The gold standard gives priceless insights into how to save the euro
THERE is almost no economic problem for which there is not at least one precedent. Examining precedents can help guide policy makers and their advisers – if they are willing to look. But policy makers trying to deal with the euro crisis have not taken advantage of this opportunity.
Many currency unions have been formed in the past. Some have survived, while others have not. What do the ones that survived – including those which collapsed not due to economic stress, but the stresses of war – have in common?
The best example to use in answering that question is at first glance a surprising one – it is the international gold standard, which lasted from the mid 1870s to the outbreak of the First World War, and resumed in a substantially modified form soon after the end of the War, finally crumbling in the Great Depression.
That system was remarkably like the Eurozone. Every country on the gold standard linked its currency rigidly to gold. No country had control over its money supply – the basis for that was determined by the world stock of gold. Most countries issued their own currency, but that was no more than the same currency as that of any other gold standard country. Different only in name, for all currencies were linked rigidly together. That pretty well describes the monetary arrangements of the Eurozone.
Most of the gold standard broke up under the strains of the Great Depression. But the US held together as a monetary union, as it had in previous severe downturns in the 19th century. Its relevance may seem puzzling as the US was a country; but in one important respect it was not quite a country. It did not have a nationwide banking system. There was rigid separation of banking along state boundaries. The only nationwide bank from 1914 until well after the Second World War was the Federal Reserve.
So why did the US hold together as a monetary zone? Of course, there were no doubt several contributory factors. Labour mobility was probably greater, due in part to a common language. Legal systems, although differing somewhat from state to state, had a substantial and significant common core.
But there was one big difference. In the Great Depression, while many banks failed, there was no case in which the banking system of an entire state teetered on the edge of insolvency. Thus, although the Federal Reserve acted somewhat hesitantly as a lender of last resort to the banks, there was never a case where a whole state’s banking system was unable to offer to the Fed the kind of collateral it required in return for liquidity assistance.
The main reason for banks remaining solvent was that there were transfers through the Federal government’s budget. These came largely automatically, but also through discretionary payments from relatively prosperous states. These fiscal transfers from a central budget kept state banking systems afloat and the monetary union together.
There were no such transfers in Europe. It was a Europe of nation states. That is the crucial difference between the US then and Europe now.
It needs to be asked whether that was a special case. Does it actually generalise? Did a central budget with automatic transfers play a part in other monetary unions which held together, and were such transfers absent in unions which fell apart? The answer to both is yes. Every monetary union which survived all strains but war had a substantial central budget that transferred resources between regions in times of stress.
However, not every monetary union which had a fiscal union was a success. Where the provinces are stronger than the centre, fiscal union is not enough. Argentina had strong provinces relative to the centre; this repeatedly led to the sequence of debt, inflation, and default.
A substantial central budget is what the Eurozone needs to survive. Not just to get through this episode, but to survive as a stable and prosperous monetary entity. Whether there is consent by the electorates to the setting up of such as system we do not know. And whether there is sufficient time we doubt.
Forrest Capie is professor emeritus of economic history at Cass Business School. Geoffrey Wood is professor emeritus of economics at Cass Business School.