Tag Archives: Europe

What Germany can Learn from Interwar France

The story of interwar France should warn governments of the consequences of large capital flows in a fixed exchange rate area. It also reminds us how countries who have trade surpluses in this situation will deny the effects, and how deficit countries suffer as a result. These insights imply that if Germany wants to keep the Eurozone together, it needs to look past a moralizing story about Greek borrowing and instead accept that dramatically more expansionary monetary policy may be needed.

This post has three parts. I first discuss the theory of fixed exchange rates and how they played out in the interwar period. I then make comparisons to today’s Eurozone and conclude with implications for Eurozone monetary policy.

The Interwar Gold Standard

Under fixed exchange rates, capital flows are controlled by relative price adjustments. If the price level is low in a country, its exports become competitive. Goods flow out of the country as its central bank buys up gold from abroad. This continues until prices are too high and exports uncompetitive. Then prices grind down until they became competitive again. Savvy readers will recognize this as David Hume’s price-specie flow mechanism.

This is painful. Prices and nominal wages are downward sticky, and as such uncompetitive countries suffer through long stretches of unemployment and social unrest. As such, in the prewar gold standard there were “rules of the game” to ease adjustment. Central banks in trade surplus countries were supposed to expand monetary policy to raise their price levels. The trade deficit countries would then have an easier adjustment — they no longer had to lower their price levels by as much to become competitive.

A short note on how to think about balance of payments. Readers with an economics background might wonder how the trade surplus countries could also run a capital surplus. Aren’t they experiencing “gold inflows”? So there’s an excess of capital flowing in from abroad! This is incorrect intuition. The better way to think about it is that foreigners are giving their foreign currencies to domestic exporters in exchange for goods. The exporters, who cannot use the foreign currency on domestic purchases, instead buy up gold from foreigners with that currency. As such, “gold inflows” are actually purchases of foreign assets, and as such correspond to a capital deficit.

Back to the history. France destabilized the interwar gold standard by refusing to play by the “rules of the game”. Due to large fiscal battles in the immediate aftermath of the war, the Franc was forced to devalue several times. Eventually it settled at a level that made the Franc very competitive, and exports flowed out of France (read: gold flowed in). But instead of following the rules of the game and letting the French price level rise, the Bank of France sterilized the gold inflows, stuffing them under the proverbial central banker’s mattress.

From Irwin 2010, “Did France Cause the Great Depression”

This caused severe problems in deficit countries such as the UK and Germany. Since the French price level was not rising, the deficit countries were stuck with their trade deficits. And so while France boomed, the UK suffered through a mass strike of coal miners in 1925 and both the UK and Germany experienced mass protests of unemployed workers in 1929.

But French officials did not see this as their fault. I quote economic historian Douglas Irwin directly: “French officials such as Rist (1931) argued that the inflows represented confidence in their economic policies and that they were doing nothing to encourage the gold movement.” Or as Eichengreen describes in Hall of Mirrors: “If France enjoyed a balance-of-payments surplus, then this reflected the innate frugality of the French, who preferred saving over spending.”

The French government also argued that there was nothing they could do. The Monetary Law of 1928, which prevented government financing of fiscal deficits, tied their hands. As such open market operations were not an option†. While this may have been literally true, it also demonstrated how a deep fear of how monetary policy would simply finance fiscal expenditures.

Back to Present Day

In an ironic twist of history it is now Germany that runs a trade surplus. The deficit bug has traveled south to Spain, Italy, and Greece. For example, ever since the founding of the Euro Germany has had net exports at around 7% of GDP, whereas Greece has had net imports of around 15%.

This gap did not close because prices did not adjust in the correct direction. Unit labor costs stagnated in Germany while they rose in Greece. This was not a story of blistering German productivity growth. Rather, it was the result of purposeful restraints on wages.

From Shambaugh 2012, “The Euro’s Three Crises”

And so Greece was left with trying to adjust a roughly 30% gap in unit labor costs. Admittedly, the reason for Germany’s competitiveness is very different from the sharp devaluation that interwar France used. And the fact that Greece had a dysfunctional tax collection system does not help the moral case for further bailouts. But reversing trade flows in a fixed exchange rate regime is just as painful, no matter the initial cause of the trade balance.

That German policy makers are committing many of the same mistakes as French policy makers during the prelude to the Great Depression is, frankly, depressing. Again we see claims about national identity and thriftiness and a refusal to recognize the difficulty of current account adjustment. Again there is fear of monetary financing even though nominal GDP has fallen off a cliff. Lars Christensen also finds that French newspapers accused Germany of economic crimes in language eerily similar to what you might expect in a German paper today:

Germany reduced the national debt to nothing, then borrowed abroad on short terms credit which was invested on long terms, and is thus unable to repay her creditors. Now the enriched country merely declares it is insolvent and spits on Its victims

The solution must be monetary. Sustained inflation would allow sticky nominal wages in Greece to become more competitive. This would ease the adjustment process and make sure that Greece has the ability to finance its debt. Yes, it would incidentally be a “bailout” of Greek debt as debtors are now able to pay back with inflated euros, but the necessity of higher inflation to help with relative price level adjustment comes with the territory of a currency union. And yes, it would lower Germany’s overall competitiveness, but that’s just a part of the “rules of the game” that keeps a fixed exchange rate area together.

The Greek debt negotiations obscure the more fundamental dilemma facing the Eurozone: how do countries adjust relative price levels? History has shown that “natural adjustment” does not work — monetary policy must support the process. And so the question is whether policy makers are willing to shut out the echoes of interwar gold standard and come out in strong support of reflation in the name of preserving a currency union.

†See Eichengreen’s Golden Fetters, Ch. 7 “The Interwar Gold Standard in Operation”

Should Europe Utilize Quantitative Easing?

Quantitative easing is a measure taken by a central bank purchasing government securities in order to increase an economy’s money supply and, therefore, lower interest rates.

Aside from Greece, every country in the Eurozone’s long-term interest rates have fallen from their January 2014 rates. Some countries’ rates have fallen almost 2 and three-quarters of a percent, the average fallen amount among Eurozone countries (excluding Greece) being 1.77%. As many countries’ interest rates approach zero, quantitative easing fails to be as effective or even possible.

Governing Council member of the European Central Bank Jens Weidmann announced Thursday that the ECB will not be taking part in any quantitative easing strategies in the immediate future. The ECB would consider quantitative easing to remedy recent declines in inflation rates. However, Weidmann explained that these levels indicate disinflationary trends rather than deflationary trends. He attributes recent disinflationary trends with the falling costs of energy, which are temporary.

This comes after ECB executive board member Peter Praet explained that the ECB had “an obligation to act” to ensure it meets its remit of near 2% annual inflation for the region, he said.” Praet does not believe that inflation is caused by fluctuating energy prices.

Stephen Williamson, Vice President of the St. Louis Fed, argues that quantitative easing not only does not help disinflationary trends, it is deflationary in nature. His argument is as follows:

“when the Fed engages in quantitative easing it acquires securities held by investors in exchange for dollars. Investors will only accept those dollars, according to Williamson, if they believe the dollars will rise in value. Which is to say, the operation of QE seems to imply deflation.”

Senior Editor for CNBC John Carney argues that term premiums have much more to do with it. Investors will accept these dollars if term premium—the added return of holding long-term bonds over cash—shrinks. He believes that quantitative easing leads to shrinking term premiums and therefore it is a self-starting cycle that does not cause deflation.

I think Europe should not engage in quantitative easing until the deflationary period that Weidmann discussed ends. The risk of acting too quickly and not allowing other effects to take place would be hasty. The ECB should wait and see what will happen with energy prices and the cost of oil. Also, the ECB should observe Greece’s recovery and see if the Greece’s government will stick to the measures that have been placed on them and how that will affect the broader economy.

New Proposed Oversight Regulation Could Lead to Less Regulated Markets

A new law in the European Union is in the early stages of being implemented that will require, as Margot Patrick and Juliet Samuel write in their Wall Street Journal article, New Rules Reshape Research Sector, “investment managers, such as those at hedge funds, to pay specifically for any analyst research or services they receive.” Some people are claiming that this law will be good by fixing an old outdated system where as Matt Levine writes in his article, Valuing Analysts and Hedging Death, “High finance operates on basically a gift economy, in which many goods and services — sports tickets, strategic advice, jobs for relatives, investment banking research — are given away to create goodwill in the recipient. The recipient is then supposed to reward the donor with lucrative merger mandates or trading commissions, but not in a straightforward transactional way. That would be crass. This is about relationships, not a mechanical balancing of accounts.” While I agree that this system is outdated, I am going to argue that this new law is going to lead to less regulated markets in two distinct unintended ways that create a system worse off than before.


The first unintended consequence of this law will be that some people and organizations will get information before others. Whoever pays the most will have first access to research and therefore be able to act on this research before others. This will create an even greater imbalance in the stock market towards large institutional investors (such as hedge funds) over individuals. The large hedge funds will be able to pay the most for this research and act upon it before others may even receive this research. This will lead to a market where firms pay extra to have these research reports before their competitors. You could have already purchased a report, but not received it because your competitor paid twice as much to receive it before you. This will create an imbalance and a largely unregulated market of firms having access to more resources and research than their competitors, not leveling the playing field in the slightest.


The second consequence of this law will be that it “could be most damaging for small brokers, particularly those specializing in less-traded stocks from smaller companies. Those brokers could end up out of business, if money managers use less research and fewer providers, industry officials said.” This will not only be devastating for smaller brokers, but will create a relatively large sector of smaller companies whose stocks don’t trade as frequently largely unregulated. This will leave certain companies without any research done on them, which could potentially leave companies susceptible to being part of a bubble because of lack of research on them. At the very least this lack of research will reduce the amount of transparency in this part of the market, the opposite effect of this new law.

Still Tough for Europe

Europe expects to raise its economy due to the lowering euros and the slumped oil price. Because of the disastrous crisis in 2008 globally, many European countries were immersed in a big troublesome. Greek, Spain, Italy, Portugal and so on, were suffered from essential pressure of debt. People lost credibility of their governments, which endured budget deficit badly. The oil price dropped tremendously from the end of last year in an unbelievable speed. However, Europe seems can gain something unexpectedly from this kind of circumstance. “‘Europe’s economic outlook is a little brighter today than when we presented our last forecasts,’ Mr. Moscovici said. ‘The fall in oil price and the cheaper euro are providing a welcome shot in the arm for the EU economy.’The commission said lower oil prices should boost corporate profits and household incomes in Europe, which is a large net importer of oil. A weaker euro should boost European exports.”(http://www.wsj.com/articles/eu-raises-eurozone-growth-forecasts-1423131184)


Without comprehensive learnings, those inferences are seemingly rational. However, if we can view this issue in a more profound way, there are many flaws in it. Admittedly, if euros goes down, then European exports will be more competitive since the relatively cheaper price. Increasing price will hopefully fueled European economy a lot. Wait! We should not only consider about exports, which is one of the most important part of economics. Let’s analyze the investment. If euros keep falling, then nobody will want to get it but change it to other kinds of currency. Then no euros will be saved in the bank thus no investment can be made. Moreover, foreign investors will retrieve their money in euro zones. This will make a significant hurt for European countries.

Falling oil price looks like a perfect chance for European countries to surge their industry and manufacture. As the price of oil goes down, the expenditure of sources will be cheaper and cheaper. But in another point of view, when oil price keeps slumping, more and more investors and entrepreneurs are readily hoping invest more and produce more in the future since the price of oil is expected lower further.


Furthermore, the inner relationships between European countries are not so well. “The ECB announced on Wednesday evening that it would no longer accept Greek government bonds as collateral for its loans to banks in the country. While freshly recapitalized—partly with bailout money—Greek banks still rely on the central bank for short-term loans that keep them operating from day to day. That reliance now threatens to reduce the new Greek government’s ability to bargain with its euro zone creditors.”(http://www.wsj.com/articles/ecbs-squeeze-hampers-greeces-bid-for-debt-relief-1423171743) Every country want to keep more money in their own pocket. Though everyone knows that increasing liquidity of money can produce more money, nobody want to take the risk of being the victim of giving free-ride to others. Therefore, do not put much reliance on falling euros and oil price to revive Europe.

Will Europe Finally Join the QE Bandwagon? (Revised)

Europe has struggled to rebound from the Great Recession.  A few years ago, it appeared that the EU and the United States were recovering at roughly the same pace, as shown by this graph of World Bank data on GDP growth rates.  In 2012, the EU dropped off of the path to recovery, posting a -0.4% growth rate, while the United States continued to chug on at around 2% growth per year.  This divergence was largely a product of the two different policy approaches taken by the central banks of each economy.  In the US, the Fed engaged in three separate rounds of large monthly bond purchases, or quantitative easing, with the goal of expanding the money supply and lowering interest rates.  In contrast, the European Central Bank responded with the European Financial Stability Facility to provide liquidity to EU members, and several European states undertook austerity policies.  It may be slightly naive to attribute all of the US economy’s recovery to QE, but it certainly appears to have been incredibly effective.

So why did the EU not even attempt QE while the Fed was rolling out several rounds of it?  One big obstacle that the ECB faces is the fact that it is composed of a multitude of national central banks, making it far more difficult to coordinate asset purchases.  However, it appears that the time may have finally come for the European Central Bank to enlist the help of QE.  As reported in the Wall Street Journal, the ECB’s executive board has proposed a 12-month (at minimum) round of QE, composed of asset purchases of €50 billion per month.  The bank’s governing body will meet Thursday to discuss the proposal.  As noted by MIT professor Athanasios Orphanides in the Journal article, “the potentially open-ended nature of the program—the idea the ECB could continue beyond a year—is a bright spot that could give the program additional power”, since many economists believe one of the core strengths of QE is the effect on the market that expectations of aggressive future monetary policy can have.  More specifically, a central bank indicating that it wishes to keep interest rates low will have far more credibility if it is engaging in QE, since it is exposing itself to the risk of losses on the assets it’s buying up if rates were to rise, as pointed out by an article in The Economist that gives a fantastic overview of the implications of QE.

As news of the potential ECB actions broke, the euro fell against the dollar – good news for the multitude of European states that rely heavily on exports to fuel their economy.  Italian prime minister Matteo Renzi was one of those who welcomed the news, who claimed that he dreams of parity between the Euro and the Dollar in an interview with the Wall Street Journal earlier today, believing that it would grant Europe greater economic flexibility.  However, it is not good news for everybody – German officials oppose the ECB plan, as noted in the first Journal article, since German taxpayers have concerns that they would be responsible for the more risky debt of other European countries.

Since I originally wrote this post, the official ECB press release has been issued, and thus some new pieces of information have emerged.  The official plan is more ambitious than what was originally proposed by the ECB exec board: the monthly purchases will be €60 billion each, and will continue through September 2016 at minimum, far longer than the original 12 months.  This would result in about a €1.1 ($1.24) trillion injection into the eurozone, making it about 75% the size of the Fed’s QE3 program (which was roughly $1.7 trillion), in a very similar format.  The Germans are likely to be pleased with the loss-sharing arrangement: only 20% of asset purchases will be subject to risk-sharing, which, in my opinion, is a necessary arrangement to ensure that every member of the monetary union is convinced.  It’s worth noting that the ECB is strictly targeting inflation with this policy, whereas the Fed’s primary goal with QE was to put downward pressure on interest rates.  It is this disparity in policy goals that leaves me with doubts about how effective QE will be for the eurozone: interest rates are already quite low, so the ECB stands to gain little ground in that respect.