by Matthias Matthijs
While the whole world has been adopting a pragmatic consensus on economic policy since the Great Recession, Europe — and Germany in particular — is stubbornly sticking to a policy that has all the downsides of the old classical gold standard.
From the US to Russia and Japan, and from Brazil to India and China, the rest of the world has been careful to preserve substantial flexibility with its domestic fiscal and monetary policy levers. No such caution in continental Europe, where a "one size fits none" monetary policy by an independent central bank that cannot act as a true lender of last resort and a Brussels-imposed fiscal straightjacket that has not served a single euro member state well reign the day. Add to that the problem of intra-European financial markets with "national" regulatory institutions and the lack of a Europe-wide deposit insurance scheme or common debt instrument, and one can start to understand why the euro zone is going through an existential crisis with still no real end in sight.
The euro experiment raises serious questions about the future of building legitimate institutions outside of the nation-state framework and holds lessons for regional integration in other parts of the world.
In order to understand the euro zone's current predicament, it is useful to see Europe's Economic and Monetary Union as an intra-EU gold standard system: a fixed exchange-rate system with strict internal budget rules for external adjustment and therefore a deflationary bias. I will explain this in more detail below. But first, how do we know a gold standard is an unworkable idea for modern democracies?
Examining the role of the gold standard during the Great Depression during the 1930s in Golden Fetters, Berkeley professor Barry Eichengreen convincingly argued that the system was structurally flawed and was one of the central reasons why the worldwide slump was so deep and lasted so long. The commitment to the gold standard resulted in steadily falling prices, which only further enhanced the power of creditors (who grew richer while they were sleeping) and weakened the hand of debtors (who saw the real value of their debt skyrocket). So, the gold standard could only work well in the depoliticized environment of the Belle Époque, when the electoral franchise in most advanced economies was limited to wealthy white men and well before the advent of powerful labor unions. Financial elites across Europe and America could therefore run a global financial system based upon gold where the external price of a country's exports dictated internal prices and wages. The shock absorber in the system was the price of labor, not the exchange rate or the inflation rate.
During the tumultuous years of the interwar period, Eichengreen pointed out, significant political changes had made a successful return to the gold standard impossible. Political and economic elites could no longer ignore the demands of their significantly bigger electorates. The focus had to shift towards maintaining "internal equilibrium" — or full employment and high domestic growth. Popular legitimacy was now at the heart of any successful economic policy, and the countries that stayed on the gold standard the longest (i.e. France), suffered the most, while the countries that left the gold standard early (i.e. Britain), saw a much quicker recovery in the 1930s.
The lessons of that period were enshrined in the 1944 Bretton Woods system that established the IMF and the World Bank. Countries would maintain a fixed-but-adjustable peg and keep their monetary independence through capital controls, while committing to a liberalizing world economy by gradually lowering their barriers to trade.
The Bretton Woods system essentially provided sovereign states a menu of choice between four different national "shock absorbers" in the case of an economic crisis: inflation, deflation, devaluation, and default, with the latter always thought of as a last resort. Most European countries used at least three of those four instruments during the postwar period, which allowed them the flexibility to deal with economic shocks depending on their specific national economic contexts. In the end, it was a national government's choice which path out of a crisis they followed, and no supranational entity could impose that choice. The responsibility always lay with the national political elite whose decisions would later be judged by the ballot box.
The world economic turmoil of the early 1970s saw the collapse of the Bretton Woods fixed exchange rate system, but the four national shock absorbers of inflation, deflation, devaluation and default were preserved. Continental European countries initially pegged their currencies to one another by creating a currency basket, the "European Currency Unit" (ECU), a weighted average of all European currencies, with the strongest weight for West-Germany — de facto letting the anti-inflationary Bundesbank run their monetary policy. This already made one crisis solution — inflation — much harder to do. But it was not until the signing of the Maastricht Treaty in December 1991 that the Europeans decided to give up not one but two of their shock absorbers — inflation and devaluation — once and for all.
With the creation of the single currency governed by a European Central Bank with the sole mandate to keep inflation just "below but close to two percent," and a Stability (and Growth) Pact to make sure fiscal policy would not be abused for domestic purposes, François Mitterrand and Helmut Kohl managed to reconstruct the gold standard — with all of its flaws — in a modern European setting.
At the time, that did not seem like such a bad thing. Given that the ideological consensus back then was firmly that one could not trust politicians with one's money, the Economic and Monetary Union seemed to be well ahead of the curve. The relatively rapid economic convergence in the 1990s after the EMS crises of 1992-93 and the initial success of the euro in the early 2000s seemed to validate Europe's audacious plan for monetary union.
However, since the euro crisis took the European policy elites by surprise during the Greek spring of 2010, it has become painfully clear that the Brussels-imposed deflationary austerity measures do not work, lack all popular legitimacy, and make the crisis go from bad to worse.
It is one thing for the British to follow the austerity road given that this is the path their own government opted for. But it is quite another thing for Greece or Spain to be forced to implement draconian spending cuts by Brussels and Frankfurt, or for a democratically elected prime minister in Italy to be forced out in favor of a former European Commissioner to introduce 'unpopular but necessary' structural reforms.
In the end, the euro crisis has underscored that democratic legitimacy remains first and foremost with the member states and their national elites. States still control fiscal policy and fund their national welfare states, which are bigger and more popular than ever, and are at the very heart of any European country's politics. Every euro area member state has its own peculiar welfare state makeup and historically and culturally determined priorities for economic policy. The EU's strength was always that it tried to celebrate and preserve this diversity. However, trying to make all euro members more like Germany is bound to result in an anti-Europe and anti-German backlash.
It seems hard to imagine that the current strategy of 'muddling through' can last, which leaves Europe with two serious options out of the current crisis. One option is to try to broaden the ECB mandate to also focus on growth and employment — making it more like the Fed in the US. Brussels could start issuing commonly held Eurobonds and construct a fiscal and banking union together with a political union. However, this option would entail an unprecedented transfer of power from sovereign states to the EU, essentially ending any notion of a sovereign nation state in Europe. This has arguably already happened in Europe's periphery, with dire consequences.
The other option is to dissolve the euro and to go back to the common market of the mid-1980s. The advantage of this option is that it would bring back the two lost shock absorbers of inflation and devaluation. It would also restore the national economic sovereignty of states like Greece, Portugal, Ireland, Spain and Italy, while removing the excuse, popular with national politicians, that Brussels and the EU are to blame for unpopular economic measures. The disadvantage of this option is that it is not clear that the European project can survive such a dramatic slide backwards in its process of integration. But then, as Alan Milward taught us in the 1980s, states only agreed with further steps in the process of EU integration insofar as they were convinced of the benefits of those steps in the first place. Since many states are now thinking that the euro was one step too far, we should not be surprised that they might at some point decide to go back one step.
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