John Maynard Keynes, after 1917, wanted to achieve full employment for England, but also for other major countries in Europe and the western world. The reason for this goal was that he was afraid of the Bolshevik menace threatening his civilized world.
Thus, beginning with the time that he returned to England from the Paris Peace Conference following World War I, Keynes sought ways that would allow a country to follow an independent economic policy that would primarily focus on full employment for the nation. Before the First World War, Keynes was, like most of his liberal counterparts, a free-trader who believed in capital mobility and flexible exchange rates
Keynes, in essence, developed a policy prescription that is consistent with what is now called the “Trilemma” problem as it is applied to economics. The “Trilemma” problem is that a nation can only achieve two out of the following three policies: fixed exchange rate, independent economic policy, and capital mobility.
Keynes opted for an independent economic policy for a government in order to achieve high levels of employment. He also believed, in his later years, that exchange rates should be fixed. This was ultimately achieved in the Bretton Woods agreement in 1944. This agreement set up the current system of international financial organizations and created a foreign exchange system that stayed in place until August 15, 1971.
The third component of this, international capital mobility, was severely restricted at the time.
What occurred in the 1960s was that inflation increased in the United States due to the fiscal and monetary policies of the government and capital began flowing throughout the world. Thus, the value of the dollar had to float in world markets. Thus, President Richard Nixon set free the dollar on August 15, 1971 and we entered a new age.
Full employment remained a policy goal of the United States government written into law by the Congress. So, the monetary and fiscal policy of the government had to remain independent of what other nations did.
Capital mobility increased as the world became more and more globalized in the latter part of
the 20th century.
And, the consequence of this combination of events left the value of the dollar on its own. And, since the early 1970s, the value of the dollar has declined by about 40% against other major currencies.
The fundamental reason for the decline in the value of the dollar was the credit inflation created by the United States government. The gross federal debt of the United States has risen at an annual compound rate of about 9.5% in the fifty years from 1961. Financial innovation on the part of the United States government has been huge.
The private sector has emulated this governmental behavior as incentives all pointed to increasing amounts of leverage on family and company balance sheets. Again, following the government, financial innovation was everywhere, especially in the area of housing finance.
World financial markets reacted by sinking the value of the dollar…except in a crisis when there was a so-called “flight to quality”. The dollar continues to remain weak and will continue to be weak as long as the United States government follows its policy of underwriting the credit inflation which is undermining the strength of the economy.
But, given conditions of the Trilemma, the dollar must continue to sink as long as international capital mobility continues and the deficit of the United States government is expected to add $15 trillion or more to federal debt over the next ten years. The United States can inflate credit all it wants, but it will have to pay in terms of a falling dollar. The two parts of the Trilemma, flexible exchange rates and the independent economic policy of the government are not really compatible at this time.
For one, this seems to play right into the hands of the Chinese. They are building up enormous international reserves. These reserves are being used to buy productive resources around the world, acquire commodities which they badly need, and increase their political power and influence throughout the nations. (See my post “Monetary Warfare: U. S. vs. China?”: http://seekingalpha.com/article/227632-monetary-warfare-u-s-vs-china.) Yes, we have a major case of mercantilism, here.
And, how does the United States respond? In terms of the policy of the government, it continues to pump things up, just what the Chinese want. And, then the United States government points its finger at China as if it is the bad guy. Well, China is the “bad guy” because it is growing stronger as the United States weakens itself.
The other piece of the picture has to do with what the economic policy of the United States government is doing to its own economy. Well, the results are not good: one in four workers of employment age are under-employed; in industry, capital utilization is between 75% and 80%; and income inequality has increased dramatically over the past 50 years as the wealthy have taken advantage of the credit inflation and the less-wealthy have suffered dramatically from the massive increase in debt leverage. (See my post “Does Fiscal Policy Really Work?”: http://seekingalpha.com/article/227210-does-fiscal-policy-really-work.)
The United States must either get its monetary and fiscal policy in order or it must seek to reduce or prohibit capital mobility. The United States cannot continue to pursue a policy of credit inflation in this era of almost totally free capital mobility without serious ramifications to the strength of its economy. The evidence of this is the current status of the American economy.
The weakness in the economy is what is driving the decline in the value of the dollar. The first conclusion one draws from a declining currency is that the decline is related just to monetary factors, to inflation. However, what we are seeing in the case of the United States is that the U. S. has exported inflation to the emerging nations through the freely flowing capital in the world. The inflation has not shown up explicitly in U. S. prices. But, the inflation has shown up implicitly in terms of the dislocation of economic resources within the United States economy.
That is why I argue that either the United States must change its philosophy about what governmental policy can do or it must seek to reduce or prohibit capital mobility. It cannot continue to support both.
In this mobile global world we live in, we cannot achieve the Keynesian requirement that the monetary and fiscal policies of a country can conducted independently of the rest of the world. Economists have to move on from the Keynesian prescription. The funny thing is, I believe that Keynes would have changed his mind many years ago.