With Greek politics in turmoil, much of Southern Europe in recession and apparently diverging views on the economy emerging in Germany and France, no swift end to the eurozone crisis appears in sight. Worse still, some are beginning to see the continent’s crisis as a perpetual norm. When talking about economic crises, it is often the case that history can inform about the advantages and disadvantages of different policy choices. Nowhere is this more important today than in this everywhere-discussed topic.
Although the euro is a currency, it is also useful to think of monetary union as the ultimate expression of a fixed exchange rate. For countries like Sweden with a floating exchange rate, a depreciated currency in times of crisis is the norm. When tied to a fixed exchange rate or single currency, however, changes in competitiveness in a country cannot be expressed through a weaker exchange rate in this way. Adjustments in competitiveness in the eurozone countries must therefore occur internally. This takes place through “internal devaluation”, consisting of the reduction of wages, costs and prices and the austerity measures to which vocal protests and riots have been the response.
But in order to earn money to pay off its debts, a country must grow its economy. As opposed to expansionary policies which promote growth, but also inflation, austerity and cuts are contractionary policies which limit growth. The prospect of a country like Greece achieving enough growth to pay off its debts by following austerity policies is therefore limited.
The policies of reducing internal prices and wages now being pursued in the eurozone are deflationary. This mix of deflationary policies and fixed exchange rates has an alarming historical parallel in the interwar gold standard. During the 1920s and 30s the zealous commitment of policy-makers to the maintenance of the fixed exchange rates of the gold standard also precluded external currency devaluation. Chained to the idea of keeping their currencies fixed, interwar policy-makers implemented harsh austerity measures, restricting credit and lowering wages. This worsened the prevailing economic downturn and caused the Great Depression. With most countries pursuing austerity and in effect becoming poorer it became impossible for them to export or produce their way into renewed growth. The result was a deflationary spiral which was only alleviated when the gold standard was later abandoned, allowing expansionary recovery to ensue.
One of the main criticisms against the Euro is that it shares the same in-built deflationary bias of currency regimes like the interwar gold standard. Without the euro, losses in competitiveness in Southern European countries could be resolved more smoothly via a depreciated currency. If the “golden fetters” of the 1920s and 30s caused the misery of those decades, then perhaps the shackles of the euro are preventing recovery in the 2010s…
In economic policy though, there are rarely such easy conclusions. Benefits in one area are offset by disadvantages in another, and in the case of a country leaving the euro the disadvantages are great. For example, a unilateral Greek default and exit from the euro may relieve deflation there and eventually increase competitiveness, but it would also rock the European financial system as a whole. Loans made by European banks that are “exposed” to Greece would be wiped out. This would potentially cause new bank failures throughout Europe and lead to a new “credit crunch”, since with banks facing losses they would again be less willing to lend. When banks do this, the supply of credit to businesses and private persons becomes limited. This causes the velocity of activity in the economy to slow down, leading to slower or even negative growth throughout already struggling Europe.
Perhaps the most dangerous thing about a Greek default is that it could encourage other countries also experiencing difficulty to default on their debts and leave the euro. The above effects would therefore be compounded massively, especially if larger economies such as Spain or Italy were to exit. The financial catastrophe to which these events would lead is what gives rise to the oft-occurring statements by world leaders of their commitment to keeping countries in the eurozone.
In the search for a solution then, the parameters appear to be: Resolve the competitiveness issues in the South with less deflation and less painful austerity, while still keeping the eurozone intact and preventing Europe-wide financial meltdown.
Economists well-aware of the presence of history such as Nobel-prize winner Paul Krugman have been active in the euro-crisis debate and have proposed possible solutions. Though himself no fan of the single currency, in widely read entries Krugman calls for an end to austerity, rails against deflation and proposes higher inflation and more expansionary policies, especially in Germany. This, he argues, would help to redress the economic imbalances (large surpluses in Germany and deficits in the South) that have appeared in Europe and contributed to the crisis. Allowing wages and spending to rise in Germany would lessen the disparities in competitiveness between North and South and make it easier for the crisis countries to boost production and exports without the accompanying chaos of leaving the euro. Importantly, a deflationary-spiral situation of 1930s ilk would also be worked against. Sentiments such as these have also been echoed by the IMF.
But here the weight of economic history is also great. Germany remains staunchly averse to adopting such expansionary and inflationary policies. The spectre of the Weimar Republic and the hyperinflation Germany experienced in the 1920s is not easily exorcised in the psyche of German policy-makers. However, the rampant deflation, unemployment and economic contraction in the 1930s ultimately brought a much worse fate to Europe and the world…
In the debate between inflation and deflation, austerity and growth, the tide may be turning. Recently elected French President François Hollande has put calls for more growth friendly policies to the fore, and there are signs that German attitudes on growth and inflation may also be changing.
Neither continued austerity and deflation nor exits from the euro would seem to provide a viable solution to Europe’s crisis. Instead agreement on coordinated economic expansion is perhaps the least worst alternative.