OMINOUS LESSONS OF THE 1930´S FOR EUROPE / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( HIGHLY RECOMMENDED READING )

Ominous lessons of the 1930s for Europe

By Paul De Grauwe

Published: January 17 2010 16:37

The Great Depression taught us several lessons. The first one is that central banks must be ready to provide ample liquidity to save the banking system. Present-day central banks did exactly that. They did not repeat the mistakes of the 1930s when their predecessors tightened money in the face of a banking crisis. The second lesson is that governments should not try to balance the budget when economic activity collapses. Governments today did not repeat the mistakes made by many governments in the 1930s that desperately tried to balance their books when the economy crashed.

There is one area of policymaking where authorities may not have learned the lessons of history and are in the process of repeating the same mistakes. During much of the 1930s a number of continental European countries, the so-called gold bloc countries (France, Italy, Belgium, the Netherlands and Switzerland) kept their currencies pegged to gold. When in the early 1930s Great Britain and the US went off gold and devalued their currencies, the gold bloc countries found their currencies to be massively overvalued. This had the effect of depressing their exports and of prolonging the economic depression in these countries.

It is remarkable to see that the same mistakes are being repeated today involving some of the same countries as during the 1930s. This time it is again the continental western European countries tied together in the eurozone that have seen their currency, the euro, become strongly overvalued. The two countries that in the 1930s responded to the crisis by devaluing their currencies, the US and the UK, today have also allowed their currencies to depreciate significantly. Since the start of the financial crisis the pound has depreciated against the euro by about 30 per cent. After having strengthened against the euro prior to the banking crisis of October 2008, the dollar has depreciated against the euro by close to 20 per cent.

Thus, as in the 1930s, the dividing line is the same. The US and the UK have allowed their currencies to depreciate; the continental European countries tied in the euro area have allowed their currency to become significantly overvalued. Even the numbers are of the same order of magnitude. During the 1930s the overvaluation of the gold-bloc currencies amounted to 20 to 30 per cent. Today, the euro is overvalued by similar percentages against the dollar and the pound. Why do the euro area countries repeat the same policies as the gold bloc countries in the 1930s? The answer is economic orthodoxy. In the 1930s it was the orthodoxy inspired by the last vestiges of the gold standard. Today the economic orthodoxy that inspires the European Central Bank is very different, but no less constraining. It is the view that the foreign exchange market is better placed than the central bank to decide about the appropriate level of the exchange rate. A central bank should be concerned with keeping inflation low and not with meddling in the forex market. As a result, the ECB has not been willing to gear its monetary policy towards some exchange rate objective.

Just as in the 1930s, the euro area countries will pay a price for this orthodoxy. The price will be a slower and more protracted recovery from the recession. This will also make it more difficult to deal with the internal disequilibria within the eurozone between the deficit and the surplus countries that Martin Wolf described so vividly in these pages.

One could object to this analysis that the central bank is powerless to affect the exchange rate. This is a misconception. A central bank can always drive down the value of its currency by a sufficiently large increase in its supply. And that is what the US and the UK have done with their policies of quantitative easing that have gone farther in flooding the US and UK money markets with liquidity than in the euro area. True, since the start of the crisis, the ECB has injected plenty of liquidity in the euro money markets to support the banking system. Yet it has been much more timid than the US Federal Reserve and the Bank of England in creating liquidity. While the latter more than doubled the size of their balance sheets since October 2008 and thereby more than doubled the supply of central bank money, the ECB’s balance sheet increased by less than 50 per cent.
Such an imbalance in the expansion of central bank money inevitably spills over in the foreign exchange markets. The massive supply of dollars and pounds created by the US and UK monetary authorities was transmitted to other financial markets in search of higher yields and in so doing put upward pressure on the value of the euro. Thus the greater timidity of the ECB in providing liquidity is an important factor explaining why the euro has rallied since the start of the banking crisis and why it is now excessively overvalued.

Ultimately a central bank has to make choices. The Fed and the Bank of England have opted for massive programmes of liquidity creation, attaching a low weight to the possible inflationary consequences of their actions. The ECB has been more conservative in its liquidity, creating programmes attaching a low weight to the consequences for the exchange rate and to the chances of a quick recovery. The future will tell us which of these choices was right.

The writer is professor of economics at the University of Leuven

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