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.
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.
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”