American monetary policy has had to manage the impact of a "global savings glut": essentially a fire-hose of savings into the American economy, driven by factors like demand for safe assets to be used as collateral and reserve management rather than an effort to get a good risk-adjusted yield on an investment. The demand problem does not result (or does not primarily result) from growth in the income share of rich savers. Instead, it is the result of an exchange-rate kept out of equilibrium by the flood of capital from abroad. An overvalued dollar hurt net exports (and, therefore, demand). It also made investments in trade-exposed segments of the economy unattractive. And so the economy remained depressed (in 2001 and 2002) until financial intermediation honed a method for channeling capital inflows into investments in housing, which also boosted consumption.

Here's an interesting question: what if that channel had been blocked? What if financial regulators had taken extensive steps to prevent capital inflows from generating booming credit growth, by sharply limiting leverage? There are a few possibilities that I see. One is that the wily financial sector would simply have found other ways to get credit flowing. In the absence of strict capital controls a firehose of capital will find a way through the cracks. In that case a crash might have occurred any way, albeit one of a slightly different flavour.

Or maybe foreign purchasers of Treasuries would have settled for buying every piece of oustanding government debt available, and would never have messed around with "safe" mortgage assets. In that case Treasury rates might have continued their long decline and, if the government didn't heed market demand for even greater supply of debt securities by running even larger, and more stimulative, deficits, then the demand shortfall that characterised the period from 2001 to early 2003 might well have continued.

One interesting question is how the Fed would have responded to that eventuality. From 2002-3 the American economy was in the grips of a sustained disinflation. Core PCE inflation fell from 1.8% in 2001 to about 1.3% in late 2003. The Fed responded by cutting the federal funds rate a half point in 2002 (to 1.25%) and another quarter point in 2003. Had disinflation continued it might have kept cutting. But Ben Bernanke also gave a speech in late 2002 discussing how the Fed might combat falling inflation or deflation if rates fell all the way to zero. He says the Fed could simply begin targeting yields on longer-maturity bonds, using asset purchases if necessary. He mentions the possibility that the Fed might buy "agency debt", like Fannie-issued or guaranteed mortgage-backed securities. Had the Fed responded to the persistent demand shortfall in that fashion, the outcome might have been similar to what was actually observed: a flow of money into the housing sector, essentially making up for the purchases of mortgage securities foreign buyers aren't making (in this scenario).

But given broader regulation the bubble might not have managed to become as dangerous. And QE would have, through the portfolio-balance effect, placed some downward pressure on the dollar. Putting things differently, the outcome once all these things are more or less simulataneously determined probably would have been a weaker dollar, slightly smaller current-account deficit, slightly less growth in private debt, and a slightly less bad crisis.

But Mr Bernanke also had this to say in his speech:

The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt. I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange. In the United States, the Department of the Treasury, not the Federal Reserve, is the lead agency for making international economic policy, including policy toward the dollar; and the Secretary of the Treasury has expressed the view that the determination of the value of the U.S. dollar should be left to free market forces. Moreover, since the United States is a large, relatively closed economy, manipulating the exchange value of the dollar would not be a particularly desirable way to fight domestic deflation, particularly given the range of other options available. Thus, I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar. Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly.

Now there was basically zero chance that the Fed would go down this road. As evidence for this we might observe that after this speech Mr Bernanke almost never discussed intervention in foreign-exchange markets as a possible policy option, or the fact that when a really severe crisis threatened to cause serious deflation this option never appeared on the Fed's menu. And foreign governments would absolutely lose their mind if the Fed followed such a course.

But foreign governments weren't particularly happy when President Nixon closed the gold window either. And this is an intriguing possibility to think about. Unlike purchases of American government debt, purchases of foreign-government debt would not have shrunk the available pool of the world's safest safe asset. Foreign-debt purchases would have directly opposed inward flows, greatly reducing the potential for domestic credit growth. And they would have substantially improved the outlook for industries—and investments—in the tradable sector. The bang from the policy would be limited by the level of inflation the Fed signalled it was prepared to accept. But it doesn't seem crazy to think that announcing a higher level of desired inflation and supporting it with foreign-debt purchases would have very quickly triggered a strong boom (just like in 1933). Whether that all would have, on net, contributed to greater global stability is unknowable. But a meaningful reduction in the odds of a several American financial crisis seems the sort of thing that is generally good for the world.

This has all been a fairly mechanical, adding-up sort of discussion of demand issues, in which the Fed has to use lever A to lift economy B. But it could be that that isn't the right way to think about things. It could be that the Fed found itself facing these uncomfortable trade-offs then for the same reason it faces uncomfortable trade-offs now: because it was and remains unwilling to say that the goal of policy should be and is higher inflation. In his initial post Mr Krugman writes:

One answer could be a higher inflation target, so that the real interest rate can go more negative. I’m for it! But you do have to wonder how effective that low real interest rate can be if we’re simultaneously limiting leverage.

But if you create higher inflation you don't need low real interest rates to solve the demand problem; it's already solved! Maybe this is the confusion that keeps the economy in its rut. Markets are looking to the Fed, saying "which equilibrium, boss?". And the Fed is saying that it would prefer the adequate-demand equilibrium but priority one is keeping a lid on inflation. And markets are saying "well I guess we have our answer".

Or to be succinct about things, there is no a priori reason to think that generating adequate demand requires rising indebtedness. But when an inflation-averse central bank is trying to generate adequate demand when the zero lower bound is a binding or near-binding constraint (as it was in 2002-3 and is now) it just might.