Macroeconomic “Excuses”: A Look at Europe

Policy makers are good at coming up with excuses for bad policy. That’s one of my key takeaways from Barry Eichengreen’s recently released “Hall of Mirrors”. In this book, Eichengreen compares the policy responses to the Great Depression and Great Recession and finds that while we may have done better this time around in the initial monetary and fiscal response, we have still managed to unlearn the lessons in the policy responses during the years after the initial crisis. Neil Irwin, summarized this in his NYT review: “Rather than hoist anyone to our shoulders for preventing another Depression, we should be more cleareyed about the ways in which global leaders did not really learn the lessons of the 1930s at all and made many of the same mistakes as their Depression-era counterparts”

An important part of making mistakes is coming up with excuses to justify them. It is here that we see a troubling parallel between the current permissive attitude towards the European collapse in nominal GDP and the passivity of European central bankers in the face of the Great Depression.

Prior to the Great Depression, the global monetary system ran on the gold standard. Since every country’s currency was pegged to gold, each country’s gold stock served as a limit to how much it could expand its money supply. This meant that if you enjoyed the privilege of capital inflows, you could expand your money supply in response to a recession. But if on the other hand you suffered capital outflows, then you were forced to raise interest rates and contract the money supply, even if you were in the depths of a recession.

Prior to the first World War, there were “rules of the game” that helped to mitigate these constraints. In particular, central banks in countries with gold inflows were supposed to expand their money supplies in response to gold inflows. This way, if a country ran a substantial trade surplus and had lots of gold flowing in to buy its goods, the central bank would allow the price level to rise. This would eventually reduce that country’s competitiveness relative to other countries. The trade surplus would turn to deficit, and then gold would flow out as it chased cheaper goods abroad. In doing so, central banks in surplus countries let gold flow back to deficit countries, thereby returning some degree of monetary sovereignty to those deficit countries as they could then expand their money supply

But in the interwar period, France refused to play by these rules. Due to large fiscal battles in the immediate aftermath of the war, the Franc was forced to devalue several times. Eventually it settled at a level that made the Franc very competitive, and gold flowed into France. But instead of following the rules of the game and letting the French price level rise, the Bank of Japan sterilized the gold inflows, stuffing them under the proverbial central banker’s mattress.

From Irwin 2010, “Did France Cause the Great Depression”

(Image from Irwin 2010, “Did France Cause the Great Depression”)

This caused severe problems in deficit countries such as the UK and Germany. Since the French price level was not rising, the deficit countries were stuck with their trade deficits. But the French did not see this as a monetary problem. As Eichengreen describes in his new book, “If France enjoyed a balance-of-payments surplus, then this reflected the innate frugality of the French, who preferred saving over spending.” Douglas Irwin, a monetary historian at Dartmouth, notes that French officials attributed the capital inflows to renewed confidence in their economic policies.

This is remarkably similar to the current European situation, except now it is Germany that is the surplus country and peripheral Europe that is running a trade deficit. And again, the surplus country does not see this situation as something about the quasi fixed exchange rate regime of the Euro, but rather as structural superiority relative to the deficit countries. Eichengreen too makes this connection.

The historical lesson for modern Germany would be to recognize that monetary inflation for the Eurozone indeed may be a bad deal for Germany right now. It would open the gate for peripheral Europe to sustainably lower their real wages and thus rob Germany of its competitive advantage relative to peripheral Europe. But that’s the point. Had France consented to expanding their money supply prior to the Great Depression, it would have substantially eased the adjustment process for the UK and Germany. With the benefit of hindsight, Germany should reject moralism about trade surpluses and recognize that monetary expansion is the only true sustainable way to bring South European competitiveness back on track.