Q&A on “EMU as reprise of the gold standard”

A few more points on this topic…. eventually I’ll need to write about something else.
From comments here and elsewhere I highlight the following:

Greek/Club Med default will make European banks (German, French especially) insolvent.
In other words, “the cure is worse than the disease”. There is an historical parallel. When Credit Anstalt imploded in Austria (May 1931), the searchlights turned on Germany, visiting it too with banking crises. One of the main reasons Britain came next was exactly because Britain was a big creditor to these countries, and when they imploded, these assets vanished — providing even more reason to question the sustainability of Britain’s peg to gold. Sales of sterling turned acute.
That’s why the EU must aim the eur 750 bn firehose at the balance sheet of the banking system. Make it a European TARP.

Won’t some combination of euro weakness and an inflation differential Germany-Club Med be enough to rescue these economies?
In other words: if one of the root requirements is increased competitiveness, then this can be achieved vis-a-vis extra-EMU via euro weakness, and intra-Euro via an inflation differential, i.e. this should provide the real devaluation needed in Club Med. In this scenario, the euro weakness overheats the German economy, the ECB stays on the sidelines, and voilà, a positive inflation gap between Germany and Club Med. Any part of this argument is ripe for contention. But the main problem is that it won’t provide the scale of devaluation needed, even if the EU relieved Club Med of its debt burden. European economies deflated madly in the Great Depression to achieve an inflation differential with the United States; it wasn’t enough. The whole point of seeing the gold standard as a dogma is that it drove policymakers to tighten the screws even when unemployment was 25% and deflation was rampant. Who in their right mind would pursue more austerity under these conditions? Yet the pressure to do so was extreme. Likewise I see EMU as a dogma. (I am not a euro-hater and I am not politically opposed to EMU; it is purely the economics I’m worried about.)

Please say more about how depreciation of the Euro might work 
It won’t solve the Club Med conundrum. It doesn’t solve their competitiveness problem vis-a-vis the rest of the euro-area unless it touches off a massive inflation in the latter but not the former. But this requires the ECB to sit on its hands. And anyway the inflation gap required is just too big to be plausible. It’s all about the Greek real exchange rate (xls file). But I do think the euro weakness poses a real problem for the US economy; Menzie Chinn is less convinced.

You cite Argentina as an example of the capital market’s short memory. But Argentina is still at loggerheads with creditors nearly ten years on.
True. I should have cited Russia and other post-communist countries, which did default and did come straight back to the markets, quite quickly. (That post is fixed.) The Economist got this right on the first try, in Default, and Other Dogmas


So who cares about Argentina 
Argentina illustrates the burden of being shackled to an expensive currency. It tied the peso to the dollar at the beginning of the nineties in a particularly severe arrangement called a currency board. When emerging markets started tumbling (Asia Crisis, 1997) there was no thought of leaving the currency board. Argentina clung to this woefully overvalued peg (with the blessing of the official international sector and much of the commentariat) until end-2001, suffering four years of negative GDP growth. After devaluation and default, growth went to 7%+ and stayed there till the recent global downturn. You have to be Hong Kong to sustain a currency peg, because it requires hyper laissez-faire.

Unlike Argentina, Greece doesn’t produce enough for export to benefit much from competitive exchange advantage
Everything we know about capitalism says this will not be a problem. That’s a pretty curt response, but it is true. The economy will find its feet, I assure you. (The same holds true of the US economy under a devalued dollar; the problem is that it needs a bloody weaker dollar and can’t get one.)

EMU as a currency regime / Why doesn’t California leave the dollar?
“Monetary union” is an exchange-rate regime. It appears with all the others (“free floating”, “crawling peg”, “currency board”…) in the taxonomy of exchange-rate arrangements. Monetary union is an exchange-rate regime because the states which adhere to it are sovereign. They choose monetary union; they un-choose monetary union. California does not have an exchange-rate regime because California is not sovereign.

Gold standard
The precedent for death-by-overvalued currency writ universal is the gold standard. The other posts in this blog go into details; particularly The Great Amnesia. Here I suggest further reasons why it fits.

  • Like EMU, the adherents to the international gold standard were sovereign. (There is also a parallel between GS and EMU in the sense that the core countries came onto gold by choice, while some peripheries chose it under duress, strong guidance, or even had it written into their central banking law by foreigners. Similarly, longtime members of the EU were able to opt-out of EMU, but EU accession states have had to aspire to EMU as a condition of accession.) 
  • Like EMU, the gold standard was a dogmatic arrangement. I use the term advisedly. (I am not sure whether the Austrian school favours EMU. But it definitely likes the gold standard, and I will post on this later.) Dogmatism is capable of shielding people from seeing what is before their very eyes. It was not until the 1980s that academic scholarship generally fixed on the idea of the gold standard as a regime of death-by-overvalued currency. (The pillar of this literature, for whom I have unlimited respect and admiration, does not advocate EMU dissolution; see page 5. He’s ten times smarter than me, so let this be a health warning for anyone reading this blog.) 
  • Incidentally: the gold standard had this same capricious quality even in the glory years (1870-1914). The international monetary system was on the cusp of complete break-up in the 1890s due to the inherent deflationary quality of the gold standard; it drove commodity exporters to penury and then to default. The system was rescued by an avalanche of gold mined in South Africa (as well as the application of a new technology to mining: arsenic, I think). 

What would be the equivalent to today’s Germany in 1931?
France. And the comparison is worth exploring. France adopted a very orthodox, ‘hard-money’ viewpoint once it was on the gold standard. That is because it saw a pretty bad inflation after WWI and did not stabilise the currency until 1926. By the time 1931 rolled around, France’s advice to its neighbours was “take the pain”. Credit where it’s due: France put its money where its mouth was; the Bank of France lent the Bank of England several million dollars in 1931 to sustain the attacks on sterling. What I want to emphasise is that France’s hard-money approach was inspired by its inflationary troubles. Likewise Germany’s approach today is inspired by its hyperinflation post-WW1. They simply will never again tolerate anything with even a whiff of soft money. I don’t see this changing anytime soon, which is why I advocate EMU-exit for Greece rather than hope for a tighter federal union within EMU. I wrote a post two years ago about the importance of the foundational experience for each central bank: The Fed’s was the great depression, and its behaviour today reflects that. The ECB’s was the German hyperinflation. The lessons one draws from those two episodes are diametrically opposed.


What is the right thing to do, part 1 (policymakers)
  1. Convert the eur 750 bn rescue fund to a re-capitalisation fund for the banking system.
  2. Force a restructuring of Greek sovereign debt; 70% write-down.
  3. With an EU imprimatur, forcibly redenominate Greek contracts in drachma, including cross-border contracts.
  4. Greek central bank exchanges euro for drachma at the rate of 1 for 1. There is no need to make it 1 to 5 or whatever. The point is that the drachma will depreciate against the euro and other currencies in the fx market, whilst still being used like a euro at home.
  5. Gain the agreement of Greek unions not to index wage demands to expectations of inflation for a period of four years.
These steps are crucial, and I’m surely missing a bunch. They are also not very pleasant (esp. EU assent in forcible debt re-denomination and Greek labour agreeing to tie its hands). But they are not unprecedented. Labour agreements like this are a staple of “exchange-rate based stabilisation” policy and have been done dozens of times. On the forcible re-denomination: FDR devalued the gold value of the dollar in 1933 and forcibly abrogated the gold clause in all US debt contracts (which abrogation was upheld by the Supreme Court). I can understand how odious this sounds, but in fact it was crucial and US recovery got underway once FDR devalued the dollar. Look at just about any time-series graph of activity in the 1930s. It’s unmistakable.
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