Thursday, February 6, 2014

The Euro as artificial gold standard (for better and worse)

2011 Nobel memorial laureate Thomas Sargent said of the Euro in an interview that:
The euro is basically an artificial gold standard. 
The Euro is a fixed exchange rate system where member governments have no control over the supply of the medium of account -- the medium of account being:
 the ultimate standard of value; it could be gold or silver or copper or dollars or pounds. All prices for monetary exchange are quoted in terms of the medium of account.
Or, slightly more precisely:
The unit of account is the word used to quote prices, make contracts, and keep accounts.
Dollar is a unit of account.
The medium of account is a good (or bundle of goods) that is used to define the unit of account.
[If] A dollar is 1/20th of an ounce of gold. The dollar is the unit of account and gold is the medium of account.
In the Eurozone, the Euro is the medium of account and it is controlled by the European Central Bank (ECB), not the member governments. So, the Euro is indeed, in effect, an artificial gold standard. 

For worse
But the Euro is worse than the gold standard in two ways. First, it is a lot easier to leave the gold standard -- one simply stops pegging one's currency to a set quantity of gold. Leaving the Euro requires issuing an entire new currency. Which has been done (e.g. when states breaks up), but involves a lot more effort and transitional problems than simply announcing in a press release that one's currency is no longer redeemable for a given quantity of gold.

The second problem is that, given central banks effectively control aggregate demand (i.e. the level of nominal -- i.e. money -- spending), the Euro can be managed to suit a particular economy rather than the Eurozone economy as a whole. Which is precisely what is happening. The ECB concentrates on managing German aggregate demand, and everyone else just has to cope -- so the more like the German economy yours is, the better Euro-aggregate-demand works for you. The less like the German economy yours is, the worse Euro-aggregate-demand works for you.

This is worse than the gold standard because central banks in the gold zone could set interest rates and, in extremis, change the currency/gold exchange rate to specifically tailor monetary policy to their circumstances. Moreover, since the currency was the medium of exchange but not the medium of account, notes could be issued to suit the demands of exchange without affecting the value of the medium of account (and so every transaction denominated in said medium). None of these options -- or any equivalent -- is open to members of the Eurozone. If the ECB decides that it will manage aggregate demand to suit Germany, then that is what happens and everyone else just has to accept the consequences.

For (mostly) better
There is one way that the Euro is better than the gold standard. The Euro operates under a inflation targeting monetary regime. Inflation targeting is less stable in the long run than the gold standard -- the compounding effects of (say) 2% inflation per annum are going to be much greater than the long run tendency of the gold standard to 0% inflation. It is, however, more stable in the short run than the gold standard. 

Under inflation targeting, the price level will change at about the inflation target -- typically, 2% pa. While gold production tends to be relatively stably a small proportion of gold supply (hence its long run stability), gold demand can shift dramatically -- particularly if a few central banks dominate gold stocks, as happened in the interwar period.  A big enough shift in gold demand can see dramatic changes in the price level in gold standard countries -- this is what happened in the Great Depression, where wholesale prices declined 30% in three years as the gold-hoarding policies of the Bank of France, with the acquiescence of the US Federal Reserve, drove up the demand for gold (the medium of account in gold zone countries). Driving up the value of the medium of account means driving up the value of money and so driving down the value of goods and services (i.e. the price level). 

That inflation targeting is more stable in the short run than the gold standard is why the Great Recession has not been as bad as the Great Depression. (Since if prices do not collapse to that extent, neither do incomes.)

Unless, of course, you are Greece, the Eurozone country whose economy is least like Germany's, where price (and so income) collapses are heading towards Great Depression levels. Leading to Great Depression politics. The way in which the Euro is better than the gold standard, for Greece, not so much.

The DM for everyone
The appeal of the Euro was that one could sign up for a Deutsche Mark for everyone (who joined). Just as the appeal of the gold standard in the 1870s was a pound sterling for everyone (who joined). It turns out that signing up for the Euro-as-inclusive-Deutsche-Mark also meant signing up for as-it-suits-Germany monetary policy. Not nearly so much fun.

People eventually bailed on the gold standard because signing up for being locked in with the insanity that was French monetary policy turned out to be a really bad idea. But countries could bail simply by issuing a press release. The Eurozone Deustche-Mark-for-everyone is a much harder shared-disaster to exit, if less of an actual disaster.

No comments:

Post a Comment