Euro: A 'loose cannon on the deck of the world'?

  • 27 September 2011
  • From the section Business
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There has been much crowing over the "death of neo-liberalism", but actually we are moving into a phase beyond the collapse of a mere ideology.

Actual physical systems that were seen as permanent in the old era are beginning to fall apart. The world of rules is being replaced by a world in which rules are made up.

Fortunately we have a precedent to learn from. That period in the 1930s where a prolonged Depression precipitated the high-speed collapse of trade, currency arrangements and international co-operation.

I've been re-reading Charles Kindleberger's The World In Depression 1929-1939. In particular the chapter on 1931 ("the abyss") and where the "Gold Bloc" (of France, Belgium and the Netherlands) collapses between 1933 and 1936.

Both episodes stand like cautionary monuments to the chaotic ending of currency arrangements, so that it is rational for people to say to each other in 2011, "let's hope we don't repeat 1931, or 1935".

But there is something positive to learn from this period too. How, in a period of uncertainty, it is only politicians who understand they are in a rule-free environment who have any hope of maintaining domestic stability.

Crucially, it is politicians and economists who understand the extraordinary power of currency who retain the freedom to act, and the ones that do not who do not.

In 1931 the crisis that started in the United States became a truly world Depression. At this point all the world's major economies had their currencies pegged to gold, which meant that:

a) They could not engage in competitive devaluation;

b) In the face of deflation they could not adopt expansionary monetary policy and

c) In the face of bank failures, they could not cope with rapid cross-border flows of funds without direct loans from each other - which were sometimes punitive or not forthcoming.

In 1931, as the Austrian bank Creditanstalt collapsed, pulling down the banks of Germany, Czechoslovakia, Hungary and Poland, a run on the German currency forced it off the Gold Standard in May, then the British Labour government struggled to maintain its currency peg - imposing austerity onto its own voters as the price.


Labour split, and fell, to be replaced by a coalition that, in the midst of a Royal Navy mutiny and a run on sterling, also left Gold. The US left in 1932. France and the Benelux countries persisted until 1936.

The most telling comment from the entire episode came from a stunned ex-Labour minister who, on hearing Britain had quit Gold, observed: "We didn't know you could do that."

Kindleberger also observes the haplessness of the French left when it came to currency. The Popular Front, coming to power on a wave of worker unrest in 1936, explicitly promised not to devalue the franc.

Weirdly, the strongest opponents of devaluation were the communists, who saw devaluation as the same as a cut in workers' wages.

"It was as if the Popular Front had been dealing with a closed economy," Kindleberger observes (page 252).

As it awarded its own workers real and immediate pay rises, and hours cuts, the Popular Front government had no policy to offset the global impact of this sudden hit to competitiveness. France was forced off Gold not long after, and that was the end of the Popular Front.

From this distance, what is interesting is to observe how confused politicians were as they moved from a world in which you were required not to have a currency policy into a world where currency policy was the key weapon.

They began to be able to do powerful things they had previously "not known you could do". Bilateral loans, overt trade protectionism, wrecking each others' economies with politically inspired runs on banks, currencies etc.

It is quite similar to the world we are moving into.

We have already seen the BRIC countries shore up their own competitive position with overt currency protectionism. China, of course, with its dollar peg, and Brazil with the imposition of capital controls to prevent the real rising against the US dollar.

Currency policy

Then, over the past 12 months, you have Quantitative Easing used as an overt competitiveness weapon.

QE in the US tanked the dollar against the BRICs, exporting inflation. Japan retaliated against American QE with its own QE, aiming to depress the yen. Finally the Swiss moved to depress their own currency against the euro.

The Brits had already depressed sterling by 20% against everybody else at the start of the crisis. But, of course, as with the modern trend not to declare war on those you are bombing, nobody is prepared to admit they have a currency policy.

Bit by bit, countries on the receiving end of appreciation are trying to take their currencies out of the free market. Meanwhile, the one area where there is a modern equivalent of the Gold Standard - the eurozone - is under extreme stress.

What you learn from reading the micro-details of the early 1930s is how immediately domestic social policy, banking and currency were related. A strike here, a wage rise, a run on this bank, the failure of this or that loan, even a moratorium on war reparations… it all becomes, instantly, a destabilising factor.

If you lock failing economies together in a currency union, is the lesson, you have to be very nimble to prevent the micro symptoms of failure destroying the union.

What does nimble mean in this context? For the Germans and Brits in 1931 it meant exit. Both Chancellor Heinrich Brüning and Prime Minister Ramsay MacDonald took their countries off Gold amid intolerable social crisis (the Invergordon Mutiny of 1931 was, directly, inspired by a Royal Navy pay cut dictated by defence cuts).

For the French, and to an extent the US, it meant being prepared to do adjust the rules of the currency peg, to do protectionism by other methods (the Smoot Hawley Tariff Act in the US in 1930 instituted trade protectionism, Glass-Steagall in 1933 was seen as a hostile act by French banking).

'A straw in the wind'

The lesson of the 1930s drawn by current Fed Chairman Ben Bernanke, when he was still an academic, is clear, those who devalued their currency first, recovered first.

It is an argument summed up in a celebrated graph beloved of the anti-Gold economists.

recovery current graphic
Inflation-adjusted industrial output

But we do not live in the 1930s. The world's trade, finance system and mass culture are so interconnected it is impossible to conceive of the retreat to national or continental "blocs" as in the 1930s.

For this reason, it is possible to under-estimate the hugeness of events like the Swiss franc currency peg, or the Brazilian capital controls, they do not look massive because they cannot be 1930s-style massive. But they are still a straw in the wind.

And where it leaves the eurozone is this - internally, the euro is the one major currency that has no strategy to save itself or defend itself.

Internally, the idea of expanding the EFSF through leverage, had to be pushed by the US and IMF. It was not thought up in Berlin and it will be resisted in Berlin.

Externally, the eurozone also has no strategy. It does not and cannot respond to the Swiss move, or to American QE. The European Central Bank (ECB) has a set of rules and a culture that is preventing it acting in the way other central banks do, to shore up the competitiveness of its own economy.

It cannot do QE, there are severe doubts as to whether it will be allowed to mortgage the future tax receipts of Germany to create the expanded EFSF.

The one logical move - to create a fiscal and political union - is not going to fit the time scale even if the north Europeans who will pay for it can be persuaded.

This is why US President Barack Obama said on Monday that Europe is "scaring the world". It reminded me of President Herbert Clark Hoover's famous quote in 1931, that Gold was "a loose cannon on the deck of the world, amid a tempest-tossed era". (Kindleberger page 148).

'Spiral of austerity'

In Greece last week, one woman who had seen her income halved said to me: "It would be a nice time for the politicians to be heroes."

You hear this a lot. People want leadership, clarity, decision, communication. A plausible course of action that is going to stop the spiral of crisis and austerity.

The tragedy of the 1930s was that, in each case, the politicians who found the freedom to act only did so they understood that the world of currency rules was over, and that currency policy was an indispensable tool for offsetting social unrest and gaining competitive advantage.

However, some of the actions they then took were not so pretty. As Kindleberger points out:

"Beggar thy neighbour tactics may lead to retaliation so that each country ends up in a worse position from having pursued its own gain." (page 10).

He points out that rules based systems need leadership. A country prepared to "set standards of conduct… take undue share of the burdens of the system… accepting its redundant commodities, maintaining a flow of investment capital and discounting its paper".

It was the decline of the UK and the retarded rise of the US in this regard, says Kindleberger, that prolonged the Depression. Absent one of the BRICs taking on this role, we may be stuck (and in Europe, absent German leadership ditto).

The big takeaway from re-reading a historical period like this is not that you should do a) or b), but that you should not let yourself get into a situation where neither a) nor b) works.