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The Euro (Double) Standard

Posted by Tyler Watts
February 20, 2012

The received wisdom in economic history places much of the blame for the Great Depression squarely on the shoulders of the gold standard. For instance, Berkley economist Barry Eichengreen states, “Far from being synonymous with stability, the gold standard itself was the principal threat to financial stability and economic prosperity between the wars” (Golden Fetters 1992,  p. 4). Eichengreen claims the tight constraints on money expansion present in the gold standard—the “Golden Fetters” indicated in his book title—forestalled the expansionary monetary policy needed to boost economies in the early 1930s.

In this view, some negative demand shock, like a stock market crash, sets off a decline in consumption spending.  This hits business investment spending, even though there’s no damage to the economy’s “fundamentals.” This reduced spending in turn sets off deflation, as retailers must cut prices to move excess inventories. If left unchecked by counter-active monetary policy, deflation encourages increased savings (deferred consumption) and exposes indebted entrepreneurs and asset holders to bankruptcy as the real burden of their debt grows. A deflationary spiral may ensue as business failures beget less investment, further reduced spending, more deflation, more failures, etc.  Banks are particularly damaged as business bankruptcies bring defaults on bank loans, piling up losses for banks. Fear of bank insolvency then sets off devastating bank runs that further cripple the financial sector and the ability of entrepreneurs to access credit needed to fund their operations.

The only way to break this vicious deflationary cycle is massive monetary intervention in the form of an expansion of money and credit. Such a policy is designed to: 1) reduce interest rates, making entrepreneurs more willing and able to invest; 2) stem the bank runs by providing banks the “liquidity” necessary to cover their liabilities; and 3) turn the deflationary tide by “reflating” the economy, as an increase in the quantity of money can offset a decline in the pace of spending and force prices back up. The gold standard in the early 1930s was, with its strict requirements that increases in the monetary base be accompanied by concomitant increases in gold, the major institutional factor preventing the desperately needed policy response to the Great Depression.

Many prominent mainstream voices support this view. Paul Krugman claims that central banks during the early 1930s were “constrained by the gold standard” from providing liquidity (i.e. printing money) to lend to troubled banks. Krugman also endorses the argument that countries that went off gold earlier recovered sooner. Fellow Keynesian Brad DeLong repeats the common refrain that “countries that were not on the gold standard, or that quickly abandoned gold, by and large escaped the Great Depression.” And no less an authority than Ben Bernanke points out that when the Fed mistakenly tightened monetary policy with interest rate hikes in 1931 to defend its gold reserves, the fixed exchange rates of the international gold standard “exported deflation” by forcing other countries to adopt similar contractionary policy lest they face a run on their gold. The gold standard thus acted as a “constraint on monetary policy.”

But this isn’t the whole story on the effects of the interwar “gold standard” on the Great Depression. Indeed, many scholars argue that this system was nothing like the true pre-WWI gold standard due to the fact that most European currencies were not “pegged” or defined in gold, but instead in terms of US dollars, thus making this a “gold exchange standard.” Moreover, activist central bank interventions, especially by the Federal Reserve, eroded or even abolished the functionality of a true gold standard. A complete version of monetary events of the late ‘20s-early ‘30s, such as told by Milton Friedman or Richard Timberlake, indicates that a woefully incompetent Federal Reserve actively and willfully “broke the rules” of the gold standard by sterilizing gold inflows, which contributed to the banking panics and money supply collapse of the early ‘30s.

In other words, what critics claim were faults of the “gold standard” were not the operation of a real gold standard at all, but the machinations of central bank bureaucrats. To claim that the gold standard caused the Great Depression would be akin to saying water pistols are responsible for gang shootings.

But assume for a moment that the standard story about gold and the Great Depression is correct: keeping national currencies “pegged to gold” was a recipe for devastating deflation, and the cure was removing the gold constraint so that central banks could engage in massive money-printing operations to “reflate” their economies.

With this argument in mind, return to the present world, where 17 national economies, with a total output of over $9 trillion, operate under an international monetary system in which no single government  has the ability to engage in monetary policy. In other words, should any of these countries face deflation or recession, they cannot print money or cut interest rates to try to stimulate their economies. In this system, “reflation” is out of the question due to exogenous constraints on monetary policy.

Of course we’re talking here about the Eurozone—the national economies currently using the Euro as their currency, and importing their monetary policy from the German-dominated European Central Bank. In relinquishing the ability to print money or even engage in monetary policy, Eurozone economies have adopted something quite similar in operation to that detestable gold standard of yore, which caused so much trouble back in the ’30s. While the Euro is a paper money and opposite from gold in that somebody can print it at zero marginal cost, for Eurozone periphery countries suffering from severe recession, massive government debt, and the possibility of deflation, (and who would desperately love to reflate their economies and monetize their debts) the Euro might as well be gold, in the charge of those stubborn, frugal German central bankers.

So where are the calls to go off the Euro, in the same way these economists are so certain that going off gold was the salvation in the Great Depression? There seem to be few respected, mainstream economists publicly calling for cutting of the “Euro fetters” and allowing these economies to reflate. Barry Eichengreen, the godfather of the blame-gold camp, does not foresee Euro abandonment, nor does he seem to endorse the idea. But there are some professional voices calling for desperate nations to drop the Euro, including prominent inflationist Ken Rogoff of Harvard, and some Greek economists, as noted in this New York Times article.

Nonetheless, there seems to be a disconnect here. If those economists who are so certain that the “gold standard” was responsible for the extreme economic pain of the Great Depression stick to their guns, shouldn’t they now be endorsing a widespread abandonment of the Euro, particularly by the PIIGS economies (Portugal, Ireland, Italy, Greece, and Spain)? After all, if inflation is the answer, as so many economists, bureaucrats and pundits seem to be saying these days, then the Euro (at least with its current management) is the problem.

The problems with dropping the Euro are well known, however. Once it becomes clear that a country is quitting the Eurozone in order to reflate with a national currency, a run on its banks and capital flight will immediately commence, as holders of Euro-denominated assets realize that they’re about to be had by a coming wave of inflation. The further financial turmoil and uncertainty that such an action would unleash leaves it still unpalatable, even for otherwise staunch inflationists.  Even though it could “solve” these rampant sovereign debt crises. Funny, though, how when it comes to governments systematically expropriating the wealth of long-dead people and altering the obligation of contracts back in the 1930s, such qualms are mysteriously absent. At any rate, the remarkable silence of inflationists on the Euro question should indicate one clear-cut principle: expansionary monetary policy, even for those who are sure it will fix our economic woes, is not without its own set of moral and economic shortcomings. There’s no such thing as a free lunch; nor a quick, easy fix for huge fiscal woes.

Tyler Watts is an assistant professor of economics at Ball State University.