Tuesday, May 25, 2010

Golden Euro

Following the great stock market crash of 1929, the global financial system was in was in complete disarray and the world was flung into arguably the worst depression we will ever see. What did the gold standard have to do with it? How is this a perfect analogy for the modern day Euro?

First let me try to tackle the gold issue. There seems to always be a rabble of goldbug economists pointing to the gold standard as the magic bullet that will end our woes and return peace and stability to the world. Under a gold standard, they argue, our governments will be forced to maintain the value of the national currency, and not secretly, diabolically chip away at the fortunes of their citizens through inflation. Of course, what they don't realize is that 1) governments are just as trustworthy under both regimes 2) tying a currency to a (arbitrary) raw material removes the ability to combat recessions, ie. monetary policy and 3) This leads to deflation and deflation does not help the economy grow.

Now back to the history lesson:In 1931, when 13 countries decided to abandon the gold peg and pursue monetary measures, all of them experienced growth by 1932. The countries that stuck with gold, by contrast, experienced an average output decline of 15% in 1932. By 1936 there were three faithful left (France, Poland and the Netherlands) and by gosh they suffered for it. While all the de-gilded countries were growing, these three shrunk by 6% in 1936.

Ok, we don't really need ancient history to tell us deflation has terribly disruptive effects on the financial system. So to the moral of the story; monetary policy is key for fighting recessions. Nations like Greece, Spain and Portugal cannot pursue their own monetary policy. They are stuck to the Euro like they were to gold.

So not only is Greece suffering but now Germany is very angry (sorry for the poor source) because the Euro is being pimped out to help bail out the Greeks. Greece (Spain, Portugal, Italy...) would do better, if could escape with their banking systems intact, to throw off the shackles of the Euro, lest they forget...

Unfortunatly for countries up against the zero lower bound interest rate, monetary policy becomes ineffective, as Japan has found. This is when they should turn to fiscal expansion. But this is another argument for another day.

And yes, that is a gold vending machine.

HT: My professor, Joachim Voth

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