Monday, November 24, 2014

Is Europe on a Cross of Gold?

ROME – Increasingly, one hears predictions that the euro will go the way of the gold standard in the 1930’s. And, increasingly, the reasoning behind such forecasts seems persuasive. But does that mean that the euro doomsayers are right?

Following the 1929 stock market crash, Europe was hit by a massive deflationary shock. Output collapsed and unemployment soared. Unable to agree on coordinated reflationary action, governments opted to move unilaterally. One after another, they abandoned the gold standard, depreciating their currencies. By loosening credit in this way, they recovered, one after another, from the Great Depression.

Today, Europe has been hit again by a massive deflationary shock. This time, the constraint on reflationary action is the euro. Governments lack a national currency to depreciate, and lack the power to relax credit, having delegated monetary policy to the European Central Bank. As unemployment again rises to catastrophic heights, they will have no alternative, it is said, but to abandon the euro unilaterally.

I wrote the book on Europe and the gold standard. Literally. In Golden Fetters: The Gold Standard and the Great Depression, published in 1992, I argued that the deflationary engine that was the gold standard was a key cause of the 1930’s depression, and that abandoning it opened the door to recovery.

Yet I am reluctant to believe that things will turn out the same way this time. Four differences lead me to believe that maybe – just maybe – the euro will survive.

First, mounting an appropriate monetary response is easier when you have a single central bank. Under the gold standard, it still would have been possible for central banks to reflate their depressed economies had they moved together. Unfortunately, getting central banks to move together is easier said than done. Central bankers speak different languages. They view economic prospects through different lenses.

By contrast, were the ECB to adopt decisive measures, it could reflate the entire eurozone and obviate the need for countries to act unilaterally. But, while the ECB has the capacity, the question remains whether it is has the will.

A second difference is that, notwithstanding recent cuts in social programs, the unemployed receive more extensive public support than in the 1930’s. This makes populist pressure to abandon the euro correspondingly less severe – the key questions, of course, being how much less severe, and whether the political center can hold. 

A third difference is that the political preconditions for a cooperative response are better today. In 1931, France refused to help stem the Central European financial crisis because it believed that Germany was rearming, in violation of the Treaty of Versailles, signed at the end of World War I. Political tensions between France and Germany may very well grow in the coming months and years, following François Hollande’s victory in the French presidential election, but they will not begin to rise to that level.

Moreover, European countries today are prepared to go to great lengths to save the euro, fearing that its collapse would jeopardize their single market. By contrast, when countries started abandoning the gold standard in 1931, tariff barriers had already gone up. There was no longer a single market to protect.

Finally, abandoning the gold standard was less disruptive than abandoning the euro would be. Reintroducing national currencies today would take weeks, at a minimum, whereas Britain in 1931 could take sterling off gold while the markets were closed for the weekend. Back then, countries still had their national currencies; they could simply stop supporting them. Bank deposits, along with most other private and public debts, were denominated in that national currency.

Today, these assets and liabilities are all in euros. Reintroducing the national currency in order to depreciate it, but leaving the euro value of other financial instruments untouched, would destroy balance sheets and wreak financial havoc. The alternative – converting those other instruments into the new national currency – would tie up the offending country in litigation for years.

Each of these differences casts doubt on the notion that the euro will go the way of the gold standard. But a fifth difference points in the other direction. In the 1930’s, countries could not act together because they could not agree on a diagnosis of the problem. Each attributed the Great Depression to different causes, leading them to prescribe different remedies, which they administered unilaterally.

Agreement today on the diagnosis facilitates mounting a common response. Unfortunately, there is growing evidence that the medicine on which European countries have agreed – austerity – is killing the patient. There is now talk of adjusting the dosage, but talk has not yet given way to action.

Will things turn out differently this time? There is no question that the greater scope for cooperation that exists today bodes well for the euro. But it is the precise policies on which European governments cooperate that will tell the tale.

Read more from our "The Euro at Bay" Focal Point.

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    1. Portrait of Christopher T. Mahoney

      CommentedChristopher T. Mahoney

      At present, all of the jawboning is about the need for debt mutualization, not reflation. Debt mutualization is a debt solution to a monetary problem. Piling debt upon debt while the eurozone's NGDP stagnates is a prescription for a continental depression. If the ECB would just throw off its Bundesbank mentality and target 5% NGDP growth, catastrophe would be avoided. But the ECB won't do that, and therefore the outcome will be another depression.

    2. CommentedNichol Brummer

      Haven't germans started to make noises about allowing some kind of European bonds used for investment in assets with a safe income stream, like solar energy, in sunny countries? Though limited, it would be something.

      In fact: why don't the 'core' countries already do this kind of thing on their own account, now they can lend at extremely low interest rates? They don't because they don't think it is their responsibility to invest in other countries. Why are 'core-country banks' not doing it? Or are they? Is this a kind of negative bubble that governments or the EU should step into?

    3. CommentedCharles Dover

      If the Gold Standard is a bad idea, then let European banks sell their gold reserves to those who wish to buy them (China and other net importers of gold) to make themselves whole again. In a world where gold, oil, and corn are at record highs, would not cost-push inflation eventually accomplish the required leveling of deflation? And, would allowing a second tier of national currencies to be slowly introduced in an orderly manner be as bad as the opponents of the "Free Silver" movement in 19th Century America thought it would be?

    4. CommentedH Gerken

      The 1929 crisis was caused by Wall Street and the 2008 US financial crisis sent the tsunami to Europe. so its first and foremost two times regulatory failure on the US side exported to the rest of the world. It is destructive US capitalism that needs to internalise the costs it causes to peace and stability in the world. So instead of singing the growth song gbet your garden in order as we get ours in order.

    5. Portrait of Christopher T. Mahoney

      CommentedChristopher T. Mahoney

      "The alternative – converting those other instruments into the new national currency – would tie up the offending country in litigation for years."
      True, but that is much cheaper than trying to pay back in hard money. The Latin Americans have shown that the costs of default are manageable.

        CommentedGary Marshall

        Hello Christopher,

        Did you ask the people of those nations that must suffer for their Government's profligacy?


    6. CommentedStéphane Genilloud

      The euro is deflationary in the same way the gold standard was, but the euro does not replicate the gold standard, it replicates gold itself.
      Under the gold standard, national economies had national currencies pegged to gold. In the eurozone, national economies use a common currency, in the same way as they did with gold before the 20th century.
      When those economies progressively issued bank notes (with a promise to repay in gold) in the 18th and 19th centuries, they created their own currencies. Gold (and other metals) remained in use until the gold standard was abandoned in the 30's.
      The difference between the euro and gold is that the ECB can increase the supply of euros at will, while no one ever had the power to create gold out of nothing. But if the ECB does not make enough use of its power, that difference is of little use for troubled European economies. Those might then choose to issue notes (called maybe IOUs, maybe pesetas) and recreate their own currencies in order to relieve their liquidity problem.
      Provided they do it parsimoniously and remain clear about their intentions, it might not trigger panic, not require capital controls. Existing contracts could remain denominated in euros, and euros would continue to circulate.
      There are certainly plenty of open questions, necessary conditions, and drawbacks. But that's true for alternative solutions as well.

    7. CommentedPaul A. Myers

      Excellent paper. Thought-provoking.

      At any point in time, paper assets (and liabilities) have some "real" value which is equal to the "real" future value these assets can be exchanged into, the realizable value. It may be hard to measure this value at the present time because open markets have not been allowed to fully function (the pooh bahs say sovereign debt bonds are worth 100).

      Why does a paper asset have to be converted from euros into drachmas to be depreciated? In fact, all across Europe we have paper assets whose real value is considerably less than the nominal stated value.

      Why don't we set up mechanisms to "discover" these values and then a path of adjustment to move towards these values? Without going back to drachmas, pesos, lira, and francs. And try to make the path of adjustment the least disruptive as possible. Exiting a currency and devaluing a new currency unit is just a method of adjustment. Why not choose a less painful way? Don't devalue the future obligation, just partially default on it.

      A managed path of adjustment towards true realizable values would most likely cost much less than the cost of a crisis-driven adjustment process.

      If the tide goes out on administered prices, most likely we are going to see a lot of ministry of finance and central bank officials not wearing any clothes. But we probably already know that, too. We are not where we are by the intellectual agility of the elite.

      At the end, voters will have to buy into the costs of managed adjustment or risk the higher costs of crisis-driven adjustment. There will be the siren calls of many, many demagogues telling people that someone else can be made to pay. But across all of Europe that is a negative sum game of potentially ruinous proportions.

      One must remember that in a world governed by hard-edged economics there is little justice but mistakes are mercilessly punished.

    8. CommentedJohn A Werneken

      Why is it to be assumed that unemployment and declining asset prices are bad? Perhaps quite a few houses should never have been built nor purchased at the prices they went for. Perhaps quite a few people are paid far more than they produce, especially in health care, education, and other abysmal sectors of the economy. Perhaps desperation would induce some beneficial changes.

    9. CommentedZsolt Hermann

      Although I do not have sound economical knowledge I would like to note one thing:
      The Euro is not the problem. We are not in a financial or economical crisis, we are in a system crisis.
      Economics, financial relationships are simply the external expressions of how humans relate to each other.
      It was true before, but today when we evolved into a closed, finite, integral, interdependent system it is truer than ever.
      Today each and every tiny change resonates all through the system, and since our present socio- economic system, this constant growth, expansive, exploitative machinery is totally excessive and unnatural, we are continually injecting negative influence into this interconnected, natural, living system.
      Thus the reactions we get are increasingly more negative and aggressive since our negative input comes back as a boomerang but multiple times reinforced by the systemic reaction.
      We will never solve our problems on the financial or economical, not even on the political level.
      We have to start from the foundations, how we relate to each other, how a human being connects, relates to another human being.

    10. CommentedJoe Bongiovanni

      Many excellent points.

      Ultimately, it will be better if the European central bankers move together to solve their present deflationary problem, but that does require an acknowledgement by the ECB of the nature of the problem.
      Listening to Chief Economist Praet last month at the Levy-Minsky conference, it is clear that today their policy options consist of choosing how much more of the same.

      The major determinant of a beneficial outcome will be a candid pondering of the options available, those that are meant to overcome the potential disruptions you offer in your fourth point on why the EMU will continue.

      So to me the question becomes, in the face of the posture being presented by the EMU countries and their central bankers, is anyone in the back room actually working on an exit strategy that will shorten the 3 week currency normalization time period in order to effect the most orderly transition possible?

      Agreement on the ultimate cause of the Euro crisis requires, I am afraid, the most hugest Pogo moment for our modern monetary internationalists.