“Editing history”

The Euro crisis has reached a “tipping point”. Italy has been “marked to die” and that really spells the “death of the euro project”. Nick Rowe and Free Exchange have come up with potential last minute “games” that could be enacted to give additional “oxygen” to the “weak and sick” and, who knows, save the project. But even they do not put much faith in the success of the “trick”.

I wasn´t very surprised to see that with little editing, a few paragraphs of Doug Irwin´s just released paper on “Gustav Cassel´s analysis of the interwar gold standard”, give a perfect description of present day events:

…Many of these problems were mutually reinforcing and helped put the world economy Eurozone economies into a death spiral, but central banks the ECB did little to address the situation.  As Eichengreen showed, the gold standard euro constrained monetary policies and prevented countries from undertaking expansionary measures that could have ended the severe deflation recession. Politicians and central bankers clung to the “gold standard mentality” “euro mentality” which viewed the gold euro parity as an inviolable contract that had to be defended even at the cost of high unemployment (Eichengreen and Temin 2000).  The belief that deflation  internal devaluation was a necessary and inevitable adjustment from the preceding boom also provided an excuse to refrain from any significant policy response.

Among most economic historians, the gold standard euro standard interpretation has come to represent a “consensus view” of the Great Depression Great Eurozone Recession. The fact that countries not on the gold standard euro standard managed to avoid the Great Depression Great Eurozone Recession while countries on the gold standard euro standard did not begin to recover until they left it, provides strong evidence in support of this explanation.

The same “result” is obtained through analogy by David Glasner in his excellent “The economic consequences of Mrs Merkel”:

…Fast forward some four score years to today’s tragic re-enactment of the deflationary dynamics that nearly destroyed European civilization in the 1930s. But what a role reversal! In 1930 it was Germany that was desperately seeking to avoid defaulting on its obligations by engaging in round after round of futile austerity measures and deflationary wage cuts, causing the collapse of one major European financial institution after another in the annus horribilisof 1931, finally (at least a year too late) forcing Britain off the gold standard in September 1931…

… Now, it is Germany, the economic powerhouse of Europe dominating the European Central Bank, which effectively controls the value of the euro. And just as deflation under the gold standard made it impossible for Germany (and its state and local governments) not to default on its obligations in 1931, the policy of the European Central Bank, self-righteously dictated by Germany, has made default by Greece and now Italy and at least three other members of the Eurozone inevitable…

… If the European central bank does not soon – and I mean really soon – grasp that there is no exit from the debt crisis without a reversal of monetary policy sufficient to enable nominal incomes in all the economies in the Eurozone to grow more rapidly than does their indebtedness, the downward spiral will overtake even the stronger European economies. (I pointed out three months ago that the European crisis is a NGDP crisis not a debt crisis.) As the weakest countries choose to ditch the euro and revert back to their own national currencies, the euro is likely to start to appreciate as it comes to resemble ever more closely the old deutschmark. At some point the deflationary pressures of a rising euro will cause even the Germans, like the French in 1935, to relent. But one shudders at the economic damage that will be inflicted until the Germans come to their senses. Only then will we be able to assess the full economic consequences of Mrs. Merkel.

The figure below illustrates Glasner´s argument that the European crisis is a “NGDP crisis not a debt crisis”, with the ECB “targeting” Germany´s needs.

And to end this post “realistically”, there is this “cold” description of “Breaking up the euro” from Free Exchange:

…The technical challenges are not great. What is vastly under-estimated by advocates of euro exit is the financial and social chaos that would ensue both in the departed country and in the rest of the world. A euro break-up would not, as some seem to believe, be a slightly messier version of the ERM crisis of 1992-93. It would be a gigantic financial shockwave. Once departure by Italy were a serious prospect, there would be runs on its banks as depositors scrambled to move savings to Germany, Luxembourg or Britain, in order to avoid a forced conversion into the new weaker currency. The anticipated write-down of private and public debts, much of which is held outside Italy, would threaten bankruptcy of Europe’s integrated banking system.

There would be runs on other countries that might even consider leaving. A taboo would be broken. Credit would collapse. There would be a dash for cash (those €500 euro notes would come in handy). Businesses short of it would go under. Capital controls and restrictions on travel would be needed to contain the chaos. Once the recriminations start, the survival of the European Union and its single market would be under question. It’s all a frightening prospect.

But that doesn’t mean it won’t happen.

4 thoughts on ““Editing history”

  1. Surely getting the ECB to become the lender of last resort is a solution, but no one understands that the shackles of the EU treaties are so strong that such a possibility is close to impossible unless Mario Draghi is some kind of a strong political leader (of last resort) similar to FDR for example who is ready to risk everything by breaking (literally) “the law”. In the 1930s it was also obvious that if France (and the USA) let go of some of their gold the situation would have improved, but alas that did not happen and the only solution was the end of the golden standard. I am not saying that the only solution now is the breakdown of the EU, but I believe the ECB would only (properly) intervene if the EU first builds a fiscal union. The ECB really cannot intervene without a corresponding EU treasury ( barring literally printing EUR without sterilisation but then again how will it get the EURs to the governments?)

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