28/11/2013
The financial crisis of 2007-09 – the worst since that of the early 1930s - brought economic historians to the fore and their testimony has since been much sought after in the ensuing euro crisis. For in several ways Europe’s currency union resembles the gold standard that functioned so badly when it was resurrected after the first world war.
By fixing their exchange rates against each other the members of the euro can no longer resort to devaluation if they become uncompetitive. Instead they must regain competitiveness the hard way through “internal” devaluation, allowing their wages and prices to fall relative to those of the other members. That is painful, so much so under the gold standard that Britain went off it in 1931, and was swiftly followed by several Scandinavian countries like Sweden. The nations that were the first to devalue in the 1930s did much better than those like France that clung on to gold. Given this experience, an obvious question is why the euro has survived whereas the gold standard disintegrated.
In a new paper, Nicholas Crafts, an economic historian at Warwick University, gives three main reasons. First, it was easier to leave the gold standard than the euro because countries still had their currencies in place and were not bound by treaty obligations, whereby an exit from the euro entails leaving the European Union (though whether this strict interpretation of the law would prevail in practice is unclear). Second, the “pernicious” link between weak banks and weak sovereigns in the eurozone – like two drunkards trying to support each other - was less in evidence in the interwar years because banks were much smaller. And third, the eurozone countries in difficulty have received support from other European partners and the IMF. Moreover, the European Central Bank (ECB) has lent freely to banks and, belatedly, assumed the role of lender of last resort to governments through its pledge to buy if necessary unlimited amounts of sovereign bonds for countries under siege in the markets.
But survival is not enough and Mr Crafts asks whether saving the euro may be a Pyrrhic victory. This is not just because of the woeful performance of the single-currency club since it started in 1999 in terms of living standards (which are now for example lower in Italy) but also because the prospects for the euro zone are so gloomy. And this judgment goes well beyond the short-run worries about a feeble recovery sparked by recent figures showing that euro-wide growth in the third quarter was a miserable 0.1%.
What Mr Crafts highlights is the damage to the eurozone’s longer-term growth prospects. For one thing, European countries are becoming more protectionist, which bodes ill for hopes of completing a genuine single market. Despite the creation of a single supervisor in the form of the ECB the retreat from financial integration is likely to continue. But his main concern is that the crisis has left a malign legacy of high public debt. That is likely to hurt growth (through for example higher tax rates) as will the attempts to reduce debt by fiscal retrenchment.
The easiest way to ease the burden of debt, which is fixed in nominal terms, is through inflation. But the eurozone is instead experiencing very low inflation, with prices rising by only 0.7% in the year to October, and falling in Greece, Cyprus and Ireland. The ECB is belatedly trying to combat the risk of deflation, but Mr Crafts thinks that the euro zone needs a different sort of central bank that actively seeks to promote growth.
The trouble with his solution is that the ECB’s mandate, which is narrowly focused on price stability, was set out in the Maastricht treaty. If there is one thing that European politicians now shy away from, it is changing treaties; and if there is one treaty they would be especially loth to touch it is the one defining the ECB’s role.
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