Stephen King: Latter-day Gold Standard leaves eurozone countries facing grim choices
Economic outlook: The European Central Bank is against a default or any choreographed restructuring
Monday 27 June 2011
Winston Churchill brought Britain back to the Gold Standard in 1925. After years of inflation associated with the costs of the First World War, Churchill and his colleagues wanted a return to monetary credibility. In the absence of any alternative monetary arrangement, the pre-war Gold Standard had its attractions.
But Britain after the First World War was a very different proposition. Years of wartime inflation had led to a dramatic loss of competitiveness. The costs of the war had left the country awash with debt to its foreign creditors. To repay the debt, Britain needed to export more and import less. But Churchill pegged sterling back to gold at its pre-war parity. By doing so, he locked in competitive losses that could be undone only via massive domestic deflation and painful austerity. British prices and wages had to fall relative to prices and wages elsewhere in the world.
What followed provides a lesson in the dangers of pursuing monetary credibility without regard to either the domestic political situation or the implications for international financial stability. The return to the Gold Standard was swiftly followed in 1926 by the General Strike. Thereafter, sterling became increasingly vulnerable. To keep the pressure off the pound, Britain became ever more dependent on the Americans' keeping their interest rates low. Low US interest rates, in turn, fuelled the Roaring Twenties. In 1929, however, it all went wrong. Following the Wall Street Crash, the world headed inexorably into the Great Depression.
Today, the countries that find themselves shackled to the euro could think of themselves as members of a latter-day Gold Standard. Like Britain in the 1920s, those in heavy debt face years of punishing austerity. To repay their foreign debts, they need to consume less and export more. But to do this in the absence of any exchange-rate flexibility is no easy task: it requires punishing austerity and massive domestic wage cuts.
Like those who sold sterling in the 1920s, speculators today simply don't believe the likes of Greece, Ireland and Portugal – and, on occasion, Spain – really have the political stomach for such draconian policies. But whereas speculators in the 1920s sold sterling, speculators today sell government bonds. Nations without their own currencies who cannot pay their bills eventually have to default.
Default, however, is a messy business. It has the potential to trigger all sorts of undesirable side effects. For the modern-day policymaker, the big worry is another Lehman-style event. For students of the Great Depression, the defining moment was Creditanstalt's bankruptcy in 1931. Either way, ruinous financial collapse beckons. It's for this reason that policymakers try their hardest to stabilise financial conditions, to set rules of the game.
This was exactly the conclusion reached by Montagu Norman, the Governor of the Bank of England, and Benjamin Strong, the head of the New York Fed, in the mid-1920s. They co-operated to keep sterling pegged to gold, reasoning that a sterling collapse would lead to terrible financial consequences, not least a descent into global financial anarchy as other currencies tied to the Gold Standard found themselves picked off, one by one. Norman and Strong failed to recognise, however, that attempts to keep sterling pegged to gold would lead to widening strains elsewhere in the system. They were trying to stabilise a relationship that was inherently unstable.
Is the same happening today? Those who seek to resolve the current crisis want to achieve three aims: get the peripheral nations back on to a stable and sustainable fiscal path; make sure that this can be done without significant political upheaval in the peripheral nations; and protect the interests of the creditor nations and their taxpayers and financial institutions.
It's far from obvious that these three objectives are mutually achievable. Germany had austerity forced upon it in the 1920s and the 1930s under the terms of the Treaty of Versailles and ended up with more than a handful of domestic political problems. The US banks protected their interests in the 1980s during the Latin American debt crisis, but at the cost of casting Latin American economies adrift for year after year. And, of course, Norman and Strong themselves failed in their own endeavours: they wanted stability (and Strong, who died in 1928, went to his grave thinking he'd got it) but their plans ultimately went awry.
Today, the European Central Bank is dead against a default or any form of choreographed restructuring. It will happily use the examples of Lehman and Creditanstalt to support its view. By opposing this option, it is effectively arguing that the costs of adjustment must be entirely borne by the debtor nations in the periphery. But why should an unelected central bank be able to decide that only the debtors should pay the bill for the crisis? Why should the high priests of monetary policy be allowed to absolve the creditors of all blame?
The ECB, of course, has its own agenda. Like those before it who were committed to the Gold Standard, it is terrified of losing its reputation as the guardian of sound money. And it knows that, in the event of a default that might undermine the European financial system, it would be obliged to print money almost without limit to keep the banks and other financial institutions open for business. It doesn't want to put itself in that position. Yet by refusing to countenance this option, it is effectively condemning the peripheral nations to continuing austerity on a scale that led to such political turmoil in the 1920s and 1930s.
Is there a way out? Yes, but it's not clear that Europe is politically ready as yet. Following the collapse of the Berlin Wall in 1989, German reunification led to a fusion between two entirely different economies: one rich, the other poor. The German mark/ostmark exchange rate was selected to achieve social stability but it priced East German workers out of the market almost overnight. The East German economy collapsed.
What then followed provides a template for the eurozone more broadly. West Germans bailed out East Germans. Investment headed East, funded by rising taxes in the West. The West German economy stagnated, burdened by the costs of reunification. Yet ultimately, the bill was worth paying: a nation was brought together.
Reunification worked for two reasons. Those involved were all German. And Germany had a federal government which allowed competing claims over resources to be resolved. To apply the same model to Europe as a whole would require two big changes: people of all eurozone countries would have to think of themselves as Europeans first and Greeks, Germans or Portuguese second; and the eurozone as a whole would need some kind of federal government. Neither of these things will happen any time soon. So we are back to difficult choices: painful austerity, political upheaval or default.
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