LONDON – The European Monetary Union, as many of its critics maintain, looks a lot like the pre-1913 gold standard, which imposed fixed exchange rates on extremely diverse economies. But is that resemblance as bad as it sounds, or as the euro’s critics insist?
The appeal of the historic gold standard lay in an institutional capacity to build confidence. A completely fixed exchange rate rules out monetary-policy initiative, and consequently makes adjustment to large external imbalances very difficult to carry out. And the burden is unequal, because there is much more pressure on deficit countries to adjust via deflation than on creditor countries to allow higher inflation.
Pessimists are especially worried by the unpleasant gold-standard analogies and lessons. They foresee years and even decades of slow growth in Europe. Politically, too, the process of adjustment by deflation in deficit countries is so unpleasant and difficult that many pessimists think it will ultimately prove to be unsustainable.
But critics of the euro should take the gold-standard analogy more seriously. Like any system in the real world, it was more complex, more interesting, and also filled with more real policy possibilities than textbook caricatures suggest.
First, there was no automatic deflationary pressure following from some alleged peculiarity of the adjustment mechanism. The question of overall deflationary – or inflationary – impact depended (and still depends) on the total quantity of money.
Thus, in periods after large new gold discoveries – for example, following the California Gold Rush of 1849, and again in the 1890’s, when new mining techniques opened up South African, Alaskan, and Australian reserves – the classical gold standard had a mild inflationary bias. In an era of paper money, however, the link to a physical stock of some precious metal – or, indeed, some other commodity – does not exist, and there should be no reason why a central bank cannot aim at an overall inflation rate. In fact, almost all modern central banks, including the European Central Bank, do precisely that.
The second lesson to be learned from the gold standard concerns the extent and limits of capital-market integration. In the early 1990’s, policymakers, market participants, and economists alike simply assumed that the European Community’s “1992 program” – the legislative framework for the single market, and thus for a single capital market – would create a new reality, within which the single currency would work its magic. From this followed an official obligation to treat all types of risk in the monetary union – bank risk or government risk – as identical.
But the history of the gold standard, and of other large common-currency areas, was more complex. Despite the theoretical possibility of capital being sent over vast distances to other parts of the world, much capital remained local. Creditors and banks often preferred to do business with known borrowers, and where local jurisdictions could settle any disputes.
In particular, a critical part of the gold standard was that individual national central banks set their own interest rates, with the aim of influencing the direction of capital movements. This became the central feature of the gold-standard world: a country that was losing gold reserves would tighten interest rates in order to attract money.
The gold-standard rules look very different from the modern practice of monetary union, which relies on a single uniform interest rate. That one-size-fits-all approach meant that interest rates in southern European countries were too low before 2009, and too high in northern Europe. A gold-standard rule would have produced higher rates for the southern European borrowers, which would have attracted funds to where capital might be productively used, and at the same time acted as a deterrent against purely speculative capital flows.
Since the 2008 financial crisis erupted, there has been something of a renationalization of financial behavior in Europe. Up to the late 1990’s and the advent of monetary union, most European Union sovereign debt was domestically held: in 1998, the overall ratio of foreign-held debt was only one-fifth. That ratio climbed rapidly in the aftermath of the euro’s introduction.
In 2008, on the eve of the crisis, three-quarters of Portuguese debt, one-half of Spanish and Greek debt, and more than two-fifths of Italian debt was held by foreigners, with foreign banks holding a significant proportion, especially in the case of Greece, Portugal, and Italy. One consequence of the ECB’s large-scale long-term refinancing operation (LTRO) has been that Italian banks are once again buying Italian government bonds, and Spanish banks are buying Spanish bonds.
German Economics Minister Philipp Rösler has made the fascinating suggestion that members of the European System of Central Banks should set their own interest rates (though, interestingly, he made this suggestion explicitly as a party politician, not as a government minister). Autonomous interest-rate determination would penalize banks that have borrowed in southern Europe from their national central banks. Meanwhile, the German Bundesbank would have lower rates, but southern European banks would be unlikely to have access to that credit for use in their own markets.
There are also signs that individual central banks are using the leeway that they have within the existing framework in order to carry out important policy shifts. The Bundesbank has stated that it will no longer accept bank securities as collateral from banks that have undergone a government recapitalization.
The new collateral requirements, together with tentative talk of autonomous interest rates, represents a remarkable incipient innovation. In the aftermath of the crisis, some policymakers are beginning to see that a monetary union is not necessarily identical with unfettered capital mobility. Recognition of diverse credit quality is a step back into the nineteenth-century world, and at the same time forward to a more market-oriented and less distorting currency policy. Different interest rates in different countries might open the door to a more stable eurozone.