The last quarter of the 19th century witnessed a period of sustained global deflation. In the 1896 U.S. presidential election, William Jennings Bryan famously attacked the gold standard as the cause of deflation, declaring “You shall not press upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold.”
Today, Euroland is being crucified upon its own cross of gold – the institutional arrangements behind the euro. Those arrangements have distorted the monetary-fiscal balance, creating deflationary central bank dominance. That balance needs correction and failure to do so could even risk the viability of the euro in its current form.
The euro was introduced in 1999, the high-water mark of neoliberal economics. As such, its institutional design embeds neoliberal monetary theory which in many regards rests on the same economic principles as the gold standard. These principles are that fiscal policy is ineffective; inflation is caused exclusively by money supply growth; and the real economy quickly and automatically returns to full employment in response to negative shocks.
All three principles have been fundamentally discredited by the current recession. Around the world, countries have turned to fiscal policy to offset the collapse of private sector spending, and the recession would have been far deeper absent that fiscal response. Money supplies have risen dramatically almost everywhere without matching increases in inflation, showing that the money-inflation link is highly contingent upon economic factors such as unemployment, capacity utilization, commodity prices, and business expectations of profits. Finally, rather than rebounding to full employment, the global economy looks set for high unemployment that will last years. This possibility was Keynes’ message in his 1936 General Theory.
Owing to its neoliberal monetary arrangements Euroland has run smack into these economic realities. The European monetary union (EMU) establishes central bank dominance through an independent central bank that is prohibited from providing financial assistance to member country governments. Thus, whereas the US and UK have been able to finance their fiscal and financial market rescue plans with assistance from the Federal Reserve and Bank of England respectively, eurozone governments have received no equivalent assistance. Instead, they have had to fend for themselves in private capital markets, which has raised the costs of policy and dissuaded more aggressive action.
Not only do these monetary arrangements contribute to sub-optimal fiscal policy, they are also aggravating fissures within Euroland. The periphery economies of Greece, Italy, Portugal, and Spain, suffer from high public debt, large budget deficits, high unemployment, and lack of competitiveness. Capital markets are therefore driving up periphery country bond rates and aggravating their financial distress. Meanwhile, these economies no longer have their own exchange rate or interest rate to restore full employment and financial balance. Consequently, their sole internal adjustment mechanism is deflation, which is counter-productive in a situation of high indebtedness.
Given this, the stronger European economies must embrace expansion and act as an economic locomotive for the periphery economies. But instead, the European monetary system imposes a deflationary bias by restricting fiscal space, while Germany has shown persistent recalcitrance toward expansionary policies and exports deflationary pressures.
Part of escaping this trap requires rebalancing monetary-fiscal relations and increasing access to money-financed fiscal policy. To this end the European Central Bank (ECB) should establish annual country loan quotas set according to each country’s economic size and output gap, making them a form of automatic stabilizer. This would create a mechanism for countries to monetize part of their budget deficits. In the current environment it would provide a flow of low-cost deficit financing that would facilitate periphery country rebalancing, while also providing an expansionary impulse in Europe’s core economies.
Additionally, the ECB should establish emergency stand-by country loan facilities that would be governed by pre-determined policy conditionality. In effect, the ECB would act as an analogue International Monetary Fund (IMF) for euro member countries.
This has direct relevance for Greece’s current financial crisis. Having Greece borrow from private capital markets at exorbitant interest rates only compounds the country’s financial burdens. Alternatively, having the IMF bail out a euro-member country will damage the euro’s standing as a reserve currency and it too makes no sense. Greece needs euros to refinance its debt and the ECB is the logical source given it is the ultimate creator of euros.
Lastly, to counter potential inflationary consequences, the ECB could be given discretion regarding distribution of seignorage dividends resulting from issue of currency and bank reserves.
Monetary reform alone will not bring prosperity to Euroland. That will also require breaking with the neoliberal approach to labour markets and macroeconomic policy. However, monetary reform is a necessary ingredient and absent such reform Euroland faces stagnation and protracted high unemployment. Moreover, some financially weaker member countries may be forced to exit the euro because of financial market pressures or domestic political discontent. Either way, this could have potentially devastating global economic consequences, which means all countries have an interest in EMU reform.
(This article was published in the Financial Times, Economist Forum on 10 February 2010)