Some describe the period between the 1870’s and the first world war as a golden age of international trade and early globalisation with relatively low barriers to trade and great improvements in living standards across the rich world. All that trade was made possible by the wide adoption of the gold standard, which made exchange rates stable enough that one could engage in foreign trade with low risks. While the gold standard is long gone in Europe there is still widespread international trade with the use of a similar fixed price currency regime: the Euro. In this blog post I will attempt to explain the benefits and problems the gold standard and then the Euro, and why I’m convinced that the Euro will inevitably lead to its own destruction.
The gold standard was in some ways a brilliant currency regime. Commodity currencies like bank notes which can be exchanged for gold have the benefit of having an actual tangible and definitive value unlike fiat currencies, i.e. paper money that is only worth something because the government says it’s worth something. This creates a stability in the value of money and assures that the rate of inflation is limited to the speed at which new gold is found and excavated, assuming that the government will continue the gold standard without fail for the forseeable future. As with independent central banks, having a commodity as the base for a currency makes hyperinflation unlikely which is great as hyperinflation harms those who have to endure it tremendously, Venezuela is a good case in point. Another strength of a wide scale adoption of a gold standard is that it makes trade easy as exchange rates are always exact and constant.
That being said there are also some quite major drawbacks to having a gold standard. For example, if a country has a negative trade balance, meaning that it imports more than it exports, then it essentially exports gold in exchange for the goods it buys. This means that it will have to decrease the amount of money in circulation as there is not enough gold should all the citizens want to exchange their money for gold. This causes a vicious cycle in the form of deflation which will lead to less economic activity and thus high levels of unemployment until the country cannot afford to import goods and thus the system corrects itself. Those drawbacks are only endured in a society where either people are fine with very high levels of unemployment or where the people have no say in how affairs are run, but in a democracy people typically prefer low unemployment which brings us on to the EU and the Euro.
The Euro is a fiat currency which might at first make it seem like it has little in common with a gold standard regime. However, with some abstraction we’ll find that it is in some ways functionally very similar. Imagine a Eurozone where there are still national currencies like the Italian lira and the Finnish markka except they are all pegged to the Euro at a fixed rate. The Euro in essence cuts out the middle step between the commodity backing the different currencies and the national currencies, which for practical reasons wasn’t possible with the gold standard. This means that the Euro gets some of the advantages and drawbacks of a fiat currency and some of a commodity currency (mainly when it comes to Eurozone trade). As the Great Recession and the subsequent Eurozone crisis showed, the Euro has led to extraordinary unemployment levels in some mainly Southern European states. In some ways the same mechanisms which sort out trade imbalances in a gold standard system are at play in the Eurozone except that it can’t self-adjust as there is no gold to export and the govrenments cannot fix it as individual governments cannot control their exchange rates.
When the Euro was formed the implicit exchange rate between the national currencies and the Euro were fair, i.e. a euro represented the same value across the Eurozone. Since then though, the implicit exchange rates between the Eurozone economies have changed and the Euro system has no way of adjusting to those changest. After the Great Recession the productivity that a set amount of Euros could buy has changed across the different Eurozone member states without that being reflected in the currency. This greatly benefits the most productive and developed countries at the expense of the least productive and developed countries. If the implicit exchange rates between the German economy and the Greek economy was fair in 2002 then it seems that it wasn’t during the Eurozone crisis. If it was then surely the Greek economy could compete with the German economy and avoid such extreme levels of unemployment? I think that the Eurozone crisis made the Greek implicit exchange rate overvalued, meaning that you could buy more or better goods and services for the same price in other Eurozone countries which is why the Greek economy fared so poorly.
This problem could be avoided entirely by having national currencies and sovereign control over monetary policy as that would enable the states which have overvalued currencies to adjust their currencies to be competitive again, thus sparing them from long bouts of economic hardship. Unfortunately, the problems of overvalued implicit exchange rates are not going away and were not unique to the Eurozone crisis, in fact I’d wager that they will worsen over time as things change and the implicit exchange rates established in 2002 become less and less relevant. There is a historical precedent here, the reason that the return to the gold standard in the interwar years failed was that some of the currencies, like the pound sterling, were brought back at their pre-war rates which made them overvalued. All in all, I think national crises due to overvalued implicite exchange rates will come again and be progressively worse until there comes a point where the people direct their anger towards the EU and/or the Euro. In fact, we already see a government in Rome which has toyed with the idea of abandoning the Euro.
The Euro is a beautiful idea, that all of Europe could come together with a common currency to become more interconnected and more prosperous, but the reality is that a common currency only works if it’s in the more abstract form of a common commodity base or inside of a single state. There’s no doubt whatsoever to me that the Euro will continue to produce problems for the weaker Eurozone members until the day they finally realise this and abandon it.
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Text by Karl Johansson, Founder of Ipoleco
Text by Karl Johansson, Founder of Ipoleco
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