Hamish McRae: Keynes and Hayek - whose ideas hold the key to growth?
Thursday 20 September 2012
Keynes or Hayek? Do you try to offset a downturn with demand management or do you allow it to happen and purge the excesses that caused it? This is I suppose the greatest practical issue facing the western economies right now, and there are two utterly different approaches that are now coming to a head-on clash.
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On the one hand, the US is following the Keynesian model and there are some American economists, such as Larry Summers, former US Treasury Secretary, who believe that the Coalition here should give a greater fiscal stimulus. Fiscal laxity is reinforced in the US by monetary laxity, with the chairman of the Federal Reserve, Ben Bernanke, unleashing another bout of quantitative easing.
On the other hand, there is Germany, where the government under Angela Merkel is tightening fiscal policy and should balance the budget by 2014.
Germany does not control its monetary policy for this is handled by the European Central Bank, but the president of the Bundesbank, Jens Weidmann, has just likened the ECB's policy of buying bonds of the weaker eurozone states as the work of the devil – a reference to Faust – which even those of us who are sympathetic to the German plight would think a bit strong.
So two quite different views, with I suppose the UK somewhere in the middle, unlike the Americans, trying to restore fiscal discipline but with the Bank of England spraying money all over the place. Which is the more effective approach?
I have been looking at a paper by Chris Watling at Longview Economics, with the stern title Does Currency Debasement Matter? The answer, you might imagine, must be yes, but actually it is not that clear-cut. He argues that in the past 30 years as far as the US is concerned, the Keynesians have been proven to be right, for it has recovered swiftly from several perilous crises: the savings and loans one in the 1990s, the dot.com bust of 2000-02 and, of course, the 2008 financial crisis.
On the other hand, the countries that took the 2008 crisis on the chin did not attempt demand management and had a savage recession, such as the Baltic states, have recovered very strongly – much more strongly than Western Europe. This experience suggests that the Austrian School of economists was right.
Of course the US, as custodian of the world's only reserve currency, has a freedom that others do not. But by following such a lax policy, it must to some extent be undermining the dollar's reserve role, notwithstanding its current safe haven status.
"The key question," Mr Watling says, "is whether at any stage that international desire to hold dollars might change? And if so, what might bring about that change?"
The answer so far is "not yet". But meanwhile there is decent argument to be made that the loose monetary policy of the US (and for that matter the UK) has not been cost-free. One way of getting at this is to look at the different pattern of savings and investment in the US and UK vis-à-vis that in Germany.
Total savings are much higher in Germany and have tended to climb (left-hand graph) since the middle 1990s, whereas they have fallen in the US and UK; and while investment has fallen in all three countries (right-hand one) it has remained higher in Germany than in the US or here.
This is not to suggest a close causal relationship between the tendency in the US to bail out the economy with low and falling savings and investment, or in Germany between the higher savings and investment and the more austere approach to demand management. But there must be some association.
At its simplest, Germans may save more because they trust their money – which is why they are so upset by what they see as debasement of the euro by the ECB. By contrast, Americans and to some extent Britons, save less because at some level at least they think the authorities will bail them out.
As it happens, I was at a conference in Munich organised by the Ifo Institute and the Bundesbank last weekend that gave an insight into Germany's current dilemma. Several points emerged.
One was that Germany's current competitiveness in the eurozone is seen as reward for several years of austerity through the first part of the past decade, not some sort of bonus conferred on the country as a result of euro membership. It followed that the fringe countries that had lost competitiveness had simply to adopt the same policies that Germany had done: restrict wages and curb consumption. If, one delegate pointed out, Spain were to have zero wage increases for 10 years and German wages were to go up by 3 per cent a year, the two countries would have similar competitiveness.
You can immediately see the difficulties with that. But a contrasting point was that it was in Germany's self-interest to keep Spain in the eurozone (there was more ambivalence about Greece) even at the cost of large transfers from German taxpayers, because costs of break-up would be even greater. As for the ECB bond-buying plan, one delegate points out that not to do it would have broken up the eurozone, and preserving that was the purpose of the ECB. You could not expect an institution to destroy itself.
But what emerged most strongly was that Germany already faced huge contingent liabilities to the rest of the eurozone. Some of these are explicit, through for example the temporary loans given to Greece, Portugal and Ireland. This will rise if, as expected, Spain seeks a formal bailout. But much of the support is hidden, through the central banking system, the so-called Target 2 balances, where debts of the central banks of the periphery end up on the balance sheet of the ECB. This is an issue highlighted by the head of the Ifo Institute, Hans-Werner Sinn, and is clearly of profound worry to the Bundesbank.
So what is happening is that Germany is more convinced than ever that its Hayekian austerity is the right one: that is why it is successful now. But it is in practice underwriting Keynsian laxity for much of the rest of Europe. The result is a sense of anguish.
This does not answer the question as to which approach is more appropriate. That will not be resolved for some years yet. My own instinct, however, is that the German perspective is a more helpful and responsible one and that the argument is moving their way.
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