We recently wrote an article called Austerity + Gold Standard = Greece, which ruffled some feathers. The heated reactions testify to this, such as "worst author/article ever posted on Seeking Alpha" and the like.
It's a little bit of a pity that the author deemed that comment so self-evident he didn't find any substantiation necessary. While we are aware that one cannot please everybody all the time, we're still quite bemused by all the fuss. In essence, what we argued was really quite uncontroversial.
It starts off from a comment of Evans-Pritchard in the (conservative) British newspaper The Telegraph:
Greece has been subjected to the greatest fiscal squeeze ever attempted in a modern industrial state, without any offsetting monetary stimulus or devaluation.
Now, we made three observations that we deemed to be rather completely uncontroversial.
Fixed exchange rate regimes
The fact that Greece couldn't offset the effects of "the greatest fiscal squeeze ever attempted in a modern industrial state" is the result of it being a member of a fixed currency system, the euro. Being member of the euro doesn't allow Greece to embark on monetary stimulus (lower interest rates, quantitative easing, whatever), nor can it devalue its currency.
With that respect, Greece is in exactly the same predicament as countries under the Gold Standard in the 1930s were. The only difference (pointed out by the excellent Lawrence J Kramer), is that it was way easier to leave the Gold Standard than it is to leave the euro. Which is why most countries indeed left the Gold Standard in the 1930s, and we provided some empirical evidence that the sooner they did, the faster their economies recovered. They left for a reason and were better off as a result.
Many commentators embarked on long historical digressions about the workings of the Gold Standard, but nobody has been able to conclusively refute the above rather simple and straightforward observation.
We could add by asking the following question: If Greece today would have been a member of a Gold Standard, rather than the euro, would it still be in it? Or alternatively, if it would be a lot easier to leave the euro, wouldn't Greece be out already?
While the answer to these questions seem intuitively obvious (a resounding yes, if you had any doubts), we can point to a couple of cases to compare:
Argentina coupled its currency 1:1 to the U.S. dollar in the 1990s and held onto that (for too long). While severing the ties to the dollar and defaulting on its debt wasn't exactly cost free, the ensuing devaluation ensured that the economy recovered rather remarkably (growing twice as fast as Brazil in the last decade, even if Argentina has wasted chances to reform the supply side for which it is now facing considerable problems again).
Iceland never had the Euro, but its banking crisis was bigger even than Ireland's. But currency devaluation and monetary autonomy were crucial ingredients in restoring economic growth, while euro members like Greece, Portugal and Ireland are still mired in recession (or even depression).
Any fixed exchange rate system, whether easy or near impossible to leave, can become quite constraining, at times. This is one of its attractions. For instance, Argentina had a history of runaway inflation and falling currency. By tying the peso to the U.S. dollar, it hoped this would serve as a disciplining device.
This policy can be successful. After a history of falling currency value and higher inflation, France took its ties to the German Mark more seriously under Delors from 1983 onwards, and that policy is generally considered a success. But France basically had to give up its monetary independence to do that, having its monetary conditions set in Germany. This state of affairs has been a main impetus to create the euro, at least the French (and Italians) would have a say at the board of the European Central Bank (ECB).
There are times that a fixed currency system can become quite constraining. There are good reasons why countries left the Gold Standard in the 1930s, or why Argentina gave up its peg to the U.S. dollar, and history has proven them right.
The origin of the constraints
Basically the constraints set in when a country accumulates higher inflation than its most important trading partners, losing competitiveness in the process. This can be the result of policy mistakes (and Greece really is a prime example here), but it can also result from asymmetric shocks of no fault of the country.
For instance, just when the U.K. joined the exchange rate mechanism (ERM) in the late 1980s, effectively tying the pound to the German D-mark, the U.K. entered a recession (as did most of the world) while Germany started to experience a boom caused by the spending on German reunification.
To rein in an overheating economy, the Bundesbank increased interest rates, which put the U.K. (and a few other countries, like Italy) to a very awkward choice. Either keep its membership of the ERM and match the higher interest rates, but deepen the recession, or devalue the currency.
In the end, speculators like Soros forced the issue and the pound (and lira) left the ERM altogether, and a year later the fluctuation bands in which currencies were allowed to move within the ERM were greatly expanded after another crisis.
But had the euro been in place or a Gold Standard, policy would have been quite constrained.
Another example is that of the eurozone periphery. Entering monetary union (the EMU) removed the currency risk on investing in Greek, Portuguese, Spanish, Italian, Irish etc. assets. Since the currency risk pre-EMU was considerable for these countries, this made their assets much more attractive- overnight. The result was a huge capital inflow, the mirror image is a worsening current account balance.
All these capital inflows were first seen as rather benign, as the flows were roughly from the rich center to the poorer periphery, they were seen as a natural process of adjustment and a mechanism of producing convergence. However, the capital flows created property bubbles (Spain and Ireland) and higher inflation, widening trade deficits and causing a loss of competitiveness.
And now, while a simple devaluation could restore much of the balance, these countries are forced, by 'virtue' of their eurozone membership, to enforce deep austerity and 'internal devaluation' (that is, cutting wages and prices), "without any offsetting devaluation or monetary stimulus," as Evans Pritchard from The Telegraph had it.
Is this a terrible constraint on policy, enforcing austerity? You betcha!
What's more, membership of the euro has caused something else in the periphery too. While countries like Spain and Ireland had budget surpluses and low debt, by the 'virtue' of being a eurozone member, their debt is effectively in a foreign currency, one they do not control.
This state of affairs increases the default risk simply because the eurozone countries cannot, like countries who are masters of their own monetary affairs, print money to pay off debt. When this started to sink in on the financial markets (when talk of a Greek 'haircut' became concrete), bond yields on peripheral eurozone debt ratcheted upwards, creating a negative feedback loop on public finances.
Here the Gold Standard would have something of an advantage, simply because it is infinitely less costly to leave and regain control over the money supply. But this wasn't a point that was made by any of the commentators. Not really a surprise because we're not sure the proponents of a return to the Gold Standard immediately think of the fact that it is relatively costless to leave the Gold Standard as one of the main advantages.
Other criticisms were more predictable. The euro crisis is supposedly all the fault of 'socialism' or 'Keynesianism' in Europe, leading to an untenable public spending spree. We'll leave the 'socialism' stuff aside and concentrate on the 'Keynesian' stuff.
To blame the eurozone crisis on Keynesianism is, to put it mildly, not supported by the facts. First of all, Keynesians argue in favor of counter-cyclical policies, that is, running a budget surplus during an economic boom, like the one the euro created in the periphery up until the financial crisis of 2008. Indeed, countries like Spain and Ireland did run a budget surplus on the eve of the financial crisis, but this wasn't a guarantee for them not to be gravely affected by it.
So apart from Greece and to a lesser extent Portugal, the euro crisis was caused by perverse capital flows, rather than any public sector indulgence (let alone 'Keynesianism').
What's more, austerity forced by 'virtue' of eurozone membership has deepened the economic crisis considerably. This isn't a surprise. The economic literature only has one convincing example where austerity increased economic growth. The exception is Ireland in the late 1980s. In that episode, interest rates were so much reduced and the currency lost value that the expansionary effects outweighed the deflationary ones from reduced public spending.
But we remember readers that this isn't possible in the eurozone with the help of that quote from Evans Pritchard above. In the periphery, there is no offsetting monetary stimulus or devaluation...
What they could do is make their economies more competitive and liberalize their markets, but we've already expressed ourselves in favor of such policies.
In the meanwhile, austerity policies will only worsen the economic crisis and increase the debt levels.
We argued three things:
The eurozone functions much like the Gold Standard (or any fixed currency regime)
Fixed exchange rates can be very constraining on policy just when flexibility is needed most. In the eurozone periphery, it enforces austerity on countries, just as the Gold Standard did in the 1930s
Austerity in a deep recession worsens the economic crisis.
Neither of these seem anywhere near controversial and have solid support in the data. We're a bit surprised the article draw such strong reactions, therefore.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.