The gold standard forced austerity and helped cause the Depression. Today's problem is the hard-money elites of the euro zone
Like the gold standard of a century ago, the euro has promoted free
trade and investment across borders. The 12-year-old unified currency
also shares the gold standard’s greatest flaw: the lack of an escape
hatch. If a country runs chronic deficits, it can’t regain
competitiveness through the market’s depreciation of its currency. Under
the gold standard, exchange rates were fixed, which is to say the
escape hatch of depreciation was locked. Under the euro, exchange rates
no longer even exist. The escape hatch has been locked, welded shut, and
sat on by the leaders of the Continent’s most powerful economies.
What does a country do when it can’t depreciate its currency to lower
its prices? Now, as in the 1930s, the only alternative is an internal
devaluation, which means cutting wages and other costs, including
government benefits. That’s a painful process that creates enormous
social stress. In the 1920s and ’30s the impoverishment of the working
class led to the rise of Hitler and Mussolini. Even if fascism is
averted, punitive austerity can lead to a downward spiral as trade and
financing dry up, deflation sets in, debts loom larger, and one country
after another gets sucked downward.
Once the euro symbolized common purpose and uplift. But to quote the
Depression-era lyricist Lorenz Hart, “When love congeals/It soon
reveals/The faint aroma of performing seals.” The seals of 2011 are the
hard-money types in Germany, Finland, and other points north who insist
that the Greeks, the Italians—and maybe soon the French—must be held to
account for their financial transgressions. These calls for fiscal
responsibility, and the anger behind them, make emotional sense. But
today’s austerity tough guys sound alarmingly like Andrew Mellon, President Herbert Hoover’s Treasury Secretary, who, according to
Hoover’s memoirs, said the only way to get the U.S. economy back on
track in the 1930s was to “liquidate labor, liquidate stocks, liquidate
the farmers, liquidate real estate … purge the rottenness out of the
system.”
Purging the rottenness nearly killed the patient. In an increasingly
relevant 2000 essay called “The Gold Standard and the Great Depression”
in Contemporary European History, American economists Barry
Eichengreen and Peter Temin wrote that elites were befuddled by a gold
standard mentality that “sharply restricted the range of actions they
were willing to contemplate.” They added: “The result of this cultural
condition was to transform a run-of-the-mill economic contraction into a
Great Depression that changed the course of history.”
A gold standard doesn’t have to be deflationary. From the 1870s until
World War I, the gold standard more or less worked under the auspices
of the Bank of England: Countries that imported more than they exported
were forced to make up the difference by shipping gold to their trading
partners. Because gold was the ultimate storehouse of value, countries
feared losing too much of it. To stanch the outflow of gold, central
banks would raise interest rates to push down domestic spending and
prices. Meanwhile, the countries that imported gold would see domestic
prices rise, which would make them more receptive to cheaper imports and
shrink their surpluses. There was discipline and a natural balance.
World War I spoiled the equilibrium. War spending caused inflation,
forcing countries to suspend convertibility of their currencies into
gold. After the war most countries struggled back onto the gold standard
(though not Germany, which suffered hyperinflation). Returning to the
old exchange rates required reversing the wartime inflation—namely,
imposing punishing deflation. Democracies weren’t as good at imposing
austerity as autocracies had been. The rise of labor unions and the
introduction of minimum-wage laws made it harder for employers to cut
pay, so they cut workers instead.
Creditor countries such as the U.S. didn’t play fair in the 1930s.
They bought tons of gold to take it off the market so it wouldn’t affect
their money supply or interest rates. By hoarding, they left too little
gold for the debtor countries and worsened their deflation.
Eventually all countries were forced off gold by financial crises and
popular upheavals. Britain abandoned gold in 1931 and fared best
economically. Die-hard France, which stuck with gold until 1936, did
worst. Even with prices plunging, the elites fretted about the threat of
inflation. Ralph Hawtrey, a British Treasury official, likened that to
crying “‘Fire, fire’ in Noah’s flood.”
Policymakers have not fully absorbed the lessons of the Depression.
Monetary and fiscal policy are better but “not enough better,”
Eichengreen says. There’s an understanding that big banks can’t be
allowed to fail, but “one might say, Aren’t the biggest banks too big to
save, especially in Europe?”
The most unfortunate difference between then and now is that the
euro, unlike the gold standard, is a raccoon trap: Its designers
deliberately left out an exit procedure. That means you can get in, but
you can’t get out without leaving a part of yourself behind. Eichengreen
points out that Britain was growing again by the end of 1932, just over
a year after abandoning gold under duress. Today a country—say,
Greece—that quit the euro would take far longer to right itself. That’s
because unlike Britain, to get relief Greece would have to default on
its euro-denominated debts and damage its credit rating. “The Greek
government,” Eichengreen says, “will be hard-pressed to find funds to
recapitalize the banking system. Greek companies won’t be able to get
credit lines. The new Greek government is going to have to print money
hand over fist. At some point they would be able to push down the
drachma and become more competitive. But the balance is different now.”
That’s why Eichengreen thinks leaving the euro zone should be a last
resort. The better option, he says, is to make the euro work the way the
gold standard worked in its best years. Surplus countries should
equally share the cost of adjustment with deficit countries. He favors
transforming the underfunded European Financial Stability Facility from
an emergency fund into a bank. He would have the facility borrow from
the European Central Bank so it can make unlimited loans to countries
such as Greece and Italy—on the condition, of course, that the countries
demonstrate they’re on a path to fixing their competitiveness problems.
Those countries don’t have a chance to fix things without the breathing
room afforded by official lending, Eichengreen says.
Europe’s fatal mistake was to push ahead with monetary union without
having achieved fiscal union. Limits on national budget deficits were
flouted with impunity. Now creditor nations are dragging their heels on
aid and stimulus because they don’t want profligate debtors to play them
for fools. In an echo of the gold-hoarding mentality of the Depression,
Germans have reacted angrily to the suggestion that the International
Monetary Fund might tap Germany’s gold reserves to bolster the EFSF. The
mood is angry and confused. German Chancellor Angela Merkel was correct
on Nov. 14 in Leipzig when she described the debt crisis as “maybe
Europe’s most difficult hours since World War II.”
The answer, as Merkel told her Christian Democratic Union colleagues,
is “more Europe and not less Europe.” If Germany can get the “more
Europe” it wants—i.e., tough, enforceable budget rules—it might
countenance more help for weaker nations, even if for now Merkel is
still rejecting open-ended ECB lending or jointly issued euro bonds.
There are signs that creditor nations understand their
responsibilities. In October, European Union finance ministers agreed on
a “six pack” of economic-governance rules that in theory should
penalize countries with excessive surpluses, not just those with
excessive deficits. Merkel said on Nov. 16 that “we are prepared to give
up a little bit of national sovereignty” to preserve the
euro.
Something needs to happen fast. As the debt crisis has come to a
head, economists surveyed by Bloomberg have sharply lowered their
forecasts for European growth in 2012. Output may well be shrinking in
the current quarter. The risk is that the worsening woes will make the
key players less flexible. In the 1930s, Eichengreen and Temin wrote,
“The masochistic strand of the gold-standard mentality grew stronger as
the crisis built.” Now would be an excellent time to replace masochism
with common sense.
Illustration by 731; Photographs: Getty; Alamy
