Saturday, February 13, 2010

Euro Dilemmas and the Specter of the Gold Standard

Simon Johnson and Peter Boone present a lucid analysis of the Greek and other « PIIGS » (Portugal, Ireland, Italy, Greece and Spain) adjustment problem to the great recession in the Wall Street Journal:

“If Greece (and the other troubled countries) still had their own currencies, it would all be a lot easier. Just as in the U.K. since 2008, their exchange rates would depreciate sharply. This would lower the cost of labor, making them competitive again (remember Asia after 1997-'98) while also inflating asset prices and helping to refloat borrowers who are underwater on their mortgages and other debts. It would undoubtedly hurt the Germans and the French, who would suffer from less competitiveness—but when you are in deep trouble, who cares?

Since these struggling countries share the euro, run by the European Central Bank in Frankfurt, their currencies cannot fall in this fashion. So they are left with the need to massively curtail demand, lower wages and reduce the public sector workforce. The last time we saw this kind of precipitate fiscal austerity—when nations were tied to the gold standard—it contributed directly to the onset of the Great Depression in the 1930s.”

What the authors do not explain, however, is that membership in the eurozone, that the recession puts at risk, was also, during boom time, a main source of the present difficulties of these countries. In a common currency, the centralized monetary policy is necessarily divorced from national economic conditions (one size cannot fit all), and moreover it exerts a pro-cyclical effect on national economies. Those countries that are growing more rapidly, and thus with more inflation, than the others during boom time benefit from lower real interest rates than countries with less inflation, since the nominal interest rates of the ECB are the same for all. This exacerbates the boom as was clearly the case of Ireland and Spain, and that premium explains in large part the extraordinary real estate booms in these countries.
By a theoretical “Austrian” mechanism, bad investments will be the magnified where the real interest rate is lowest. Thus the deeper will be the necessary correction in the recessionary phase.

Moreover, since no national currency depreciation is possible in a currency union, as explained above by Johnson and Boone, the only other way to cushion the recessionary shock is through government deficits, and precisely these are made easier by the “strong common currency” vehicle, which means relatively low interest rates for governments to pay on their borrowing, at least up to a point, which Greece has now reached.

Thus the euro, by itself, magnifies the business cycles in member countries, contrary to what was advertised by his promoters (see my 1998 book: L’erreur européenne, and my 2002 paper “Les promesses de l'euro: tout était faux" here).

Johnson and Boone advocate four measures to try to remedy the present problem: first ask the IMF for help (but that would amount to recognizing a failure of the eurozone policies and system); second, Europe must soon create a multilateral funding system that ensures that adequate finance is available to each nation that adhered to these conditional programs (but this amounts to progressing in the direction of a central federal financial and fiscal system, a known requirement of non optimal monetary zones, such as the eurozone, which is unlikely to be adopted in the current political state of the European Union); third, “the European Central Bank needs to adjust its policies, lowering interest rates further and allowing higher inflation throughout the currency union. If such looser money policies are not palatable to the Germanic core, then Berlin/Frankfurt should get on with the task of admitting that the euro zone itself is a failure”; and last but not least, the European Union needs “living wills” plans – plans for countries to exit from the euro zone, (a basic requirement indeed, but also again a recognition, if used, of the non-optimality of the zone and of the euro).

The euro has been launched on the vain premise that where there is a political will, there is necessarily an economic way of reaching whatever governments define as their objective: the primacy of politics over economics. Now European politicians are confronted with economic difficulties that they find difficult to ignore, but will find even more difficult to solve.

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