What’s at stake: Thanks to Ben Bernanke's series of lectures at Georges Washington University this week, the gold standard is back as a topic for debate. In particular, a number of commentators worry that the new fiscal rules in Europe (see our previous review on the Fiscal Compact) might play the deflationary role that the gold exchange standard played in the 1930s. There are parallels between the gold standard and the euro – namely in terms of the asymmetric pressure that it puts on deficit countries compared to surplus countries to adjust – but, contrary to the 1930s, the crisis can hardly be solved by countries leaving the exchange rate zone. The difficulty of the task is thus to implement rules that would ensure credibility without creating a new deflationary trap.
The Gold Standard and the Great Depression
The thesis that the gold standard was central into making the 1930 crisis the Great Depression goes back to research by Barry Eichengreen, Peter Temin and Jeffrey Sachs. The simplified version of the argument is that countries that maintained fixed exchange rate had to implement deflationary fiscal and monetary policy. As a consequence, the countries that left the gold standard earlier experienced a faster recovery. The will to keep gold as the core of the international monetary system also pushed some countries, prominently France and the US to accumulate reserves. Doug Irwin recently argues that this accumulation was key to creating deflationary pressure on other countries.
Although there is broad agreement on the role of the gold standard played in transmitting the shocks centred in the US to lots of other countries, scholars still argue as to whether the U.S. adherence to the gold standard was the fundamental constraint on monetary policy (see Chang Tai-Hsieh and Christina Romer for example). The flurry of reactions following Bernanke’s first lecture is an illustration of this (see for example Brian Domitrovic on Richard H. Timberlake and this response by Uneasy Money).
The Gold Standard and the creation of the Euro
In his recent book on the creation of the euro, David Marsh (HT Crooked Timber) argues that for Giscard d’Estaing the road to a European money was part of a journey that had been abandoned when the Gold Standard ended. “During the second half of the nineteenth century, up to the 1914 war, France enjoyed continuously successful economic growth, and a steady build-up of its engineering industry, with a currency that was totally stable. With their roots in a rural economy and their cultural leaning towards the fundamental values of savings and thrift, the French as a nation cannot cope with an inflationary economy and a weak currency. They thrive on stable money”. Helmut Schmidt, too, affirmed a link between the goal of EMU and the Gold Standard: “We had a currency union up to 1914 in Western Europe – the Gold Standard. From a historical point of view, I would draw a direct parallel.”
Deflation, then. Austerity, now.
In a 2010 essay, Barry Eichengreen and Peter Temin argued that as in the Great Depression, the second round of problems today stems from the prevalence of fixed exchange rates. Fixed exchange rates facilitate business and communication in good times but intensify problems when times are bad. The gold standard was preserved by an ideology that indicated that only under extreme conditions could the exchange rate be unfixed. The euro has gone one step further by eliminating national currencies. The euro area differed from the gold standard in that it talked the talk, but didn’t also walk the walk, of international cooperation. There was awareness that fiscal and financial policies were a matter of common concern, and that coordinated adjustments in which countries in chronic surplus expanded while countries in chronic deficit did the opposite, were desirable. But the area’s various mechanisms for coordination, the Stability and Growth Pact, the Excessive Deficit Procedure, and he Broad Economic Policy Guidelines, were honored mainly in the breach.
Ryan Avent argues that Europe imposed some of the same fiscal and monetary constraints that precipitated the collapse of the 1930s. And here we are, watching history repeat itself. Within a Europe riven by imbalances, the fiscal and monetary screws are once again being applied to countries with no hope of escaping their financial burdens. Peter Coy also notes that 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.”
Karl Whelan argues that the Fiscal Compact, in particular, severely restrict a country’s ability to use fiscal policy to stabilize its economy and will often require debt levels far below those considered sensible. Sticking to fiscal rules is today as ideological and dangerous than to stick to the gold standard in the 1930s. It could even be worse since fiscal policy is the only independent policy tool left to Eurozone members. The ongoing discussion around Spain illustrates these issues (see Eurointelligence for a nice round-up of ongoing discussions and Stephan Schulmeister about the economic consequences of the pact).
There are nevertheless important differences between the nature of gold standard and the eurozone.
Then and now: exit procedures
Peter Coy writes the euro also shares the gold standard’s greatest flaw: the lack of an escape hatch. The most important difference, however, between then and now is that the exit procedures between the euro and the gold standard are not similar at all. And what you loose when you get out is very different. In an interview for Bloomberg Business Week, 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 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.
Then and now: debt levels
Another important difference with the 1930s to keep in my mind is that the interwar crisis was not a debt crisis. Marc Flandreau, Jacques Le Cacheux and Frederic Zumer highlighted in a 1998 article for Economic Policy (HT Henry Kaspar writing @ Kantoos) the importance of debt levels under the Gold Standard. Prior to inflationary phase from 1895, only a hard nucleus of countries – including Germany, France, the Netherlands, Belgium, Scandinavia, but also the U.S. and Great Britain – were able to mobilize the macroeconomic discipline that the gold standard imposed in a deflationary environment. Other countries, including Italy, Spain, Portugal, and Greece were unable to maintain the peg to gold. The countries starting with relatively low debt levels could compromise, letting their debt drift slightly and making only partial fiscal adjustments. But for those that already had fairly high debt levels, such as the southern European countries, the adjustment cost required for continued participation in the gold standard could be very large, especially since the market mechanism implied that a sustained deterioration in public debts meant accelerating premia for new loans.
Then and now: The ECB can print more gold
Kantoos argues that, contrary to the 1930s, we have a central bank printing “gold”. That is not a minor difference, it is key: the ECB sets the overall European inflation target. With a more appropriate target, given the historical lessons for such a diverse monetary union, for instance an price level target with 4-5% inflation p.a. (or better yet: a nominal spending level target of 6-7%), this central bank could be a very important building block of a fairly successful currency union. What is more, this central bank could use its powers to conduct somewhat differentiated monetary policy and force governments into counter-cyclical fiscal and regulatory responses.
Simon Wren-Lewis argues that while the arguments for price level or nominal GDP targets are pretty universal, they apply particularly to the Eurozone. The discussion suggests that the barriers to fiscal stimulus in the Eurozone are not political but intrinsic to the union in its current conjuncture, so there appears to be no alternative to monetary stimulus. A change from inflation targeting may also be politically easier for the ECB, because it could be justified as a move back towards the ‘twin pillars’ approach and the Bundesbank’s money supply targeting.
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