Today’s European crisis trilemma is reminiscent of interwar Europe
By Michael Bordo, Harold James
This post first appeared on Vox
The European financial crisis has often produced comparisons with the historical problems of the classical gold standard. Many of the key political figures who drove forward European monetary integration admired the discipline and certainty of the gold standard. Both Valéry Giscard d’Estaing and Helmut Schmidt shared this view. But recently, the comparison is more usually a negative or hostile one. The intent is to demonstrate the unrealise-ability or absurdity of the constraints that rigid monetary systems impose (Krugman 2013), or the problems of an asymmetric adjustment process (Eichengreen and Temin 2010).
Adherence to the gold standard, and to the euro, involved an acceptance of:
- Monetary orthodoxy.
In the gold standard, the constraint is the convertibility of claims into a metallic equivalent. In the modern monetary union, it is imposed by a central bank with a price stability target.
- Fiscal orthodoxy.
Both regimes depend on the avoidance of fiscal deficits that would place the monetary objective in danger. In the gold standard era, most states had little room (little technical capacity or political consent) to raise large amounts in taxation. Before the First World War, despite a costly arms race, economic growth meant that for most countries the share of government debt of GDP was falling. The modern European monetary union – the Eurozone – occurred in the context of much higher spending levels and higher levels of government debt in all industrial countries, as well as of continual social and political pressure to expand government spending.
The benefits of the gold standard were seen in the nineteenth century as lying in:
- Ease of a common monetary standard.
- Access to capital markets (overcoming “original sin” that made financially immature economies unable to borrow abroad except in foreign-denominated currency).
- Reduction of borrowing costs; and
- The gold standard as a contingent rule.
In the event of an emergency – such as a war – the gold peg could be temporarily suspended, but with an expectation of an eventual return to convertibility at the original peg. The contingent rule gave a safety valve for fiscal policy in dealing with exceptional circumstances (Bordo and Kydland 1995).
But there were also substantial risks. Large-scale emerging market borrowers ran a substantial risk of entering into an unstable dynamic with a destabilizing fiscal policy that might threaten the maintenance of the rules of the game. The gold standard experience is filled with sudden stops of capital inflows in which advanced country creditors either hit by domestic shocks or fearful of events in the borrowing countries turn off the lending spigot (Bordo 2006).
The flows of capital almost always produced an expansion of the banking system in the importing country. That expansion could turn into a source of instability if banks became unable to repay credits, either because of a liquidity or a solvency problem. When countries credibly adopted the gold standard, they often experienced surges of capital inflows. These were almost always mediated through the financial system. Sudden stops, were sometimes caused by banking sector weakness, and sometimes lead to bank collapses. They did not inevitably end the exchange rate commitment. There was thus a close association between capital flows and banking crises.
A strong and effective state could underpin a banking system, and thus allow greater volumes of borrowing to continue for longer and with greater sustainability. In Russia, for instance, the State Bank was widely regarded as a reinsurance mechanism that would bail out problematical private debtors: it was often referred to as “the Red Cross of the bourse”. Thus Russia had large inflows, and a sudden stop in the early twentieth century, but no suspension of convertibility.
International diplomatic commitment enhanced the market perception of state effectiveness. The story of how diplomatic commitments enhance credibility is especially evident in the well-known case of Russia. The beginning of the diplomatic rapprochement of Russia with France in 1891 was accompanied by a French bond issue, which the supporters of the new diplomacy celebrated as a “financial plebiscite” on the Franco-Russian alliance.
Popular political discontent eventually limited the possibility of adjustment policy. The Tsarist Empire was an effective and capacious borrower, it never seemed to violate the gold standard rule in peacetime, but it was brought down by massive social discontent that was in large part driven by the widespread perception that its policy had been sold out to foreigners. A major part of Lenin’s analysis, for instance, was devoted to the demonstration that Russia had become a quasi-colony as a result of the large scale capital imports, and that the foreign creditors in effect controlled Russia’s foreign policy.
The linkages of these issues can be summarized as a series of impossible trinities or trilemmas.
1. The macroeconomic classic – fixed exchange rates, capital flows, autonomous monetary policy;
2. The financial sector – fixed exchange rates, capital flows, financial stability;
3. The international relations setting – fixed exchange rates, capital flows, national policy independence; and
4. The political economy – fixed exchange rates, capital flows, democratization.
The interwar experience
All four of these trilemmas became impossible after World War I.
First, the asymmetry of the adjustment problem in the gold exchange standard of the 1920s and sterilization of gold inflows by the surplus countries ( US and France) put deflationary pressure on the deficit countries ( UK, Central Europe and Latin America) when capital flows dried up ( Eichengreen 1992).
Second, in the financial sector, high inflation destroyed the capital base of many financial institutions in the defeated countries of Central Europe making them vulnerable to sudden stops. Correspondent banking networks between these countries and neutral countries exposed them to contagion.
Third, taking on international commitments by debtor countries enhanced their credibility for the lenders (US) which ultimately increased the borrowers exposure to sudden stops.
Fourth, taking on international commitments became a focus for domestic political disorder when the great Contraction after 1929 required adjustment by deflation.
The Eurozone story
The move in Europe to monetary union for weaker countries was a credibility enhancing mechanism that would lower borrowing costs. For countries that had strong creditor positions, the attractions of monetary union lay in the depoliticizing of the adjustment process (James 2012). The Eurozone worked quite well as a disciplining mechanism before it entered into effect, but much less well afterwards.
The trilemmas became an increasing constraint in the years after the euro:
Banking expanded after the establishment of the euro (Shin 2012). No adequate provision on a European basis existed for banking supervision and regulation, which like fiscal policy, was left to rather diverse national authorities. An explosion of banking activity occurred simultaneously with the transition to monetary union and may well have been stimulated by the new single money. A “banking glut” led to a new challenge to monetary policymaking.
The bank expansion could go on longer because of implicit government backstop. It was reversed when government debt management no longer looked credible – in the Greek case after the elections of October 2009.
The implicit national government backstop was really only credible because of the international commitment to the European integration project. It was that commitment that led markets to believe that – in spite of the no bailout provisions of the Maastricht Treaty – there were almost no limits to the amount to which debt levels could accumulate both in the private and the public sector. When governments turned round, in particular after the Deauville meeting of Chancellor Merkel and President Sarkozy in October 2010 and demanded a haircut for Greek creditors (or Private Sector Involvement, PSI), the yields immediately diverged. Deauville undid the framework of solidarity that the EU treaties seemed to have created.
When the democratic/popular backlash occurs, it takes the form of rejection of international/cross-border political commitment mechanism. Voters are surprisingly discerning. Opinion poll data shows a major increase in hostility to the EU in peripheral countries, but with no corresponding unpopularity of the common currency. Hostility to the EU is also evident in parliamentary elections results in Greece and Italy.
The trilemmas are worse in the recent context because of the absence of an escape clause. In the absence of an exchange-rate option, there is a need for greater debt reduction, but that raises a politically awkward question of the distribution of losses between the private and the public sector.
The result is reminiscent of the interwar political debate about whether (mostly American) private creditors or (mostly European) official reparations creditors should have priority in the payment of German debts. What made the interwar slump so intractable was that it was not just a financial issue, but also a crisis of democracy, of social stability, and of the international political system. In the interwar period, increased social tension as a consequence of increased unemployment and of widespread bankruptcy made normal democratic politics impossible. Domestic political pressure also became a source of heightened international tension.
That is true in today’s Europe. Democracy has become a central target of complaints by the European elite. Luxembourg Prime Minister Jean-Claude Juncker and former euro group chair stated that it wasn’t that European leaders didn’t know what the right policies were; but that they didn’t know how to be re-elected after they had implemented them. The 2013 Cyprus crisis and its resolution exposed two new dimensions to the clashes over Europe’s debt and bank crisis. The discussion of a levy on bank deposits, and whether small customers should be exempted, puts class conflict at centre stage. The question of foreign, and especially Russian, depositors – along with the proximity to Syria – makes the incident into an international relations problem.
Supranational commitments however do not change the problems posed by the adjustment requirement, and the asymmetric character of crisis adjustment is more apparent in the modern era (and in the interwar experience) than it was under the classic gold standard. A design that intentionally excluded a contingent clause made the system at first apparently more robust, but aggravated the eventual adjustment issue. That is why the initial crisis may not have been so acute as some of the gold standard sudden stops, but the recovery or bounce back is painfully slow and protracted. The instability is increased by the heightened complexity and length of credit chains, and by the fact of the mediation of credits through small country banking centres.
Bordo, Michael D and Finn Kydland (1995), “ The Gold Standard as a Rule: An Essay in Exploration”, Explorations in Economic History.
Bordo, Michael D (2006), “Sudden Stops, Financial Crises, and Original Sin in Emerging Countries: Déjà vu?” NBER working paper 12393.
Eichengreen, Barry (1992), Golden Fetters, New York : Oxford University Press.
Eichengreen, Barry and Peter Temin (2010), “Fetters of gold and paper,” Oxford Review of Economic Policy, vol. 26(3), pp. 370-384.
James, Harold (2012), Making the European Monetary Union, Cambridge Mass.: Harvard University Press
Krugman, Paul (2013), “Lust for Gold,” The New York Times, April 11, 2013.
Shin, Hyun Song (2012), “Global Banking Glut and Loan Risk Premium,” Mundell-Fleming Lecture, presented at the IMF Annual Research Conference, November 10-11, 2011, IMF Economic Review, 60, pp. 155-192.