Thursday, June 21, 2012

Barry Eichengreen on crosses of gold and euros

Barry Eichengreen wrote a major study of the gold standard before and during the Great Depression, Golden Fetters: The Gold Standard and the Great Depression, 1919-1929 (1995). He explains the ways in which the gold standard contributed to the onset of the Great Depression and complicated efforts to combat it.

His study won't give much encouragement to monetarist theories, and certainly not to crackpot goldbug ideas. He does a good job at showing the depression as having multi-faceted causes as he fits the role that the gold standard played into the larger picture. He argues that the pre-First World War gold standard provided considerable currency stability from roughly 1871 until the outbreak of the Great War. And he makes the case that the stability was largely due to the cooperation between the financial systems of the three key financial powers of that period, Britain, France and Germany.

After the war, attempts to restore international financial stability focused heavily on restoring the gold standard, which leaders private and public identified with stability based on the prewar experience. But the world had changed in ways that made the international cooperation necessary for the gold standard to work as expected far less likely. Not least among them were complications arising from German war reparations and the vastly enhanced role of the United States in international finance.

The hyperinflation that affected various countries, most famously Germany, provided a major incentive for sufficient international cooperation to achieve stability in the context of a renewal of the gold standard. But Eichengreen shows that this enhanced the fixation of leaders on the gold standard itself, rather than the international cooperation, as a guarantor of stability. And maintaining the gold standard came to be seen by investors as a sign of financial responsibility, requiring among other things balanced budgets.

This became a problem when the depression required counter-cyclical measures that would have required deficit spending. Other problems stemmed from national policies that "sterilized" gold inflows by counteracting the effect they would otherwise have had, thus violating one of the principle assumptions behind the expected benefits of the gold standard.

Eventually, the gold standard collapsed as countries that left the gold standard gained increased flexibility to employ counter-cyclical stimulus to combat deflation and restore economic activity. Argentina went off the gold standard in 1929, Germany in , Britain 1931, the US 1933 and France 1936.

Eichengreen explains various aspects of the process, warning repeatedly against focusing excessively on a single explanation. He deals with familiar financial categories like investor confidence and expectations and financial speculation. He looks at issues of demand and income distribution. He discusses ways in which the expansion of the franchise after the First World War gave labor in particular new avenues to press its claims in the political sphere upset the kind of prewar financial stability that central banks and the most powerful private bankers could arrange at the expense of labor and farmers. He even looks at ways in which the system of proportional representation may have exacerbated financial problems in those countries like Germany that adopted the more expansive forms of it.

Eichengreen and Peter Temin discussed the experience of the gold standard during the Great Depression in relationship to the euro crisis in Fetters of Gold and Paper (National Bureau of Economic Research; July 2010). Their description of the risks two years ago is holding up unfortunately well:

Fixed exchange rates facilitate business and communication in good times but
intensify problems when times are bad. We argue that the gold standard and the euro
share the attributes of the young lady described by Henry Wadsworth Longfellow
(American, 1807-82):

There was a little girl, who had a little curl
Right in the middle of her forehead,
And when she was good, she was very, very good,
But when she was bad she was horrid.
Echengreen and Temin summarize the dynamic of the gold standard that stuck gold-standard countries during the Great Depression will pursuing policies to defend the gold standard that were not the policies needed to stimulate their economies in the face of production decreases and deflation:

The gold standard was characterized by the free flow of gold between individuals and countries, the maintenance of fixed values of national currencies in terms of gold and therefore each other, and the absence of an international coordinating organization. Together these arrangements implied that there was an asymmetry between countries experiencing balance-of-payments deficits and surpluses. There was a penalty for running out of reserves (and being unable to maintain the fixed value of the currency), but no penalty (aside from foregone interest) for accumulating gold. The adjustment mechanism for deficit countries was deflation rather than devaluation, that is, a change in domestic prices instead of a change in the exchange rate. ...

The tight monetary and fiscal policies of the late 1920s that induced investment to fall were due to the adherence of policymakers to the ideology of the gold standard. Choices in the years around 1930 were made according to a worldview in which maintenance of the gold standard—such as it was by the late 1920s—was the primary prerequisite for prosperity. As a result of this ideology, monetary and fiscal authorities implemented contractionary policies when hindsight shows clearly that expansionary policies were needed. No analogous pressure to adopt expansionary policies was felt by the authorities with the freedom to do so. [my emphasis]
They stress that the international cooperation that was the real basis of the gold standard working as well as it did in the pre-First World War era and the mid-1920s has always been deficient in the EU, despite the institutional arrangements to provide such cooperation:

The euro area differed from the gold standard in that it talked the talk, but didn’t also walk the walk, of international cooperation. There was awareness that fiscal and financial policies were a matter of common concern, and that coordinated adjustments in which countries in chronic surplus expanded while countries in chronic deficit did the opposite, were desirable. But the area’s various mechanisms for coordination, the Stability and Growth Pact, the Excessive Deficit Procedure, and he Broad Economic Policy Guidelines, were honoured mainly in the breach. Representatives of Europe’s national governments went to Brussels to discuss them, and then they went home and mainly did as they pleased. Like the Pope, the European Commission had no army to enforce its decisions. While national politicians spoke the language of cooperation, they were mainly concerned with the reaction of their domestic constituents when taking actual decisions. In Southern Europe, deficit spending and government debts were allowed to grow all out of control. In Central Europe, meanwhile, there was nothing to prevent the pursuit of a chronic deflationary bias. For a time, this preference in one region for deficits, combined with a preference in the other for surpluses, seemed like a happy symbiosis – just as it had in the second half of the 1920s. But this did not mean that it was any more sustainable than 80 years before.
Like the gold standard in the 1920s, the euro didn't cause the current depression. But it has contributed to the contagion of problems and pushed countries into pursuing policies to protect their position in the common currency arrangements that wound up making the economic crisis more severe than it needed to be.

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