Posted by: Dirk | November 14, 2009

Will the euro act like the gold standard of the Great Depression?

During the Great Depression deflation was transmitted via the gold standard, the international monetary system of that time. In a nutshell, it worked like this. All money had to be backed up by gold in a fixed ratio. A country that imports more than it exports than has to pay its net imports with gold. It’s central bank therefore retires some of its currency, whereas the foreign central bank expands its currency supply. Therefore, the net importer will go through a phase of deflation while the net exporter will see its economy inflate. The burden of adjustment falls 50-50 on both economies. The net exporter’s higher price level will make its products dearer, while imports are getting cheaper since the other country is seeing its price level fall. This leads to balanced trade accounts where imports are close to exports. Of course, both are highly positive.

The idea of the gold standard then is to bring about external equilibrium. Trade imbalances are not likely to persist since once the gold starts flowing, price levels are working to reverse the imbalance. Since being ‘on gold’ means that rules have to be followed by changing the monetary supply, the domestic price level is free to float. Today, we have the opposite system. Monetary policy is used to anchor the domestic price level. This strategy is called inflation-targeting. The theoretical models this strategy is based on completely ignore international imbalances, just as the gold standard ignored domestic inflation.

So we are left with a dilemma on this planet. We know that international imbalances are a bad thing, since this creates extra risk for the world economy. Capital flows have to arise to finance trade deficits, and this will have some effect on other markets. Probably the labour markets of net exporters will be doing better than those of net importers, for example. Or, the financial markets of net importers will rise in value because of capital inflows. The interdependence of markets is something that today is not understood anymore. The second part of the dilemma is inflation. We know that high and quickly growing inflation/deflation are bad as well, redistributing wealth and causing problems to transfer savings into investment. Given that the policy instrument to influence both external balance and internal price stability is the same, we have a true dilemma.

Prior to the Great Depression, neo-classical thought dominated and the gold standard ruled. Adjustment to external imbalances was hard at times, leading to severe deflation and unemployment. Recurring financial crises occurred in both industrialized and industrializing countries. Today, the Keynesian view still dominates. Therefore, unemployment has to be fought by the central bank, leaving the external situation to develop without intervention. This connects with the neo-liberal idea of ‘the market always works’, so I think we could describe today’s system as a synthesis.

During the Great Depression, countries were afraid that capital would move out of the country, thereby reducing the supply of money and creating deflation. That is why central banks entered a race to increase interest rates in order to keep the capital inside the country. On the domestic side, companies found it more and more difficult to make money with the costs of capital growing and the price level falling. All countries that played this game of keeping capital inside the country by putting up the interest rates suffered deflation. As soon as countries left the gold standard, their economies were on its way to recovery:gold

source: Bernanke, Ben and Harold James (1999), NBER.

The question I want to look at today is whether the euro will fulfill a similar role in today’s economic crisis for countries of the European Union. Two words of warning: this is just a scenario that I play through, and I will assume that people might be rational in the sense that they might trade-off economic well-being for getting power (back).

Recently, people with some stake in the ECB have announced that they are prepared to pull interest rates up in the near future. Some countries are still deep in recession, and it is those countries that had seen their housing bubbles burst, like Ireland and Spain. Let me focus on the latter, since I have more knowledge about Spain. Spaniards went deep into debt to buy their houses at inflated prices and spend something around 47% of their incomes on mortgages – on average (source in Spanish). The money came from Spanish banks, which they got mostly from Germany and other net exporting countries inside the EU.

So, what is the right economic policy for Spain today? Before we answer this question, let’s see how economic policy will look like if the EU does follow the rules. At some point, the ECB’s interest rate will go up. That is pure pain for Spain, which will still be shaky at that time since it’s the laggard. The notorious EURIBOR, on which interest rates in mortgage contracts are indexed will rise, leading to higher debt payments. At the same time, a rise in the interest rate will make things more difficult for the financial sector as well. More costly capital might leave some firms underwater, and without a hope of ever coming up again. This will be about expectations also. Third, the real economy is harmed since firms will invest less. This might lead to more or longer periods of deflation, which makes debt repayment for Spanish households all the more difficult. Especially so, since at the same time nominal wages will be falling and nevertheless unemployment will continue to rise.

What Spain would need is more exports in order to repay debt. Domestic demand alone is too weak to bring about something close to full employment in Spain. However, with the euro there is no monetary policy option and fiscal policy is out as well. The stability and growth pact states that fiscal deficits cannot rise above 3% of GDP a year, and also it does not apply now it will in 2012. Even if the pact is scrapped, one wonders whether Spain can increase its government debt by much. The old solution of depreciating the currency is out, too, since Spain is part of the euro zone. A different price level from the rest of the EU is also difficult to achieve since there is the common market, which should lead to arbitrage whenever price differentials in tradables show up. The whole weight of adjustment therefore lies on wages. In order for Spain to export more, wages have to come down (or productivity go up, but this is not going to happen). With wages coming down, Spain will have prolonged deflation and also very big problems with repaying its debt.

This deflation could spread through the whole euro zone. Spanish exports will pick up, putting pressure on European firms to cut costs as well. Other countries like Ireland will also be putting pressure on wages and prices to fall, perhaps leading to a race to the bottom situation where European firms let nominal wages stagnate in order to keep their level of competitiveness constant. It might be supported by politics too, since governments will fight for jobs, as we have witnessed in the case of Opel. There is a threat here that countries of the euro zone will go through a deflationary phase with low growth rates and falling purchasing power that might resemble the experience of the early 1930s. I don’t see it happen now, but sincerely I think by now economists should have warmed up to the thought of discussing worst case scenarios instead of indulging in wishful thinking.

So, what are the alternatives? Spain might consider leaving the euro zone. It would be a bold move, but Spain might be desperate. The unemployment rate stands at 20% today, and it can be expected that it gets worse. Also, Spain has a problem with its regions. While some, like the Basque country and Catalonia are industrialized and relatively rich, others are not. The dictatorship of France has led to redistribution from those rich regions to the rest, and now there is a struggle for some regions to form their own nation. While some Basques have been doing so by armed resistance, Catalans have been using political means, and that includes using the FC Barcelona as a tool for cultural identity (Xavier Sala-i-Martin plays no small part in this, by the way).

So, what will happen if Spain leaves the euro zone? The question critically hinges on whether Spaniards would have trust in a new currency. If so, the new currency could be devalued from the beginning, thereby reducing debt burden for households, firms and the government. Spain could become a net exporter, and earn its way back to economic growth. However, if some regions would not go with the new Spanish currency and instead opt for their own currency, this solution might become difficult to follow.

These are just scenarios which I think unlikely to happen, but the pressure that will be put on Spain might be real. However, it would be easier for the EU to either support Spain through a federal fiscal stimulus paid for by the net exporters or allow Spain to default on part of its debt. The political cost of Spain exiting the euro would generate quite high negative externalities for the euro zone, so some political deal is likely to go down.


  1. […] let me copy&paste. The following is taken from the post Will the euro act like the gold standard of the Great Depression? from November 14th 2009 and concerns Spain, not Greece (for those of you close to academics, yes, […]

  2. […] year ago, I wondered whether the euro would act like the gold standard during the Great Depression. It is one of my longest blog posts ever and cannot be summarized in a few sentences. Or, maybe it […]

  3. […] that left the gold standard did very well. Almost two years ago I had a graph on my blog in a post in which I compared the euro system to the gold standard. (Feels good to reread my […]

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