## Abstract

How should countries in a fixed exchange rate system balance their current account? This question was at the center of the historical debate between Keynes and White in 1944 and is being debated increasingly these days for the Eurozone. Should consolidation by deficit countries be complemented by higher spending in surplus countries in order to avoid a downward bias in the level of consumption? We investigate the associated disequilibrium behavior experimentally, letting our experimental subjects act as heads of state who repeatedly seek to coordinate their policies. If only deficits are punished, as proposed by White, we observe that consumption is persistently reduced and adjustment is slower than in a treatment in which a surplus is also punished, as suggested by Keynes. We find support for the fact that underconsumption occurs for behavioral but not for rational reasons.

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## Notes

- 1.
The sum of current account deficits equals the accumulated surpluses. This is by definition true for a global economy. It also holds partly for a fixed exchange rate system whose joint surplus would tend to be outbalanced by an appreciation of its currency.

- 2.
We should not overlook that “good imbalances” (Blanchard and Milesi-Ferretti 2009; European Commission 2012) exist. Countries with an aging population and without attractive investment opportunities should run a current account surplus and prepare for the dissaving that will occur when the workforce retires. But a surplus may not be motivated as a “good imbalance”. A “bad imbalance” by a surplus country may come about due to domestic institutional failures that promote saving and inhibit investment (Blanchard and Milesi-Ferretti 2009). A “bad imbalance” may also result from an export-led growth strategy where the accumulation of foreign exchange reserves aims at devaluing a country’s currency (Blanchard and Milesi-Ferretti 2009). Given our focus on a fixed exchange rate system or a currency union we do not consider this issue further.

- 3.
Our approach complements research on macroeconomic models with heterogeneous agents and strategic complements (Morris and Shin 2002; Angeletos et al. 2010). We equally observe inertia in the response to shocks, non-fundamental volatility and an amplified response of the economy to noise relative to fundamentals. But we differ by giving agents complete information and assuming that they might form non-standard beliefs. In our case, noise is generated by beliefs about other players playing randomly rather than the arrival of noisy signals. This allows us to investigate the behavioral underpinnings that can bring about departures from equilibrium and experimentally testing whether they might persist. This brings our findings closer to the experimental evidence by Cornand and Heinemann (2013), who observe that subjects underreact to (private and public) signals by underestimating other players’ reactions.

- 4.
We used a version of this time series, where an ADF-test, \( \Delta i_{t} = \gamma_{1} + \gamma_{2} i_{t - 1} + \gamma_{3} \Delta i_{t - 1} + \nu_{t} \), produced insignificant coefficients \( \gamma_{2} \) and \( \gamma_{3} \) close to zero. This made sure that the process did not, by random selection, turn out to be stationary or characterized by serial correlation.

- 5.
We do not reject the idea that variations in prices and interest rates may restore equilibrium. But allowing our experimental countries to do so would diffuse the focus of our study: whether subjects choose equilibrium strategies. In reality, adjustments of prices are notoriously slow and interest rates may be set smoothly or hit the zero interest floor.

- 6.
As long as heads of state react rationally, income equals its natural level such that prices can remain unchanged. Our main interest is whether an output gap is obtained due to biases among households. That such an output gap may fade out over time due to adjustments of prices (and interest rates) is beyond the focus of this study.

- 7.
We made a gross estimation upfront about the costs for running a surplus in the Keynes treatment and considered this to be about 4 Taler, which would arise in about 50 % of all cases, while in another 50 % a deficit would arise. Given that subjects in the White treatment did not incur these costs of running a surplus of roughly 50 %*4 Taler, we reduced endowments from 20 to 18. Rather than reducing the endowment we could have adjusted the exchange rate, giving less than 4 Eurocent for a Taler. But this would have generated a confound because deficits would have been penalized more harshly in the Keynes treatment. Our approach thus preserved the marginal incentives for avoiding deficits across the two treatments. Our up-front estimation is roughly confirmed by the result that in the Keynes treatment surpluses arose in 540 of 1,200 cases (45 %) with a mean deviation of 3.69 not significantly different from 4 (F = 3.09, p = 0.079). In the White treatment surpluses were made in 328 of 720 cases (45.55 %) with a mean deviation of 4.40 not significantly different from 4 (F = 2.78, p = 0.097).

- 8.
Experiments on beauty contests (Nagel 1995; Stahl and Wilson 1995; Güth et al. 2002; Sutan and Willinger 2009) are related to our experimental design. In the classical beauty contest, subjects pick a number between 0 and 100 in order to target \( p\left( {mean + c} \right) \) where

*mean*is the average of all chosen numbers,*c*a constant and \( p \in \left( {0;1} \right) \) Iterated elimination of dominated strategies yields \( pc/\left( {1 - p} \right) \) as the equilibrium by subjects performing an infinite number of steps of iterations. Subjects normally stop after only two to three steps (Nagel 1995; Ho et al. 1998). Repetition generates convergence towards equilibrium as the previous round’s average number typically serves as an anchor (Ho et al. 1998; Duffy and Nagel 1997). Lambsdorff et al. (2013) make explicit reference to beauty contests as an approach for investigating macroeconomic price-setting. - 9.
Assuming that others set consumption above the Nash equilibrium, \( c_{ - mt} > c_{t}^{*} \), the first term would imply setting consumption between the levels chosen by others and the Nash equilibrium, \( c_{mt} < c_{ - mt} \). Contrary to this, the second term would imply setting \( c_{mt} = c_{ - mt} \). But only lowering \( c_{mt} \) below \( c_{ - mt} \) can be a best response. This can be seen by taking the derivative of the first term, which is \( dc_{mt} - 0.8\left( { \frac{1}{6}dc_{mt} } \right) = \frac{13}{15}dc_{mt} \) while the one for the second term is \( - \frac{5}{6}dc_{mt} \) and thus smaller. It is thus sufficient to take the first term into account. The same logic holds true for \( c_{ - mt} < c_{t}^{*} . \)

- 10.
An alternative is given by Quantal Response Equilibrium, QRE (McKelvey and Palfrey 1995, 1998). Unlike Nash-equilibrium, QRE conjectures that strategies with higher payoffs are not chosen for sure but only with higher probability. Players are thus assumed to noisily best respond to other players, employing a strategy space that best responds to other players with a certain probability but also includes all other strategies with non-zero probability. With respect to dominance solvable games, QRE thus implies that subjects do not delete dominated strategies but employ them with a low probability and expect others to do the same. We also determined numerical QRE estimates for our game and observed that these would also be supportive to Hypotheses 1 and 2.

- 11.
- 12.
The translation of the oral instructions can be found in Electronic Supplementary Material.

- 13.
Instructions also included an example calculation and a test of understanding.

- 14.
The reason for the higher number is purely technical, owing to the fact that this treatment also served as a baseline in a related experiment.

- 15.
Three subjects had negative earnings (and only got a flat show-up fee) and where excluded from the plots but not from regressions.

- 16.
For each level k we also ran a regression between investment and consumption of the players of level k to observe that these variables also co-integrate. This implies that limited reasoning does not motivate departure from co-integration.

- 17.
While some of our findings appear to be close to Keynesian thinking in fact they are not. Consumption is smoothed due to departures from Nash equilibrium rather than due to habits. Keynes did not consider such a behavior for households and focused primarily on habits. The deflationary bias in the White treatment also appears to be close to Keynesian thought. However, Keynes did not consider limited rationality among households to contribute to this bias (Hoover 1997).

- 18.
We incremented consumption levels stepwise by 0.01 and determined the resulting payoff, picked the consumption level with the highest payoff and rounded this level to the closest integer value.

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## Acknowledgments

The authors are grateful to John Duffy, Christian Engelen, Susanna Grundmann, Frank Heinemann, Oliver Landmann, Rosemarie Nagel, Manuel Schubert, Günther Schulze, Jean-Robert Tyran, two anonymous referees and participants of the 3rd LeeX International Conference on Theoretical and Experimental Macroeconomics, Barcelona, June 2012, the economic seminar at Freiburg University, January 2013, the Vienna Center for Experimental Economics, January 2013 and the Gesellschaft für experimentelle Wirtschaftsforschung GfeW, October 2013.

## Author information

### Affiliations

### Corresponding author

## Electronic supplementary material

Below is the link to the electronic supplementary material.

## Appendices

### Appendix 1

There are 6 symmetric countries, each inhabited by a representative household. The household of country *j* sets a constant level of consumption, savings, investment and labor input for 4 periods and lives only from the savings in a 5th period, which represents retirement. A household lives only for five periods, but in our experiment we want to determine optimal policy choices where subjects can learn from past mistakes. We thus assign the task of setting consumption to the head of state, labelled an adviser in our experiment. This head of state is influential for determining total consumption in the country, for example by designing relevant government policies, and he lives for 20 rounds (each round consisting of 5 periods). We assume that experience gathered by the government exceeds that of single households. This can be justified by assuming that households make an inexperienced decision on retirement once in their lifetime, while heads of state have their experts, constantly evaluate earlier decisions and confront new households with novel incentives. For the sake of simplicity we disregard the dynamic effects that decisions by households in previous rounds have on current consumption. The household seeks to avoid variations in real consumption *C*
_{
j
} due to a decreasing marginal utility of consumption. Lifetime utility is given by

with *I*
_{
j
} being country *j*’s investments, *S*
_{
j
} savings and *Y*
_{
j
} income. The first term captures utility in the first 4 periods, the second term denotes utility in the retirement period where households rely on previous savings, labor disutility is denoted by the third term, where labor is proportional to income and *ρ* denotes real labor costs. Deviations between the household’s savings *S*
_{
j
} = *Y*
_{
j
} − *C*
_{
j
} and a country’s investment *I*
_{
tj
} must be balanced with those in 5 other countries. This recognizes that the current account must add to zero across all countries. Households thus have an incentive to arrange for retirement provisions through local investment in order to avoid current account imbalances. Financial intermediation or political pressure imposed on countries absorb the share *γ* < 1 of the transferred real amount, which equals the current account imbalance. Due to symmetry, such transfers can only arise outside Nash equilibrium. This will concern us later and we can leave out the last term for now.

The 6 products of the six countries are homogeneous and can be used either for consumption or investment purposes. Total demand is equal to the sum of all countries’ consumption plus all investment and it is equally split across all 6 producers. Demand for a country’s production is thus given by \( Y_{j} = \frac{1}{6}\mathop \sum \nolimits_{h = 1}^{6} \left( {C_{h} + I_{h} } \right) \). Whenever a country demands goods for consumption or investment purposes 1/6 of it will end up as income in the country itself.

Households seek to maximize utility by setting *C*
_{
j
} and *I*
_{
j
}. Inserting for *S*
_{
j
} = *Y*
_{
j
} − *C*
_{
j
} and leaving out the last term, we rewrite

The first-order conditions for an optimum are:

Jointly this implies

Imposing symmetry with *C*
_{
j
} = *C*
_{
i
} we obtain 4*C*
^{−1}_{
j
}
= *I*
^{−1}_{
j
}
⇒ *C*
^{*}_{
j
}
= 4*I*
_{
j
}. Inserting this and symmetry into (5) yields

Chosen levels of investment thus decrease with real labor costs. Optimal levels of investment are given exogenously in our experiment and are not determined by the head of state. According to (8), varying levels of optimal investment require values for *ρ* to vary across the 20 rounds accordingly. For example, a level of investment of 9, as in round 1, requires \( I_{j}^{*} = 9 = \frac{1}{{16\rho^{2} }} \Leftrightarrow \rho = \frac{1}{12} \). The reported sequence of investments can thus be related to optimizing behavior with variations in *ρ* across rounds. *ρ* can be assumed to be non-stationary due to a non-stationary evolution of technology.

Is consumption complementary, as assumed in the experiment? In order to investigate this, let us assume optimal investment in all countries but excess consumption by other players −*j* according to *C*
_{
−j
} = 4(1 + *ɛ*)*I*
^{*}_{
j
}
> 4*I*
^{*}_{
j
}
. Production will amount to \( Y_{j} = \frac{1}{6}\mathop \sum \limits_{h = 1}^{6} \left( {C_{h} + I_{h} } \right) = I_{j}^{*} + \frac{1}{6}\left( {C_{j} + \mathop \sum \limits_{h \ne j}^{{}} C_{h} } \right) = I_{j}^{*} + \frac{1}{6}\left( {C_{j} + 20\left( {1 + \varepsilon } \right)I_{j}^{*} } \right) = \left( {\frac{13}{3} + \frac{10}{3}\varepsilon } \right)I_{j}^{*} + \frac{1}{6}C_{j} \). The right hand side of (7) denotes (*Y*
_{
j
} − *C*
_{
j
})^{−0.5}. Inserting for *Y*
_{
j
}, we obtain

Consumption is thus complementary across countries. If other countries increase consumption by *ɛ*, best responding to this implies an increase of consumption in the country in question by less due to 10*ɛ*/13 < *ɛ*. As can be seen, this is a reaction in line with Eq. (2), which requests consumption to be proportional to income, *C*
_{
j
} = 0.8*Y*
_{
j
}. The fact that this proportional relationship holds true even if other players fail to optimize, becomes apparent by modifying (9): \( \frac{13}{12}C_{j} = \frac{13}{12}4\left( {1 + \frac{10}{13}\varepsilon } \right)I_{j}^{*} \Leftrightarrow \frac{5}{4}C_{j} = \left( {\frac{13}{3} + \frac{10}{3}\varepsilon } \right)I_{j}^{*} + \frac{1}{6}C_{j} = Y_{j} \).

How costly is a deviation from the optimum \( C_{j} = C_{j}^{*} + \varepsilon = 4I_{j}^{*} + \varepsilon \) when all other players choose the optimum? Utility then amounts to: \( U_{j} = 4\sqrt {4I_{j}^{*} + \varepsilon } + 2\sqrt {\frac{1}{6}\left( {30I_{j}^{*} + \varepsilon } \right) - 4I_{j}^{*} - \varepsilon } - \frac{4\rho }{6}\left( {30I_{j}^{*} + \varepsilon } \right) = 4\sqrt {4I_{j}^{*} + \varepsilon } + 2\sqrt {I_{j}^{*} - \frac{5}{6}\varepsilon } - \left( {20\rho I_{j}^{*} + \frac{2\rho }{3}\varepsilon } \right) \). This functional form does not allow for a simple solution. Simulations reveal an increasing marginal disutility the more *ɛ* differs from zero, the curve coming close to a quadratic loss function. Contrary to this, in our payoff function (2), deviations from optimal values are sanctioned linearly. We introduced this modification for the sake of simplicity and can justify it by pointing out that incentives to heads of state need not be identical to those of households.

An additional sanction for missing the Nash equilibrium is determined by costs for financial intermediation and financial pressure imposed on countries with current account imbalances, *γ*|*C*
_{
j
} + *I*
_{
j
} − *Y*
_{
j
}|. In case of excess consumption by other players −*j* we have *C*
_{
−j
} = 4(1 + *ɛ*)*I*
^{*}_{
j
}
> 4*I*
^{*}_{
j
}
. If player *j* best responds according to (9), he will run a current account surplus. This is due to \( Y_{j} - C_{j} = \left( {\frac{13}{3} + \frac{10}{3}\varepsilon } \right)I_{j}^{*} - \frac{5}{6}C_{j} = \left( {\frac{13}{3} + \frac{10}{3}\varepsilon } \right)I_{j}^{*} - \frac{10}{3}\left( {1 + \frac{10}{13}\varepsilon } \right)I_{j}^{*} = I_{j}^{*} + \frac{10}{13}\varepsilon I_{j}^{*} \). The current account surplus thus amounts to \( \frac{10}{13}\varepsilon \) and generates a disutility of the amount \( \gamma \frac{10}{13}\varepsilon \). Due to \( \gamma < 1 \) heads of state will strictly prefer the lower sanction imposed for a current account imbalance to the higher one from missing the consumption target.

### Appendix 2

While Hypothesis H2 is intuitive (see explanation in the main text), it is not straightforward to derive even with standard level-k models. Nagel (1995) suggests that L1 players assume L0 players to pick an average value of 50. L1 players then best respond to this non-random number. But in this case, no difference would arise between the Keynes and the White treatment because the uncertainty about other players, in particular the potential failure to correctly predict other player’s behavior, is disregarded. We thus base our level-k simulation on a method suggested by Ho et al. (1998). We assumed that L0 players are uniformly distributed between the decision space of 0 and 100. We then calculated the best response of an L1 player for each value of *i*
_{
t
} by randomly drawing 5 values for the 5 other players from the L0 distribution. We hereby build on the mental model in Ho et al. (1998), where “level-L players are assumed to believe that all other players (beside themselves) choose from the level L-1 density (…). Believing this, they mentally simulate n-1 draws from the level L-1 distribution.” (p. 960). Then we calculated the consumption level^{Footnote 18} which best responds to this subsample. In contrast to Ho et al. (1998) we did not let L1 best respond to the average of the five numbers drawn but to each of the five draws individually, this way considering the heterogeneity among L0 players. This modification was immaterial to the Keynes treatment but implied for the White treatment that an L1-player took the uncertainty of the average of the five numbers into consideration. This means that an L1 player mentally draws a value for each of her or his opponents and determines a unique best response for a variety of such draws. We did this 10,000 times to determine the distribution for L1 players, which is depicted in Fig. 10 (blue solid line). We recursively iterated this process by then drawing 5 values out of the L1 distribution, best responding to these values and thereby calculating the L2 distribution, and so forth. The L2 distribution is also shown in Fig. 10 (red solid-dotted line). To illustrate the procedure take a consumption level of e.g. *c*
_{
mt
} = 40. From Fig. 10 it can been seen that the probability of being L1 amounts to around 0.02, while the probability of being L2 amounts to around 0.04. Assuming only L0–L2 the relative probability can be calculated. Due to the fact that L0 is given by the uniform probability of 0.01, the probability mass for all levels L0–L2 is given by 0.07 and the chance of being L0, L1 or L2 is \( \frac{1}{7},\,\frac{2}{7} \) and \( \frac{4}{7} \) in this example and the player has an expected level of 1.42. In order to converge to the equilibrium value, up to around 20 levels are necessary and were therefore simulated. We did the simulation separately for both treatments. Figure 10 also plots the L1 distribution for the White treatment, which is biased downwards (blue dashed line).

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Giamattei, M., Lambsdorff, J.G. Balancing the current account: experimental evidence on underconsumption.
*Exp Econ* **18, **670–696 (2015). https://doi.org/10.1007/s10683-014-9422-z

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### Keywords

- Beauty contest
- Current account imbalance
- White Plan
- Keynes Plan
- Deflationary bias
- Level-k reasoning
- Eurozone

### JEL Classification

- F32
- E12
- C92