The Euro: Lessons of History
1 July 2015
Peter Oppenheimer reminds the most important lessons from economic history concerning functioning of the gold standard in the 1920 and 30s, and shows how deeply harmful can be clinging to an overvalued currency. He also makes the case for a euro break up as a desirable solution to put an end to the economic misery in the eurozone.
The idea underlying the European Union (EU) – formerly, nota bene, the European Economic Community – is to use economic mechanisms to achieve a political objective.
At first, in the 1950s, the objective was post-war reconciliation. This soon gave way, however, to the aim of reasserting Europe's presence in world affairs. The EU, in other words, is to be the latest in the series of European empires since the Romans or since Charlemagne, taking its place today among the array of global superpowers – the United States, Russia (as successor of the Soviet Union), China, and prospectively India.
Amateur politicians and commentators (such as the current editor of London's Financial Times, Lionel Barber) regard the single European currency as a key element in this picture. Continent-sized powers, such as the USA and China, each have a single currency, and Europe supposedly needs one as well if it is to rank with them.
This reasoning – if one can call it that – is deeply ignorant. It shows no grasp of money's dual role in the economic system as part-convenience, part-guideline for policy; and no understanding of the way in which separate currencies act as a harmonising mechanism across countries in the presence of key economic rigidities and structural diversity.
In Europe's case, these rigidities and diversities acquired their present shape over the past 150 years, accompanying the vicissitudes of war and peace and of ideology, as well as huge technological change and strong output growth. The upheavals of the two World Wars created abrupt discontinuities in what had otherwise been a gradual process.
Before 1914 there was in fact half a century of monetary union in Europe – and indeed well beyond Europe, thanks to trading relationships and colonial networks. This monetary union was called the gold standard. Member states defined their currencies immutably in terms of gold, and hence in terms of one another. What enabled the system to function was first and foremost the character of labour markets, in allowing a sufficient degree of flexibility of money wages: not only upwards but also downwards (thereby achieving “internal devaluation” when necessary).This in turn was supported by two other features of the system. One was the prevalence of Adam-Smithean “free-market” economics – trade unions were weak, the welfare state minimal or nonexistent, and the entire government sector of the economy very small.
The second supporting feature, which reduced the amount of price- and wage-adjustment required to maintain economic equilibrium, was the steady flow of factors of production – both labour and capital – out of Europe to other territories, North America in particular but also South Africa, Australia and elsewhere. People migrated in large numbers from many parts of Europe but most especially from the east (including Jews from the Russian Empire after 1881) and also from Ireland. Capital flows came mainly from (and through) Britain, in the form of bond issues on the London capital market. It is worth recalling also that even in 1913 the value of British imports, mostly food and raw materials, was approximately 40% of the rest of the entire world's exports.
All these features of the international economy disappeared in the aftermath of the 1914-18 war. Money wages became rigid downwards in all but the most exceptional circumstances. And the liberal (in the British sense), free-market economy gave way to the mixed economy (“liberal” in the American sense), with total government expenditure in European countries at the end of the 20th century rising to around 50% of GDP.
In such circumstances, the possibility of altering currency exchange rates in order to reconcile divergent national inflation rates or asymmetrical shifts in economic structure becomes crucially important. One of the earliest statements of the point, in 1923, was J.M.Keynes' Tract on Monetary Reform, which among other things warned against the folly of trying to re-establish pre-1914 exchange rates.
Keynes had to repeat it all three years later in “The Economic Consequences of Mr Churchill” (1926), when Churchill as Britain's Chancellor of the Exchequer ignored Keynes' earlier analysis and plunged Britain into five years of gratuitous stagnation (before any global impact from the 1929 Wall Street crash), as well as 60 years of intermittent industrial bitterness rooted in the coal-miners' strike of 1926.
When Britain abandoned the gold standard in 1931, France and other “gold bloc” states copied Britain's earlier mistake by clinging to overvalued currency rates for a further quinquennium. Does that remind you of anything? It should. Europe today has not a gold bloc but a euro bloc, or eurozone as they prefer to call it. The single currency means over-valuation in some member countries, mostly in southern Europe, and under-valuation in others, notably Germany. The result is economic stress, political discord, and distortion of trans-European institutions and policies.
Instead of exchange-rate (or wage) adjustment, we get massive unemployment as well as migration of manpower between countries. Labour movements on a scale that is normal between States of the USA tend to involve dislocation and identity-loss in the context of European diversity. Capital flows and financial policies are likewise distorted. Uncompetitive cost levels deter business investment, while official indebtedness between governments is magnified. Monetary base expansion aka Quantitative Easing (QE) sets up an inflationary potential for the future while doing little to boost output in the present.
A break-up of the euro is self-evidently desirable. But it is not inevitable. Someone, some government or governments, has to take decisive action and convince others to follow. If the present mixture of stagnation, uneconomical borrowing and lending, and disruptive, sub-optimal labour migration is tolerated by politicians and their electorates in the eurozone, it can continue for decades. Europe will then gradually become an impoverished backwater, and its position on the world stage (including its military capacity) will decline ever more steeply. This is the exact opposite of what the single currency is supposed to help Europe achieve.
How could such a situation have arisen? The question resembles what historians ask about the outbreak of the First World War. Part of the answer is that the aspirations of politicians run far ahead of their understanding. But another part of the answer is that, paradoxically, most of the time this doesn't matter much. Policy-makers improvise, nothing disastrous happens, and ultimately they become complacent, assuming that solutions to problems will always somehow be found. An illustration of this important point is provided by the international monetary regime since World War Two, as I shall now explain before concluding.
Between the World Wars experts had wrestled with the task of designing a way forward from the now defunct classical gold standard. Some flexibility, but not too much, was needed both in exchange rates and in the supply of central-bank reserves. On the latter, the Genoa conference of 1922 had approved the notion of the gold exchange standard, with increased use of reserve currencies. Various analysts examined prospects for gold supply – among them the Polish economist, Feliks Mlynarski, who published several works on the subject in English in the later 1920s. In 1934 the US authorities fixed a new official gold price of $35 an ounce, as against the pre-1914 price of $20.67. But the 1930s also saw floating exchange rates and discriminatory trade policies, as well as prolonged slump.
In the light of all this, the Bretton Woods conference of 1944, chiefly Anglo-American, with Keynes leading the British delegation, devised a comprehensive blueprint for post-war international monetary arrangements. The new International Monetary Fund (IMF) was to supervise their functioning and to provide limited finance for balance-of-payment deficits.
Exchange rates were to be “adjustable pegs” - that is to say, with a fixed par value at any one time, but subject to devaluation or revaluation in the event of so-called “fundamental disequilibrium”. The par value of the dollar, as the anchor of the system, was maintained through convertibility of dollar reserves into gold at the price of $35 an ounce. Of course this par value too was in principle adjustable, either unilaterally by the United States or by international agreement on a so-called “uniform change in all par values”.
The IMF remains in existence to this day, as a forum for international policy discussions, a research institution, and an occasional source of balance-of-payments finance. But the Bretton Woods system of pegged exchange rates disappeared more than 40 years ago, in 1971-73, having lasted barely 25 years after the war. What brought it to an end was the adamant refusal by the United States to follow the rules of the system it had itself created, rules which demanded an increase in the price of gold if gold-convertibility of central bank dollar holdings could not otherwise be maintained.
It is admittedly arguable how long the Bretton Woods system would have survived even if the United States had been willing to increase the price of gold. But my point is that collapse of the pegged-rate system did not put an end to prosperity. The world coped perfectly well in subsequent decades with floating exchange rates and no definite rules for their management, and with explosive growth of central-bank foreign-exchange reserves. In the process it unfortunately fostered the illusion of policy-makers' omnipotence.
What then should one recommend to a member country of the European Union, which has still to make up its mind about whether to join the eurozone? All countries, whether members of the zone or not, suffer economically to some extent from its impact. There might be a unique opportunity for Poland to trigger its break-up – by first joining the single currency and then, two or three years later, deliberately leaving it again. Alas, the success of such Macchiavellian manoeuvres is too uncertain and might involve unjustifiable costs. In the circumstances, the best our Polish friends can do is to heed the words of the old English saying: Don't touch it with a barge-pole.
Peter Oppenheimer, after beginning his career at the Bank for International Settlements, Basle, in the early 1960s, taught economics at Christ Church, Oxford where he is now an "Emeritus Student", ie retired Fellow. In the mid-1980s he was seconded as Chief Economist at Royal-Dutch Shell. He has experience as a non-executive director in a variety of business enterprises, including electrical retailing, publishing, journalism, finance, and commodity trading.
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