Originally posted on Thursday, December 06, 2012
A recent Bank of Greece working paper makes a striking contribution to the scholarly discourse around the gold standard … as well as some trenchant observations about the Eurozone crisis in which the nation of Greece is very much at the epicenter.
George S. Tavlas, from the Bank of Greece, and Harris Dellas, from the University of Bern, produced a working paper, numbered 149, recently for the 30th annual Cato Institute Monetary Conference, entitled “The road to Ithaca: the Gold Standard, the Euro and the origins of the Greek sovereign debt crisis.” There is much to note about this remarkable, and immediately relevant, piece of scholarship.
First, although it does not necessarily represent the views of the Bank of Greece or the University of Bern it is a credit to the intellectual honesty of these institutions. And since Greece is at the epicenter of the Eurozone crisis, the Bank of Greece especially is to be commended for lending such honest scholarship to the discernment of the source of the besetting problems.
Second, it is remarkable that while the imperfections of the gold standard are duly noted so are its strengths. This is empirically-based scholarship of a high order, refreshingly different from the hyper-theoretical, and even doctrinal, work that depreciates so much of the literature.
Most strikingly, however, may be the ways in which it serves as a counterpoint to the argument put forth, last April, by justly esteemed Prof. Harold James, of Princeton, Golden Rules for the Eurozone, as published by Project Syndicate, commencing with the observation and question, “The European Monetary Union, as many of its critics maintain, looks a lot like the pre-1913 gold standard, which imposed fixed exchange rates on extremely diverse economies. But is that resemblance as bad as it sounds, or as the euro’s critics insist?”
The key insight from Tavlas and Dellas with which to embellish Prof. James’s observations may be in the manner it quietly dispels a false cognate that has been made, not necessarily by Prof. James (who has published intelligent observations about the classical gold standard) between the Eurozone system and the gold standard: Countries with external deficits would experience higher interest rates, a loss of gold reserves, and lower money and credit growth. The resulting reduction in wages and prices would contribute to the restoration of trade competitiveness. This mechanism was not operative in the case of Greece under the euro exchange-rate regime.
The paper’s epigram:
The planners of a European monetary union would be well advised to study the reasons the pre-World War I gold standard was a successful monetary regime….
— Anna Schwartz (1993)
Its Abstract:
The origins of the Greek-sovereign debt crisis were the country’s large fiscal and external imbalances. The key factor that abetted those imbalances was the absence of a short-to- medium term adjustment mechanism — due to perceptions of sovereign bailouts — in the euro-area that would have reduced members’ external imbalances. This situation contrasts sharply with the adjustment mechanism under the classical gold standard. Under the gold standard, countries with external deficits would experience losses of gold reserves, higher interest rates, lower money and credit growth, and reductions in wages and prices, which helped restore trade competitiveness. We draw two main conclusions. First, the durability of a monetary union is crucially dependent on the existence of a well- functioning adjustment mechanism. Second, adherence to a hard peg is no panacea and cannot be sustained without the support of credible fiscal institutions.
Its conclusion:
The experiences of the core and periphery participants in the classical gold-standard regime are relevant for the euro area. The behavior of the core participants has been quite similar across the two monetary arrangements (i.e., small budget deficits, or even surpluses, sustainable current-account balances). Under the gold standard, European peripheral countries ran current-account deficits, but the size of these deficits was small — relative to those experienced by Greece under the euro regime — because fiscal shocks were smaller and, more importantly, because the adjustment mechanism while imperfect, worked to mitigate the build-up of external imbalances. Countries with external deficits would experience higher interest rates, a loss of gold reserves, and lower money and credit growth. The resulting reduction in wages and prices would contribute to the restoration of trade competitiveness. This mechanism was not operative in the case of Greece under the euro exchange-rate regime. In the euro zone, the market’s perception that Greek sovereign debt represented a safe investment — probably founded on the expectation of a bailout by core countries — suppressed the effect of sovereign credit risk on Greek interest rates. At the same time, low interest rates greased the wheels of fiscal expansion by sending the message that there was no price to be paid for the build-up of sovereign debt. Hence, while external imbalances were essentially self-correcting under the gold standard, they were self-perpetuating in the euro area due to the perception of an absence of credit risk.
We draw two main conclusions. First, the durability of a monetary union is crucially dependent on the existence of a well-functioning adjustment mechanism. Second, adherence to a hard peg is no panacea and cannot be sustained without the support of credible fiscal institutions.
Indeed, the durability of a monetary union is crucially dependent on the existence of a well-functioning adjustment mechanism.
Even the intellect of the world’s best economists and officials has yet to offer an adjustment mechanism as empirically proven reliable as that of the classical gold standard.
The time has come to consider the workings of the gold standard with greater attention and to return it to consideration as a policy option.
Tavlas and Dellas here may be setting an important precedent.
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