Draghi and ECB hold the fate of the euro

I’ve argued since May 2010 that Greek travails — the debt dynamics, the dogmas, the policy response — revealed a situation all-too-similar to the breakdown of the interwar period’s fixed-rate monetary regime. The very short story of that episode is that, when capital flows to some European economies suddenly halted, the troubles which beset euro-area policy today (mostly, lender-of-last-resort) arose in spades in Europe. Because exchange-rate fixity was considered sacrosanct, heaven and earth were moved to keep the monetary order together. What this achieved was a desperate search for relief, which culminated in a turn to illiberal policy. The point here is that such illiberalism was more a consequence of the downturn and the policy course than a cause. In this judgement I am supported by contemporaries and by modern historians and economists alike.

No matter how understandable and predictable, it is nonsensical to believe that the policy solution to today’s travails is to “keep trade open”. As if open trade is a solution to imploding demand. Open trade is a consequence of economic growth, and can be synergistic with it, obviously. Repeat: if your goal is to keep trade open, then you need a pro-growth policy. If countries are being pushed deeper and deeper into austerity, you can preach to the skies about the virtues of open trade, but you’ll be missing the point. You are courting closed trade by conspiring in, or even outright advocating, slow/no growth. With enough pain, illiberal policy will materialise.

Now for the key differences between ‘then’ and ‘now’. One: the rest of the world can be more supportive than it was in the interwar episode. Back then, other countries were as committed to exchange-rate fixity as were the continental Europeans. This meant (a) they easily were swept up in the downdraught when serious implosion struck continental Europe, and (b) their own policies ramified the initial negative impulse to global demand. This time, non-eurozone economies can respond in more helpful ways, from the point of view of global demand. Even if their governments are dysfunctional or deeply confused about the proper path for policy, their monetary authorities are free to provide some heft. In the interwar period, central banks were beholden to an extremely cautious line, for fear of (a) the exchange rate and (b) some statutory limitations on the size of the balance sheet. How the Austerians would love to have lived in those ages!

But the biggest difference is that if continental Europe wanted to save the euro, it can do so in a way that was much more difficult to imagine in the interwar period. Back then, the ultimate limit on money creation was the supply of gold. (Again, how the Austerians would relish life in that heyday.) No such limit confronts the Creator of the euro-zone’s currency, the European Central Bank. The key to rescuing the eurozone lay precisely in the hands of the ECB and its new governor, Mario Draghi. It can commit to supplying unlimited funds for the procurement of euro-area sovereign debt. It can do this in an accord with Berlin the political authorities of the eurozone to create a centralised authority whose remit is to assist with members’ structural adjustment and fiscal consolidation on a long term basis. Talk about solidarity!

I’d be remiss if I didn’t mention a key disadvantage of the euro-area vis-a-vis the interwar fixed-rate monetary arrangement (1/). In the latter situation, national currencies still circulated and central banks still managed them. They just had to ensure that exchange rates did not deviate from an initial start-point. When it came time to engage with the set of illiberal policies aforementioned, one option was simply to let the exchange rate go. (2/) If you did this alone, you got a lift from better prices for domestic output, i.e. you ‘crowded in’ demand for your own economy’s output. (There is a misconception that these interwar central banks could additionally have expanded the money supply. Not so. They were still beholden to statutory limitations on the size of their balance sheet. Although these limitations were loosened, they nevertheless were an empirically demonstrable constraint on open-market expansion.)

1/ As you’ve probably realised, “fixed-rate monetary arrangement” is code for “gold standard”. I’ve learned through hard experience that these two words are simply too emotionally charged to use today. For example, when I explained to the chief economist of one of the eurozone’s largest investment banks that the interwar gold standard is a useful template for thinking through the euro-area travails, he responded something along the lines of, ‘In all due respect, I consider gold to be a kind of metal that lay in the ground and is dug up and is sitting around and really has no use.’  Sure, I agree. And that is relevant to this discussion how? The point is that he fixated on the term, with no connection to the way it had been used. The opposite happens with the Austerians, of course. Their eyes become trance-like at the mention of the gold standard.

2/ As the exchequer himself, or a parliamentarian (I can’t remember which), said, upon learning that the Bank of England had unilaterally left the fixed-rate monetary arrangement on 21 Sept 1931 (and civilisation did not collapse), “I didn’t realise we could do that.”

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