Originally published in 2008, the revised and updated 2009 edition features an additional chapter on the world balance sheet recession (ch. 8). Richard Koo, chief economist of the Nomura Research Institute, is the author of Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implication, which was a global success in 2003. Since I did not read that book, I will not be able to judge what exactly is new and what is old material in the Holy Grail.

The book’s main thesis is that the economy can be in two states, called yin (post-bubble) and yang (‘normal’). While in the yang state, the economy behaves just like predicted in the neo-classical models. Monetary policy works, fiscal policy is not so much effective, depending on whether it is crowding-out private investment or not. In the yin phase however, monetary policy does not work. Firms are trying to decrease debt, and the way they do that is by redirecting the cash flow from investment to repayment of debt. Therefore, investment slumps, pulling the economy downwards. Fiscal policy can and must come to the rescue and stabilize demand, never mind the fiscal costs.

The main idea is that cycles of indebtedness drive the yin and yang phases, explaining how the economy can change its behaviour as noticed by John Maynard Keynes in the General Theory and Irving Fisher in his 1933 paper on debt deflation. In Keynes phrase, the demand for liquidity depends on whether the company is doing just fine or must repay its debts. In the latter case, the preference for liquidity is quite high, leading to a fall in investment just like argued by Keynes. Richard Koo supports his theory by explaining that Japanese companies did have access to credit, so a ‘credit crunch’ was not a supply side problem but a demand side problem: nobody wanted to borrow.

When in such a situation, fiscal policy must be used to create money demand. Only then savings can be translated into investments and the economy be spared from a permanent fall. After balance sheets are repaired, which can take a decade or more as Japan’s example has shown, monetary policy will work once more. Fiscal policy as a tool for demand management can be blended out. In the real world, it will be very difficult to judge whether an economy is in a yin or yang phase. This means that the application of the theory will be very difficult and probably be dominated by the way you measure things. All serious economists have been aware of house price bubbles in the US, Ireland or Spain, but who is to decide whether this is a bubble? And if it is, should central banker try to burst it? These are old questions that can be dealt with in the clearer framework supplied by Koo.

Richard Koo claims he found the Holy Grail of Macroeconomics. It would explain why there are liquidity traps and prolonged recessions. He has achieved his goal, elegantly building on theories of giants, like Minsky, Keynes, Fisher and Leijonhufvud. The problem is two-fold. First, mainstream economists will ignore him, since he does not have a spelled-out economic model. The main issue is known since Hyman Minsky search for it: the Minsky moment. When exactly is existing debt too much? Without an answer to this question, modellers will be unable to predict the behaviour of an economy. This leads us to the second problem: without an alternative mathematical model, the financial community will ignore Koo as well. However, since he works at the investment firm Nomura, that is not so bad. Even if his Holy Grail cannot be translated into gold (and prove him right in this way), the intellectual achievement will stand for some time.

During the Great Depression deflation was transmitted via the gold standard, the international monetary system of that time. In a nutshell, it worked like this. All money had to be backed up by gold in a fixed ratio. A country that imports more than it exports than has to pay its net imports with gold. It’s central bank therefore retires some of its currency, whereas the foreign central bank expands its currency supply. Therefore, the net importer will go through a phase of deflation while the net exporter will see its economy inflate. The burden of adjustment falls 50-50 on both economies. The net exporter’s higher price level will make its products dearer, while imports are getting cheaper since the other country is seeing its price level fall. This leads to balanced trade accounts where imports are close to exports. Of course, both are highly positive.

The idea of the gold standard then is to bring about external equilibrium. Trade imbalances are not likely to persist since once the gold starts flowing, price levels are working to reverse the imbalance. Since being ‘on gold’ means that rules have to be followed by changing the monetary supply, the domestic price level is free to float. Today, we have the opposite system. Monetary policy is used to anchor the domestic price level. This strategy is called inflation-targeting. The theoretical models this strategy is based on completely ignore international imbalances, just as the gold standard ignored domestic inflation.

So we are left with a dilemma on this planet. We know that international imbalances are a bad thing, since this creates extra risk for the world economy. Capital flows have to arise to finance trade deficits, and this will have some effect on other markets. Probably the labour markets of net exporters will be doing better than those of net importers, for example. Or, the financial markets of net importers will rise in value because of capital inflows. The interdependence of markets is something that today is not understood anymore. The second part of the dilemma is inflation. We know that high and quickly growing inflation/deflation are bad as well, redistributing wealth and causing problems to transfer savings into investment. Given that the policy instrument to influence both external balance and internal price stability is the same, we have a true dilemma.

Prior to the Great Depression, neo-classical thought dominated and the gold standard ruled. Adjustment to external imbalances was hard at times, leading to severe deflation and unemployment. Recurring financial crises occurred in both industrialized and industrializing countries. Today, the Keynesian view still dominates. Therefore, unemployment has to be fought by the central bank, leaving the external situation to develop without intervention. This connects with the neo-liberal idea of ‘the market always works’, so I think we could describe today’s system as a synthesis.

During the Great Depression, countries were afraid that capital would move out of the country, thereby reducing the supply of money and creating deflation. That is why central banks entered a race to increase interest rates in order to keep the capital inside the country. On the domestic side, companies found it more and more difficult to make money with the costs of capital growing and the price level falling. All countries that played this game of keeping capital inside the country by putting up the interest rates suffered deflation. As soon as countries left the gold standard, their economies were on its way to recovery:

source: Bernanke, Ben and Harold James (1999), NBER.

The question I want to look at today is whether the euro will fulfill a similar role in today’s economic crisis for countries of the European Union. Two words of warning: this is just a scenario that I play through, and I will assume that people might be rational in the sense that they might trade-off economic well-being for getting power (back).

Recently, people with some stake in the ECB have announced that they are prepared to pull interest rates up in the near future. Some countries are still deep in recession, and it is those countries that had seen their housing bubbles burst, like Ireland and Spain. Let me focus on the latter, since I have more knowledge about Spain. Spaniards went deep into debt to buy their houses at inflated prices and spend something around 47% of their incomes on mortgages – on average (source in Spanish). The money came from Spanish banks, which they got mostly from Germany and other net exporting countries inside the EU.

So, what is the right economic policy for Spain today? Before we answer this question, let’s see how economic policy will look like if the EU does follow the rules. At some point, the ECB’s interest rate will go up. That is pure pain for Spain, which will still be shaky at that time since it’s the laggard. The notorious EURIBOR, on which interest rates in mortgage contracts are indexed will rise, leading to higher debt payments. At the same time, a rise in the interest rate will make things more difficult for the financial sector as well. More costly capital might leave some firms underwater, and without a hope of ever coming up again. This will be about expectations also. Third, the real economy is harmed since firms will invest less. This might lead to more or longer periods of deflation, which makes debt repayment for Spanish households all the more difficult. Especially so, since at the same time nominal wages will be falling and nevertheless unemployment will continue to rise.

What Spain would need is more exports in order to repay debt. Domestic demand alone is too weak to bring about something close to full employment in Spain. However, with the euro there is no monetary policy option and fiscal policy is out as well. The stability and growth pact states that fiscal deficits cannot rise above 3% of GDP a year, and also it does not apply now it will in 2012. Even if the pact is scrapped, one wonders whether Spain can increase its government debt by much. The old solution of depreciating the currency is out, too, since Spain is part of the euro zone. A different price level from the rest of the EU is also difficult to achieve since there is the common market, which should lead to arbitrage whenever price differentials in tradables show up. The whole weight of adjustment therefore lies on wages. In order for Spain to export more, wages have to come down (or productivity go up, but this is not going to happen). With wages coming down, Spain will have prolonged deflation and also very big problems with repaying its debt.

This deflation could spread through the whole euro zone. Spanish exports will pick up, putting pressure on European firms to cut costs as well. Other countries like Ireland will also be putting pressure on wages and prices to fall, perhaps leading to a race to the bottom situation where European firms let nominal wages stagnate in order to keep their level of competitiveness constant. It might be supported by politics too, since governments will fight for jobs, as we have witnessed in the case of Opel. There is a threat here that countries of the euro zone will go through a deflationary phase with low growth rates and falling purchasing power that might resemble the experience of the early 1930s. I don’t see it happen now, but sincerely I think by now economists should have warmed up to the thought of discussing worst case scenarios instead of indulging in wishful thinking.

So, what are the alternatives? Spain might consider leaving the euro zone. It would be a bold move, but Spain might be desperate. The unemployment rate stands at 20% today, and it can be expected that it gets worse. Also, Spain has a problem with its regions. While some, like the Basque country and Catalonia are industrialized and relatively rich, others are not. The dictatorship of France has led to redistribution from those rich regions to the rest, and now there is a struggle for some regions to form their own nation. While some Basques have been doing so by armed resistance, Catalans have been using political means, and that includes using the FC Barcelona as a tool for cultural identity (Xavier Sala-i-Martin plays no small part in this, by the way).

So, what will happen if Spain leaves the euro zone? The question critically hinges on whether Spaniards would have trust in a new currency. If so, the new currency could be devalued from the beginning, thereby reducing debt burden for households, firms and the government. Spain could become a net exporter, and earn its way back to economic growth. However, if some regions would not go with the new Spanish currency and instead opt for their own currency, this solution might become difficult to follow.

These are just scenarios which I think unlikely to happen, but the pressure that will be put on Spain might be real. However, it would be easier for the EU to either support Spain through a federal fiscal stimulus paid for by the net exporters or allow Spain to default on part of its debt. The political cost of Spain exiting the euro would generate quite high negative externalities for the euro zone, so some political deal is likely to go down.

I am reading Jeffry Frieden’s paper Global Imbalances, National Rebalancing, and the Political Economy of Recovery – and enjoying it:

In a 1932 presidential campaign speech, Governor Franklin D. Roosevelt emphasized the contradictions of the incumbent Republican government’s international economic policy, comparing it to the fantasy world of Alice in Wonderland:

A puzzled, somewhat skeptical Alice asked the Republican leadership some simple questions:
“Will not the printing and selling of more stocks and bonds, the building of new plants and the increase of efficiency produce more goods than we can buy?”
“No,” shouted Humpty Dumpty, “The more we produce the more we can buy.”
“What if we produce a surplus?”
“Oh, we can sell it to foreign consumers.”
“How can the foreigners pay for it?”
“Why, we will lend them the money.”
“I see,” said little Alice, “they will buy our surplus with our money.  Of course these foreigners will pay us back by selling us their goods?”
“Oh, not at all,” said Humpty Dumpty, “We set up a high wall called the tariff.”
“And,” said Alice at last, “how will the foreigners pay off these loans?”
“That is easy,” said Humpty Dumpty, “did you ever hear of a moratorium?”

During the Great Depression, banks broke down in large numbers. Afterwards, it was argued that the Fed let these banks fail by not increasing the money supply and keeping interest rates to high. Today, we can see why this argument is not valid.

This time it’s different. The ZIRP (zero interest rate policy) ensures the lowest nominal interest rate possible while quantitative easing (expanding monetary supply) ensures liquidity. However, instead of the banks getting better they seem to stabilize only, and now there are some more dark clouds on the horizon.

First let me explain that the nominal interest rate is not what all banks pay for their capital. The Fed accepts only very good assets as collateral when handing out additional money (although lending standards have been eroded there as well, with the Fed taking on troubled assets). So, if a bank with low quality assets needs to roll over debt, the interest rate it pays is probably going up, because the loan has to be coming from the financial market, and not from the central bank. At least the FT says so, reporting on an assessment by Moody’s.

This means that monetary policy is still without traction. The interest rate which banks face when rolling over debt, which is the most important one we are looking at right now, is different from the nominal interest rate set by the Fed. The only way to save banks now, should they go under water in the next months or years, is by direct transfers of capital – again. We saw this happen last year, we might see it again in 2010.

The above graph pictures not the LIBOR or any banking related interest rate but the one that matters to companies of a specific rating by Moody’s. You can see that although the nominal interest rate is near zero, relevant interest rates for firms in the real economy are not. I guess that the same goes for financial firms, since they hold a portfolio of assets stemming from exactly these real economy firms.

What has helped banks a lot is that the prices of financial assets have gone up worldwide. However, this is only because of the mother of all carry trades, as Nouriel Roubini calls it. Since you can lend at zero interest rate from the Fed, banks do that and then get out of the dollar by buying assets abroad. This is probably what drives the dollar down and global asset prices up. This takes some pressure of the balance sheets, but then: is this sustainable? Roubini says: nope.

When the dollar has declined a lot and bottomed out, the carry trades will unravel as everybody gets back into dollar. This race will drive the dollar up again and global asset prices back down. However, that also means that asset prices today are inflated, and everybody knows it. So the interest rates that banks face are probably not coming down, even though their balance sheets look nicer.

Roubini concludes:

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

I have been at an exhibition at Berlins Museum for Kommunikation two weeks ago. It’s all about money, from the beginnings via conspicuous consumption to the financial crisis. It’s very interesting for non-economists, I suppose, and it doesn’t costs much either (€3/€1,50). If you happen to spend some time in Berlin, this might be a nice idea. The museum is in the city center, metro stop Stadtmitte (U2/U6) if I remember it right. Don’t miss the robots in the entrance hall. They are always up for a game of football.

The reason for ignoring the WSJ – or at least its opinion pages – is that they many are not reality-based. They are misleading and use misinformation to make you afraid of certain people, ideas, and other institutions. Mark Spitznagel in his article The Man Who Predicted the Depression – Ludwig von Mises explained how government-induced credit expansions led to imbalances in the economy offers a nice example. Before I start criticizing it, lead me offer you my take on things.

The Great Depression called for explanations. Apparently, markets were not coming back to equilibrium, resulting in persistent unemployment and economic slump. Two questions were to be tackled: 1) What caused the Great Depression?, and 2) How do we get out? Roughly, Ludwig von Mises tackled the first one successfully and fumbled the second, while John Maynard Keynes skipped the first question, focussed on the second and got it right. This was the more important accomplishment, so that is why Keynes made it to the economic hall of fame while Ludwig von Mises did not. That, however, is not to say that von Mises is wrong or that Keynes would not agree with the answer von Mises provides for question 1). Here is an extract from ch. 22: Notes on the trade cycle, III:

The preceding analysis may appear to be in conformity with the view of those who hold that over-investment is the characteristic of the boom, that the avoidance of this over-investment is the only possible remedy for the ensuing slump, and that, whilst for the reasons given above the slump cannot be prevented by a low rate of interest, nevertheless the boom can be avoided by a high rate of interest. There is, indeed, force in the argument that a high rate of interest is much more effective against a boom than a low rate of interest against a slump.

To infer these conclusions from the above would, however, misinterpret my analysis; and would, according to my way of thinking, involve serious error. For the term over-investment is ambiguous.

So, even Keynes did not say that economists like von Mises which believe over-investment would cause recession were wrong. I would also agree with von Mises that over-investment is the candidate for causing business cycles. However, I would not agree that it is wrong monetary policy that causes these business cycles. Remember that in the 19th century we had no (modern) central banks, and still we had a lot of financial crises. Clearly the government was not responsible because it did not set interest rates – banks did.

As for the policy solution, von Mises proposed to do nothing and wait until the over-investment has been wiped out. This kind of ‘hands off’ policy was tried by Herbert Hoover, and it failed spectacularly, bringing about misery on a level not see in the US since the Civil War (don’t pinpoint me on this, though).

According to Keynes, the problem was that people could not save anymore, since there was nobody to invest the money. People started hoarding the money, and that meant that the drop in investment was not compensated. That drop led to unemployment, therefore to less income, which led to less demand. Because of this, firms invested even less, and this is where the vicious circle starts. The system ends up in an under-employment situation where it stabilizes. So, how do we get out of the slump?

Here is Keynes, ch. 22, II, on the use of monetary policy (my highlighting):

It is this, indeed, which renders the slump so intractable. Later on, a decline in the rate of interest will be a great aid to recovery and, probably, a necessary condition of it. But, for the moment, the collapse in the marginal efficiency of capital may be so complete that no practicable reduction in the rate of interest will be enough. If a reduction in the rate of interest was capable of proving an effective remedy by itself, it might be possible to achieve a recovery without the elapse of any considerable interval of time and by means more or less directly under the control of the monetary authority. But, in fact, this is not usually the case; and it is not so easy to revive the marginal efficiency of capital, determined, as it is, by the uncontrollable and disobedient psychology of the business world. It is the return of confidence, to speak in ordinary language, which is so insusceptible to control in an economy of individualistic capitalism. This is the aspect of the slump which bankers and business men have been right in emphasising, and which the economists who have put their faith in a “purely monetary” remedy have underestimated.

Now Keynes says in his General Theory, ch. 18, II:

But an increase (or decrease) in the rate of investment will have to carry with it an increase (or decrease) in the rate of consumption; because the behaviour of the public is, in general, of such a character that they are only willing to widen (or narrow) the gap between their income and their consumption if their income is being increased (or diminished). That is to say, changes in the rate of consumption are, in general, in the same direction (though smaller in amount) as changes in the rate of income. The relation between the increment of consumption which has to accompany a given increment of saving is given by the marginal propensity to consume. The ratio, thus determined, between an increment of investment and the corresponding increment of aggregate income, both measured in wage-units, is given by the investment multiplier.

So, it is investment that has to be stabilized at a high level in order to lead to more (and finally to full) employment. If the private sector does not bring it about, the government should do so.

Now let’s get back to Mark Spitznagel’s article:

But then, just Mises’s bad luck, along came John Maynard Keynes’s tome “The General Theory of Employment, Interest and Money” in 1936. Keynes was dapper, fresh and sophisticated. He even wrote in English! And the guy had chutzpah, fearlessly fighting the battle against unemployment by running the currency printing press and draining the government’s coffers.

He was the anti-Mises. So what if Keynes had lost his shirt in the stock-market crash. His book was peppered with fancy math (even Greek letters) and that meant rigor, modernity. To add insult to injury, Mises wasn’t even refuted by Keynes and his ilk. He was ignored.

This is a misrepresentation of what Keynes had said. Besides that, the last paragraph is also non-sensical. Keynes was a speculator, and that meant he was rich. So, like every other wealthy man during that time, he lost money during the stock market crash. Also, the ‘fancy math (even Greek letters)’ will impress you only if you happen to be attending elementary school. Alfred Marshall in his Principles of Economics from 1890 had ‘fancy math’ in it. And ‘even Greek letters’? Spitznagel is a hedge fund manager, where they throw around with alphas and betas all the time. I guess he writes for the WSJ in order to promote the public good, not his hedge fund (or the next one).

Oh, and about the last issue of that short quote, that Keynes ignored von Mises: No, he did not. And I can prove it. (Being a scientist has its advantages.) See above.

There is a new piece by Sebastian Edwards titled ‘Latin America’s Decline – A long historical view‘. It is argued that the period of 1945-1980 was not of exceptional growth, that inward-oriented policies like import-substitution have failed. The style of the ‘paper’ at times reminds of me of the WSJ’s front page editorial. There are almost no statistics, there is no model, no theoretical thinking. Don’t get me wrong: I like and value economic history, but this reads like a newspaper article. On page 16, Edwards ends chapter III. in this way:

After the Pinochet coup d’etat, and the diaspora of the left in the 1970s and 1980s, Chile has been able to make major institutional changes that have allowed it to become Latin America’s undisputable super star.

Proving that growth picked up under Pinochet misses the point. The question is what growth rate would have been achieved in an alternative scenario. And just by the way, Chile grows faster since Pinochet stepped back as president in 1990, as I have argued elsewhere. More important is the cost on human life. According to Edwards, there was a ‘diaspora of the left in 1970s and 1980s’. According to the Valech Report, more than 30,000 people were tortured and more than 1,000 exiled. The Rettig Report finds that more than 2,000 people were killed for political reasons or as a result of political violence. What good is economic growth if people are killed? Was Hitler’s Nazi Germany the ‘undisputed superstar of Europe’, Stalin’s Soviet Union the ‘undisputed superstar of Asia’?

On p. 26 Edwards, who was born in Santiago de Chile, has the opportunity to put some distance between him and the Pinochet government:

Through time, different United States administrations supported a succession of despots, including Anastasio Somoza in Nicaragua, Marcos Pérez Jiménez in Venezuela, Leónidas Trujillo in the Dominican Republic, and a long list of generals in Argentina and Brazil.  It was president Franklin Delano Roosevelt who, referring to Somoza in 1939, supposedly said: “He may be a son of a bitch, but he is our son of a bitch.”

He fails to do so. I wonder how NBER thinks about these things. In their own words (and with my highlighting):

Founded in 1920, the National Bureau of Economic Research is a private, nonprofit, nonpartisan research organization dedicated to promoting a greater understanding of how the economy works. The NBER is committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community.

To conclude, I highly value NBER for its output of high quality papers that are well researched. I have referred to these papers on this blog to comment on quite often, and I think that NBER fulfills an important role in stimulating discussion in the world of (academic) economics. The article by Sebastian Edwards misses NBER standards as defined above by far. I think that it is not a scientific article but rather an opinion piece, and I sincerely hope that this is not a new development at NBER. I would be very sad if NBER degrades into ‘he said, she said’ journalism.

The KfW (Kreditanstalt für Wiederaufbau) has found something that they want to share:

Hohe Eigenkapitalrenditen von 25 % und mehr sind bei deutschen Unternehmen in Zeiten guter Konjunktur keine Seltenheit. So konnten beispielsweise in den Jahren 2006 und 2007 sowohl die börsennotierten großen Unternehmen aus DAX und MDAX als auch die mittelständischen Unternehmen in Deutschland im Durchschnitt eine Eigenkapitalrendite von mehr als 25 % erzielen. Unter den nicht börsennotierten Mittelständlern konnte 2007 mehr als die Hälfte eine Eigenkapitalrendite oberhalb von 25 % erzielen und dabei auch ihre Eigenkapitalausstattung spürbar verbessern. Dies zeigt eine aktuelle Analyse der KfW Bankengruppe.

In short: the companies listed in the Dax had a return on equity higher than 25% during 2006 and 2007. The finding comes out of an analysis of the KfW group.

Besonders in Krisenzeiten ist für Unternehmen ein ausreichendes Eigenkapitalpolster wichtig. Ohne die in der öffentlichen Diskussion so kontrovers diskutierten hohen Eigenkapitalrenditen, die eine Stärkung der Eigenkapitalbasis erst ermöglichen, hätte die Finanz- und Wirtschaftskrise viele Unternehmen, vor allem zahlreiche Mittelständler, noch härter getroffen, als dies ohnehin schon der Fall ist.

So, in times of crisis it is important to have equity. Without a high return on equity in good times, firms would have accumulated less profits and be in more danger during bad times. Uh-huh.

The more risk you are running, the higher should be your return. Well, this is news for nobody. No economist I know would be amazed by that. What the KfW fails to mention, however, is that behaving in a risky way (by loading up with debt) will increase the likeliness of financial crisis. The KfW does not see the correlation between market risk and return to capital. Any of you guys ever heard of Hyman Minsky?

The KfW is completely unaware of the arguments that speak against taking on risks in the financial sector. The main argument is: why let companies take on big risks, if that increases their returns but also the risks for crisis, in case of which the taxpayer would have to pay the bill? Why play a zero-sum game with warped incentives? This is the argument you have to tackle if you would be aware of the discussion.

The sheer scale of ignorance at the KfW is amazing.

Last weekend I spent at a conference titled The World Economy in Crisis – The Return of Keynesianism? with about 250 participants, most of them international guests. Since the media did not cover it, let me state what I think are the main conclusions.

1. Young economists are fed up with the macroeconomic textbooks and their theories. They do not consider themselves ‘Keynesians’, but they like to think of themselves as ’serious scientists without dogma’.
2. The ‘mainstream’ (which is represented by the theories in textbooks) cannot explain the crisis, and couldn’t even put the crisis into the models. Ever tried to get a New-Neoclassical Synthesis model to explain why banks in the US hold close to 1,000 billion dollars as excess reserves? You’ll know what I mean.
3. This crisis is not over. Some participant said that the US consumers need to get the debt off their backs. Well, fine then, let us relieve the US consumer. But what is debt to the consumer is wealth to somebody else. Somebody holds the financial asset based on that mortgage and will be disappointed after default. So defaulting would not really make things better: your mortgage is gone which makes you richer (or better, less burdened by debt), but it will turn out that your pension fund holds the corresponding asset – and that is gone, too! So, there will be no significant net change in private wealth if the debt burden is reduced through default. Debt and wealth are two sides of the same coin!
4. It does not matter whether in the end Keynesians are right, or post-Keynesians, or Austrians or even monetarists (by the way, this is what Heiner Flassbeck said in his keynote address). We need to deal with this crisis without falling back to the dogmatic positions that were established in the last 30 years. Edmund Phelps is an example for somebody who should not be heard – he’s living deep inside the ivory tower (via Paul Krugman). This is not a stupid intellectual game between the ‘mainstream’ and ‘Keynesians’ – this is about saving the world economy from repeating the great depression of the 1930s, which put hundreds of millions into unemployment and poverty and led to political polarization.

US president Barack Obama is thinking about a new model for the US economy. According to the NY Times, he wants to follow Germany’s:

“If Germany, a wealthy, highly unionized industrial nation, can generate 40 percent of its economy as export-based, then it seems to me that there is something we’re missing that they are doing right, and we have got to figure that out,” he told a meeting of his Economic Recovery Advisory Board.

Now some people (hopefully, no economists among them) will say: but Germany had dismal growth rates! To which a trained economist should answer: “Well then, follow the economic policies of the world’s leaders in growth”. The top-10 for 2008 are: Bhutan, Macao, Qatar, Angola, Timor-Leste, Ethiopia, Rwanda, Azerbaijan, Equatorial-Guinea and Turkmenistan.

The idea of export-led growth is that you create extra jobs by exporting more. Of course, this is a zero-sum game on the international scale. What I export somebody else must import. So a Germany with more exports than imports must mean some other countries with more imports than exports. By the way: if you export more than you import, the countries buying your goods must go into debt. They must borrow in order to finance those net imports, or sell some of their assets.

So, Germany has recently accumulated net wealth vis-a-vis the rest of the world. Sadly, part of that wealth was invested into sub-prime assets from the US. A very important question for net exporters is hence whether they can get quality assets or not. For the US, the answer would be easy. Instead of accumulating wealth, they would first repay debt. But what kind of debt should we think of at this point? Of course, the US should repay the debt with higher costs of servicing – high interest rates – first.

Probably this is not government debt. According to the Fed, interest rates on government debt are barely above zero. However, household and private sector debt has to be serviced with high interest rates. This situation is completely different from that in Germany, where households are not very deep in debt and also companies have relatively less debt. Whereas Germany used net exports to pile up net foreign wealth, the US will do so to decrease net foreign debt. And I would say that the US strategy is appropriate for its state of the economy and will result in relatively higher growth rates. However, I believe that German policy-makers made a mistake and – with the help of the ECB – produced the lost decade of 1999-2009 (source: Eurostat; 1999-2010, 2010 is an estimate):