Tuesday, 7 October 2003

The Keynesian Way

There has been a collective sigh of relief in Europe – and elsewhere – ever since the European Central Bank yielded to pressure and lowered its interest rate in an effort to boost growth. Politicians were delighted by this decision. But my colleagues and I do not share their analysis. On the contrary, we are worried about this return to Keynesianism.

We have previously welcomed the monetary policy of the ECB. Contrary to its American counterpart, the ECB had long refused to yield to the sirens of the Keynesian revival and to lower its interest rate to encourage economic growth. The rates remained stable, particularly in 2002. Since then monetary authorities have lowered their interest rates several times. Even though the bank recently decided to hold the rate steady at 2 percent, one could wonder about a possible change of monetary policy.

ECB interest rates are not only the lowest since the creation of the euro, they are the lowest since the end of the Second World War. And it’s possible ECB authorities will cut them again, since the rates remain higher in Europe than what they are in the United States.

The comments around this decision emphasize a dangerous dead end, inspired by the unreasoned fear of “deflation.” The French prime minister called the most recent cuts a “welcome” signal “going in the right direction.” In a joint declaration, German Chancellor Gerhard Schröder and European Commission President Romano Prodi called it an “important contribution to growth in Europe.” The politicians react this way because the ECB president, Wim Duisenberg, evoked the broad consensus within the institution’s council of governors, saying they were “conscious of the risks of the fall continuing to weigh on growth.”

Jean-Claude Trichet, the Bank of France governor who will soon replace Duisenberg, confirmed this analysis in the French newspaper Le Monde and specified that companies’ financial environment is now exceptionally favourable to massive investment.

A change of course in monetary policy

This is the return of Keynesianism. Some really believe that interest rate cuts are likely to restart the economy, just because when money is less expensive, investors and consumers are encouraged to borrow in order to spend.

In fact, this newfound will to change the course of monetary policy first appeared in May during a meeting that nobody noticed. Indeed, at the beginning, in the Bundesbank logic, the principal and priority mission of the ECB was to guarantee price stability. For that reason, the ECB initially sought to control money supply growth, in a rather broad definition called M3. This moderate objective of the money supply growth was to allow price stability, or at least to maintain inflation on a level lower than 2 percent in any assumption. If the target lay between zero and 2 percent, the ideal was a zero inflation rate, the currency keeping this way a constant purchasing power.

But changes in this strategy appeared during a meeting of the ECB in May. On the one hand, the definition of price stability was somewhat modified. It seems now that prices are stable when they go up! Inflation must be maintained on a level “lower but near” to this 2 percent threshold.

On the other hand, according to the policy pursued until May, the fight against inflation was the priority. From now on, it seems, economic indicators (growth, consumer confidence, wages, etc.) come to the fore; price stability is relegated to a “long-term” objective.

Monetary policy can’t cure Eurosclerosis

This change of orientation is at the same time dangerous, unfounded, and inappropriate.

It brings us back to those not-so-good years when Western economies were being ruined by inflation. The consequence is already visible: the money supply increases more quickly than before. For the last 12 months it has progressed by 8.7 percent. Whereas everyone predicted a risk of deflation, according to us a lasting change is the best way to have inflation.

So, it is unfounded. This Keynesian idea, which presumes that a weak interest rate is needed to support growth, has been abandoned by most economists for a long time. The facts also contradict it; the Central Bank of Japan has a zero rate, and the country’s economy is in permanent crisis. But politicians like the idea: in their opinion, a little inflation seems to be the best way of reabsorbing unemployment. Even more, they do not see the advantage of a stable currency. It is always popular to distribute purchasing power, even if it is to fob someone off so that the price hikes spread beyond what was liberally offered.

Lastly, it is inappropriate, especially in Europe at the moment. In sclerotic economies there are more effective strategies than artificially doping investment and consumption. These short-term measures do not fix the faulty structures, which cause stagnation and unemployment. Our economies don’t suffer from a lack of demand, but from structural rigidities. What Europe needs are reforms of the labour market and withholding taxes. It makes no sense to agitate the spectrum of deflation to legitimate an “active” monetary policy.

In dynamic and competing economies, the fall of prices is a normal consequence of productivity profits, put at the service of the customers. In the 20th century, periods of greater growth occurred while prices were falling. All we need from central banks is a good currency.

Jean Yves Naudet

Jean Yves Naudet is Professor of Economy at the University of Aix in Marseille.

This article first appeared on Tech Central Station Europe.