Wednesday, October 16, 2013

Back to the Future--Eurozone Edition

Now that the debt ceiling and government shutdown crisis has basically been averted, I thought I'd take a bit of time to talk about something other than the sorry state of affairs in our government and instead talk about the sorry state of affairs in the Eurozone. What actually spurred this post was a passage from Paul Krugman's 1996 book Pop Internationalism. In it, Krugman discusses something called the European Rate Mechanism (ERM for short). Obviously, your first question is probably "what's the ERM?"

In a nutshell, the ERM was essentially the precursor to the Euro, with a few key differences. First, instead of the Eurozone countries adopting a single currency, the participating nations all fixed the values of their currencies to the value of the German mark. Without getting too technical, they'd do this by having their central banks buy and sell German marks to maintain a steady value of their own currencies. In any case, the key insight here is that every country that chose to do this gave up their ability to conduct monetary policy. To use an example closer to home, imagine if the Fed couldn't cut interest rates during a recession or raise them to head off inflation. 

So why did they do this? Well, on the face of it, it was an effort to further unify Europe into a common market. They chose the German Mark because the Germans, due to their unfortunate history with inflation, (see: Republic, Weimar) were exceptionally vigilant in fighting inflation, which, during the 1980s, was a serious problem in most of the industrialized world. So by pegging their currencies to the mark, these countries also sought to bring inflation down to more tolerable levels. And after a bumpy start in 1979, things seemed to be going well for Europe. Inflation was down across the board: 
Without getting too bogged down in the details, things went fairly well in Europe until the fall of the Berlin Wall. With Germany unified, the costs of supporting and rebuilding the eastern half of the nation represented a massive fiscal expansion on the part of the Germans. To head off the inevitable inflation that would result from this, Germany's central bank raised interest rates sharply. The problem was that the rest of Europe, in keeping with ERM rules, was also forced to raise interest rates to keep their exchange rates in line with the Deutsche mark. But without the same fiscal expansion that Germany was pursuing, this led to a severe recession for the entire continent, in which the UK was ultimately forced to leave the ERM and sharply devalue the pound.

At this point, some of you may be picking up on some seemingly eerie parallels to this story. Just to recap, in 1979 you had several European nations forfeit their monetary independence to Germany to further unify Europe and help fight inflation. It worked well for about 8 or 9 years and then there was a crisis. In that crisis, Germany pursued a monetary policy that was appropriate for itself but not for anyone else in Europe.

Tweak a few of those details and you'd be looking at the Eurozone today. In a nutshell, the Eurozone was formed when several European nations forfeited their monetary independence and adopted the Euro. The Eurozone's monetary policy is set by the European Central Bank, which is in Frankfurt, Germany. Things went pretty well for about 8 or 9 years from 1999 to 2008, but then a severe crisis set in. The ECB cut interest rates during the early part of the recession, but then decided that since Germany's unemployment rate was comfortably below 6%, it should raise interest rates in the spring of 2011 to head off inflation, triggering one of the most acute phases of Europe's crisis to date. A crisis, I might add, that is still very much a reality, in spite of being out of the limelight for many months. 

In short, Europe has learned nothing from the lessons of its past. It threw itself all too willingly into a monetary system that its policymakers knew from experience probably would end in a crisis. And that might just be the most damning thing of all.