Keynes is Dead, But His Ideas are Very Much Alive
By Dr. Tim Stuchtey and Marianne Schneider

U.S. economic policy today seems like a classic Keynesian approach taken straight out of an economics textbook. The Fed has reacted to the capital market downturn and slowing economic growth by cutting interest rates, thus increasing the money supply (representing a rightward shift of the LM-curve). At the same time, the Bush administration and Congress launched a big fiscal stimulus package by issuing tax rebate checks (representing a rightward shift of the IS-curve).

While Germany and Euroland in general are also facing an economic slowdown and public banks in those countries were among the first who reported huge write-offs as a result of their large investment in asset-backed securities that suffered badly due to the U.S. housing market crisis, the German/Euroland answer to the problem has been quite different from the U.S. approach. The European Central Bank (ECB) raised interest rates by a quarter percentage point to 4.25 percent on July 3, after having kept them stable since June 2007. Moreover, there is currently no initiative among Euro member states for a fiscal stimulus package. Instead, the German government has put some effort into balancing the federal budget.

These differing monetary and fiscal policies of the world's two major currency areas were analyzed during a timely workshop organized by the AICGS Business and Economics Program. The event, titled "The Return of Keynesian Politics?" brought together a wide-ranging group of policymakers and scholars from both sides of the Atlantic and featured two renowned international experts: Dr. Peter Bofinger, who has a reputation for being in support of Keynesian politics and is a member of the German Council of Economic Experts (Sachverständigenrat), and Dr. Randall Henning from the Peterson Institute for International Economics. They discussed the appropriateness of U.S. and European policies, their influence on exchange rates, international payment imbalances, and the financial and real adjustments that will be necessary in the near future.

Dr. Bofinger illustrated that Keynesian politics have more or less always been employed. While Keynesian monetary and fiscal policy has been very pronounced in the U.S., Keynesian politics have been absent in Euroland's fiscal policy due to an institutional lack of a coordinated approach by the member states. Bofinger argued that with excessively low interest rates, the Fed administered an overdose of Keynesian policies, particularly in 2004. His arguments support the view that the Fed's loose monetary policy creates inflationary pressure and supports the emergence of asset bubbles. Another problem Bofinger pointed out is that Americans do not save enough money and are therefore dependant on a constant inflow of foreign capital. Given these circumstances, the necessary adjustment process is likely to be painful when consumption has to come down and will be substituted by exports that are triggered by the devaluation of the U.S. dollar. As a consequence, the U.S. will not be a locomotive of growth for the world economy in the foreseeable future as it has been so many times in the past. But who else could it be?

It is not going to be Germany, Bofinger says. On the German side of the Atlantic, real domestic demand and private consumption have been stagnant for the past eight years. This finding comes as a bit of a surprise given the fact that unemployment decreased significantly in the past two years and with people finding new jobs and consequently generating more income, one would expect an aggregate increase in consumer spending. Instead, the past German growth was mainly driven by exports, but with the strength of the Euro and the weak state of the world economy exports will come down at some point, which would then also hurt the German economy. On the monetary side Bofinger criticized the ECB for further tightening interest rates. He argued that according to the Taylor Rule, which stipulates how much the central bank should change the nominal interest rate in response to divergences of actual Gross Domestic Product (GDP) from potential GDP and divergences of actual rates of inflation from a target rate of inflation, interest rates in Euroland have been raised more than enough.

The world economy is currently experiencing three shocks: First, increasing food and energy prices; second, the end of the strong global growth period which started in 2004; and third, an international crisis of the world financial system. In the global adjustment process it is usually the deficit countries that have to adjust, but Dr. Bofinger contended that a mechanism should be developed which requires the surplus countries to adjust.

Dr. Henning focused his talk on the adjustment process itself. He addressed the question of whether Euroland is taking the burden with the Euro increasing in value vis-à-vis the U.S. dollar and the Yen, while the Renminbi remains stable. Henning argued that in order to reduce the U.S. current account deficit to a sustainable 3 percent, a further decline of the U.S. dollar was necessary, but should occur against Asian currencies rather than the Euro. But since many of them have pegged their currencies to the dollar, with the consequence of increasing dollar reserves in their central banks, much of the burden lies on the shoulders of the Euro.

If the Euro continues to rise vis-à-vis the dollar, the case for a joint intervention could be made, depending on the level of inflation and the path of the current account balance. If it is the U.S. that asks for a joint intervention, Dr. Henning recommended that EU officials should demand a firm guarantee for the medium term reduction in the U.S. budget deficit. In the case that the EU asks for a joint intervention, U.S. officials should encourage EU officials to expand their communication of policy to markets and ask for joint intervention in regard to China. In the context of a broader international coordination package, Dr. Henning also recommended that the U.S. and EU should work together with respect to pressing China for a faster Renminbi appreciation. The U.S. and EU should each have a strategic dialogue with China, but these conversations should not be isolated from one another.

Following the presentations, it was discussed that imbalances exist not only between the big currency blocks, but also within Euroland. The Euro's first nine years have been a success story, despite tensions with some southern member states, which made finding the right policy for the ECB hard. The continued differences in productivity and wage development within Euroland could result in an exit of one or even more member states. But to ease the tension for Euroland as well as for the U.S., a better approach would consist of initiatives by the surplus countries (such as China or oil exporting countries) to reduce the imbalances through increased consumption, which would be beneficial for the world economy. However, some doubts were raised as to whether oil exporting countries other than Russia were able to do so without creating additional inflationary pressure and risking what is called a Dutch Disease.

Overall, Dr. Bofinger and Dr. Henning called for more international cooperation to overcome the global imbalances and asked the surplus countries to take initiative to do their part in the adjustment process. It was seen as likely that China will beat the oil-exporting countries in being the locomotive of growth in the years to come. Both experts stressed the need for far more fiscal coordination within the EU and with the U.S. as well as China. With the tenth anniversary of the Euro coming up in January 2009, this issue is likely one that will continue to be analyzed.

To view Dr. Bofinger's Powerpoint presentation, please click here (PDF).

Dr. Tim Stuchtey is Senior Fellow in Residence at AICGS and Director of the Institute's Business and Economics Program. Marianne Schneider is an intern at AICGS.

This essay appeared in the July 25, 2008, AICGS Advisor.