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Creditor countries such as the U.S. didn’t play fair in the 1930s. They bought tons of gold to take it off the market so it wouldn’t affect their money supply or interest rates. By hoarding, they left too little gold for the debtor countries and worsened their deflation.
Eventually all countries were forced off gold by financial crises and popular upheavals. Britain abandoned gold in 1931 and fared best economically. Die-hard France, which stuck with gold until 1936, did worst. Even with prices plunging, the elites fretted about the threat of inflation. Ralph Hawtrey, a British Treasury official, likened that to crying “‘Fire, fire’ in Noah’s flood.”
Policymakers have not fully absorbed the lessons of the Depression. Monetary and fiscal policy are better but “not enough better,” Eichengreen says. There’s an understanding that big banks can’t be allowed to fail, but “one might say, Aren’t the biggest banks too big to save, especially in Europe?”
The most unfortunate difference between then and now is that the euro, unlike the gold standard, is a raccoon trap: Its designers deliberately left out an exit procedure. That means you can get in, but you can’t get out without leaving a part of yourself behind. Eichengreen points out that Britain was growing again by the end of 1932, just over a year after abandoning gold under duress. Today a country—say, Greece—that quit the euro would take far longer to right itself. That’s because unlike Britain, to get relief Greece would have to default on its euro-denominated debts and damage its credit rating. “The Greek government,” Eichengreen says, “will be hard-pressed to find funds to recapitalize the banking system. Greek companies won’t be able to get credit lines. The new Greek government is going to have to print money hand over fist. At some point they would be able to push down the drachma and become more competitive. But the balance is different now.”
That’s why Eichengreen thinks leaving the euro zone should be a last resort. The better option, he says, is to make the euro work the way the gold standard worked in its best years. Surplus countries should equally share the cost of adjustment with deficit countries. He favors transforming the underfunded European Financial Stability Facility from an emergency fund into a bank. He would have the facility borrow from the European Central Bank so it can make unlimited loans to countries such as Greece and Italy—on the condition, of course, that the countries demonstrate they’re on a path to fixing their competitiveness problems. Those countries don’t have a chance to fix things without the breathing room afforded by official lending, Eichengreen says.
Europe’s fatal mistake was to push ahead with monetary union without having achieved fiscal union. Limits on national budget deficits were flouted with impunity. Now creditor nations are dragging their heels on aid and stimulus because they don’t want profligate debtors to play them for fools. In an echo of the gold-hoarding mentality of the Depression, Germans have reacted angrily to the suggestion that the International Monetary Fund might tap Germany’s gold reserves to bolster the EFSF. The mood is angry and confused. German Chancellor Angela Merkel was correct on Nov. 14 in Leipzig when she described the debt crisis as “maybe Europe’s most difficult hours since World War II.”
The answer, as Merkel told her Christian Democratic Union colleagues, is “more Europe and not less Europe.” If Germany can get the “more Europe” it wants—i.e., tough, enforceable budget rules—it might countenance more help for weaker nations, even if for now Merkel is still rejecting open-ended ECB lending or jointly issued euro bonds.
There are signs that creditor nations understand their responsibilities. In October, European Union finance ministers agreed on a “six pack” of economic-governance rules that in theory should penalize countries with excessive surpluses, not just those with excessive deficits. Merkel said on Nov. 16 that “we are prepared to give up a little bit of national sovereignty” to preserve the euro. Something needs to happen fast. As the debt crisis has come to a head, economists surveyed by Bloomberg have sharply lowered their forecasts for European growth in 2012. Output may well be shrinking in the current quarter. The risk is that the worsening woes will make the key players less flexible. In the 1930s, Eichengreen and Temin wrote, “The masochistic strand of the gold-standard mentality grew stronger as the crisis built.” Now would be an excellent time to replace masochism with common sense.
Coy is Bloomberg Businessweek's Economics editor.
