After an initial period of growing success with a system of fixed exchange rates, the European foreign exchange markets have been plunged into chaos, and the future of the much-heralded Exchange Rate Mechanism--and the European Monetary Union it was supposed to lead to--has been thrown into doubt.
The manner of this breakdown of a fixed exchange system in many ways offer an eerie parallel to the breakdown of the gold standard--the fixed exchange rate system par excellence--in the 1930s. How close is the parallel?
On July 9, 1896, William Jennings Bryan urged that the United States switch from the gold standard to bi-metalism--the use of silver as well as gold as backing for the nation’s currency. In bidding for the Democratic presidential nomination, he thundered, “You shall not press down upon the brow of labor this crown of thorns; you shall not crucify mankind upon a cross of gold.”
Bryan lost the argument, along with the election. But within 40 years, much of mankind was indeed “crucified upon a cross of gold,” as the adherence by the major industrial nations to the gold standard contributed to turning what may, in other circumstances, have been a manageable downturn into the Great Depression.
The years when the gold standard was the basis for the international currency system, from the middle of the 19th Century through 1914, are often presented as a truly golden era of low inflation and international financial stability. But this apparent success may well have been due to fortuitous factors: The deflationary bias of gold was relieved by the development of new gold sources in South Africa, and London exerted unquestioned dominance over the international financial system.
Eventually, however, Britain could no longer support the gold standard, and in the 1930s, concomitant with the fading of British economic leadership, a different deflationary threat arose. In the absence of any discretionary fiscal policy, it was through monetary actions that governments directed their economies.
In the heyday of the gold standard, countries in receipt of gold inflows--and especially Britain, which, as the world’s most stable economy, was often in this position--allowed their money supplies to increase and their economies to expand, offsetting the contractionary impulse in the country or countries losing gold.
The gold standard broke down between World Wars I and II when the new “gold powers,” the United States and France, accumulated huge quantities of gold but “sterilized” it--that is, prevented it from boosting their domestic money supplies. The deflationary shock given to the countries losing gold was no longer offset by a reflationary stimulus in the gold recipients; the entire burden of adjustment fell on the deficit countries.
This asymmetry imparted a deflationary bias to the gold standard’s impact on the world economy, helping to suck the world into the Great Depression.
Despite the failure of the gold standard, and later the Bretton Woods accord, the sheer volume of trade within the European Community has long kept Western Europe committed to re-creating a fixed exchange rate system. In addition, the motive of squeezing out inflation by pegging one’s currency to the German mark became increasingly important in the 1980s. But a key similarity between the gold standard and the ERM gives one pause: The common denominator of the gold standard in its latter days and the ERM is their asymmetry in the absence of a leading country prepared on occasion to put domestic concerns second to the needs of the international order.
No leader emerged in the 1930s, willing to take responsibility for the system as a whole. Similarly today, while Germany is the undisputed leader of the ERM, the Bundesbank appears to pride itself on determining its actions entirely on the basis of the German inflation rate.
Under the Bundesbank’s rigorous policies, there is an effective shortage of marks relative to ERM members’ need for liquidity, and the effect of this shortage is to impart a deflationary bias to the ERM.
Continuing the parallel, the 1930s gold bloc of countries that continued to put their faith in gold whatever the deflationary cost has been reincarnated almost country for country as the core group of the ERM. (Indeed, the complete absence of debate over the merits of staying on the gold standard in, for example, France in the 1930s is mirrored in the across-the-spectrum acceptance of the need to stay in the ERM among French politicians today.)
With the end of the booms in anticipation of 1992, and then from German reunification, Europe faces a real danger of lapsing back into “Euro-sclerosis.” The deflationary tune is being called by a highly inflation-averse Germany, whose economy--to make matters worse--has gotten out of step with the economies of other members.
The French and the rest keep hoping that by shadowing the mark so tightly for so long, they will ultimately get their reward in the form of European Monetary Union and a European central bank--that is, they will finally be able to wrench the levers of European monetary policy out of the parsimonious hands of the Bundesbank. But it remains to be seen whether the Germans will agree to give up the Bundesbank, the totem of their postwar economic miracle.
If the Bundesbank retains its leadership, economic growth among ERM members in the 1990s is likely to be dragged down by its tight money policies.
In the 1930s, most of the gold bloc held out for five years after the British devaluation of 1931, at great cost to their domestic economies. Following the September, 1992, British devaluation, more or less the same countries are declaring their intention to cling to a fixed exchange rate standard once again.
If they do, the outlook for growth in Western Europe is likely to remain bleak. And it would not be surprising if, in a final parallel with the years that marked the demise of the gold standard, some or all of these countries were eventually forced to sever their currencies’ link with the mark-dominated ERM--the new “cross of gold.”