The Economic Consequences of Mrs. Merkel

Winston Churchill, in 1925 Chancellor of the Exchequer in the Conservative government headed by Stanley Baldwin, was pressed by the Governor of the Bank of England, Montagu Norman, to restore the British pound to its pre-war parity of $4.86, thereby re-establishing the gold standard in Britain, paving the way for a general restoration of the international gold standard, one of the first casualties of war in August 1914. Having accumulated an enormous stockpile of gold in exchange for supplies it provided to the belligerents, US restored convertibility into gold soon after the end of hostilities, but sterling had depreciated against the dollar by about 25 percent after the war, so Britain could not achieve its goal of restoring the convertibility into gold at the prewar parity without a tight monetary policy aimed at raising the external value of the pound from about $4 to $4.86.

In 1925, sterling had risen to within about 10% of the old parity, making restoration of the pre-war dollar parity seem attainable, thus increasing the pressure from the London and the international financial communities to take the final steps toward the magic $4.86 level. Churchill understood that such a momentous step was both politically and economically dangerous and sought advice from a wide range of opinion, pro and con, both inside and outside government. The most persuasive advice he received was undoubtedly from J. M. Keynes, who, having served as a Treasury economist during World War I and then serving on the British delegation to the Versailles Peace Conference, became world famous after resigning from the Treasury to write The Economic Consequences of the Peace, his devastating critique of the Treaty of Versailles, protesting the overly harsh and economically untenable reparations obligations imposed on Germany. Keynes advised Churchill that the supposedly minimal 10% appreciation of sterling against the dollar would impose an intolerable burden on British workers, who had suffered from exceptionally high unemployment since the 1920-21 postwar deflation.

Despite Keynes’s powerful arguments, Churchill in the end followed the advice of the Bank of England and other members of the British financial establishment. Perhaps one argument that helped persuade him to follow the orthodox advice was that of another Treasury economist, the great Ralph Hawtrey, who submitted a paper analyzing the effects of restoring the prewar dollar parity. Hawtrey argued that Britain and the world would benefit from the restoration of an international gold standard, provided that the restoration was managed in a way that avoided the deflationary tendencies associated a remonetization of gold. Hawtrey suggested that there was reason to think that the institution that mattered most, the U.S. Federal Reserve, with its huge stockpile of gold, would follow a mildly inflationary policy allowing Britain to maintain the prewar parity without additional deflationary pressure. However, Hawtrey warned that if the US did not follow an accommodative policy, it would be a mistake and futile for Britain to defend the parity by deflating.

Keynes, who never suffered from a lack of self-confidence, undoubtedly thought that he had gotten the better of his opponents in presenting the case against restoring the prewar dollar parity to Churchill. When the decision went against him, he vented his outrage at the decision, and perhaps his own personal frustration, by writing a short pamphlet, The Economic Consequences of Mr. Churchill, a withering rhetorical assault on Churchill and the decision to restore the pre-war dollar parity. However, the consequences of the decision to restore the prewar parity were, at least initially, less devastating than Keynes predicted. Contrary to Keynes’s prediction, unemployment in Britain actually declined slightly in 1926 and 1927, falling below 10% for the first time in the 1920s. Hawtrey’s conjecture that the Federal Reserve, then led by the head of the New York Federal Reserve Bank, Benjamin Strong, would follow a mildly accommodative policy, alleviating the deflationary pressure on Britain, turned out to be correct. However, ill health forced Strong to resign in 1928 only months before his untimely death. His accommodative policy was reversed just as the Bank of France started accumulating gold, unleashing deflationary forces that had been contained since the deflation of 1920-21.

Fast forward some four score years to today’s tragic re-enactment of the deflationary dynamics that nearly destroyed European civilization in the 1930s. But what a role reversal! In 1930 it was Germany that was desperately seeking to avoid defaulting on its obligations by engaging in round after round of futile austerity measures and deflationary wage cuts, causing the collapse of one major European financial institution after another in the annus horribilis of 1931, finally (at least a year after too late) forcing Britain off the gold standard in September 1931. Eighty years ago it was France, accumulating huge quantities of gold, in Midas-like self-satisfaction despite the economic wreckage it was inflicting on the rest of Europe and ultimately itself, whose monetary policy was decisive for the international value of gold and the downward course of the international economy. Now, it is Germany, the economic powerhouse of Europe dominating the European Central Bank, which effectively controls the value of the euro. And just as deflation under the gold standard made it impossible for Germany (and its state and local governments) not to default on its obligations in 1931, the policy of the European Central Bank, self-righteously dictated by Germany, has made default by Greece and now Italy and at least three other members of the Eurozone inevitable.

The only way to have saved the gold standard in 1930 would have been for France and the US to have radically changed their monetary policy to encourage an outflow of gold, driving down the international value of gold and reversing the deflation. Such a policy reversal, though advocated by Hawtrey and the great Swedish economist Gustav Cassel, was beyond the limited imagination of the world’s central bankers and monetary authorities at the time. But once started, the deflationary downward spiral did not stop until France, finally having had enough, abandoned gold in 1935. If the European central bank does not soon – and I mean really soon – grasp that there is no exit from the debt crisis without a reversal of monetary policy sufficient to enable nominal incomes in all the economies in the Eurozone to grow more rapidly than does their indebtedness, the downward spiral will overtake even the stronger European economies. (I pointed out three months ago that the European crisis is a NGDP crisis not a debt crisis.) As the weakest countries choose to ditch the euro and revert back to their own national currencies, the euro is likely to start to appreciate as it comes to resemble ever more closely the old deutschmark. At some point the deflationary pressures of a rising euro will cause even the Germans, like the French in 1935, to relent. But one shudders at the economic damage that will be inflicted until the Germans come to their senses. Only then will we be able to assess the full economic consequences of Mrs. Merkel.

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20 Responses to “The Economic Consequences of Mrs. Merkel”


  1. 1 Will November 9, 2011 at 11:49 pm

    The ECB is beyond hope. It is just like the monetary authorities of the 20s: a slave to outdated pieties, disregarding the train wrecks it causes.

    I find it interesting that you put Ms. Merkel in the foreground of this discussion. Is Merkel really accountable for the behavior of the ECB? I know it’s common knowledge that the ECB is basically a German institution, which means that it suffers from an over-aversion to inflation due to the lingering remembrance of the famous hyperinflation (and the misrepresentation of that experience as leading to Hitler, though actually it was deflation that led to Hitler). But is there some other mechanism that allows the German government to influence the ECB?

    In a similar vein, is there a political resolution to this crisis? I’m fairly ticked off at the German SDP for remaining in coalition with Merkel’s party despite their disagreement on issuing Eurobonds (and for their failure to commit to any viable coalition that could be elected instead). Is this just sound and fury, signifying nothing?

  2. 2 Becky Hargrove November 10, 2011 at 8:07 am

    Thanks for telling this story, I only wish that such stories were a part of our education at a young age, so that it would be easier to understand that we need to think locally and globally at the same time for monetary economies to really work. When I linked back to the earlier post, this quote set off light bulbs for me: “Since the debts are fixed in nominal terms, the condition for being able to pay off the debts is that nominal income (NGDP) rise fast enough to provide enough free cash flows to service the debts.” Until now I had not truly made the connection between NGDP and the constant momentum necessary to “keep the plane aloft”. But I get why people don’t trust the process, necessary though it is. Because, locally and globally, it means breaking down further barriers that allow greater economic flow in the first place.

  3. 3 David Pearson November 10, 2011 at 9:28 am

    David,
    “And just as deflation under the gold standard…”

    12-mo. German inflation was reported today at 3%. Our 12-mo. number is 3.7%. The UK is at 3.5%. China’s m-o-m number was 5.5% (if you believe that…) The oil price has bounced back: Brent is at $113 despite the deceleration in China real growth. U.S. import inflation numbers show an acceleration in China inflation, and 12-mo. numbers above 3-4% for manufactured goods from all geographies.

    Tyler Cowen writes today that 5% inflation in Europe is clearly insufficient to change the dynamic. 10% is more like it. I agree. How is this situation like 1932, when prices were falling by 10%+? How is a small shortfall from trend in European NGDP causing so much havoc?

    http://marginalrevolution.com/marginalrevolution/2011/11/what-should-the-ecb-do.html

  4. 4 David Pearson November 10, 2011 at 9:36 am

    David,
    It occurs to me that your response might be, “unemployment during the GD was 20%+, so this is a matter of degree.” I don’t think that line of thinking is correct. The GD was a self-reinforcing dynamic of tight money, tight credit, falling prices, rising real rates, tighter money, falling prices, etc. No such dynamic exists today (nor did it exist in Japan in the last decade).

    There is modest deflation and modest inflation. Then there are self-reinforcing dynamics of high and accelerating deflation and inflation. The two groups are not different “by degree”, they are different altogether.

  5. 5 Benjamin Cole November 10, 2011 at 11:38 am

    Nice post. Europe (and the USA) is courting deflation. Unit labor costs are falling in the USA.

    Commodities prices are being set in Chindia, or by speculators (and possibly over-regulation).

    Now is not the time to fight inflation.

  6. 6 mgale November 10, 2011 at 3:37 pm

    A very informative, and well-written post. When you tell a story you write quite well, and in language anyone can understand. You should, quite frankly, do it more often, because you have a powerfully persuasive voice — when you choose to use it.

    On the other hand, your personal dislike of Keynes continues to shine through. Why muddy up an otherwise excellent piece of writing with snide comments about your take on Keynes’ personality?

  7. 7 Steve November 10, 2011 at 7:19 pm

    Well, George Soros agrees with you. He blames Merkel for deciding two years ago that Europe needed to backstop its banks, but the individual countries should be solely responsible for their individual national banks.

  8. 8 David Glasner November 10, 2011 at 8:15 pm

    Will, I am not enough of a student of German politics and relationships between the ECB and the German government to know who is really pulling the strings. However, my impression is that the President of the ECB tries really, really hard to stay in the good graces of the German Chancellor and that Mrs. Merkel has been resisting any and all efforts to provide monetary stimulus to ease the debt burdens of the weaker countries in the eurozone. And Mrs. Merkel, of course, has evidently developed a very acute sense of what the state of public opinion is in Germany and never operates outside the parameters of what German public opinion will support.

    Becky, I’m happy to hear that you found my story-telling interesting and helpful.

    David, As always you offer a very challenging perspective on the current economic landscape. By way of clarification, I would point out that the situation in eurozone is more complicated than in the US. Even if Germany is experiencing 3% inflation now, there is severe deflationary on the weaker eurozone countries to reduce their wages to be able to generate an export surplus by which to pay off their debt obligations. Germany is forcing the burden of adjustment on the debtor countries, which means forcing them to drive down wages. That strikes me as a disastrous and futile policy. On oil prices, I don’t think that rising oil prices are a response to US or ECB monetary policy, but I admit that I don’t know what is causing oil prices to rise at present.

    Benjamin, Those would be my guesses as well, but as I just said to David, I really don’t know what is causing oil prices to rise.

    mgale, Thanks for your kind words. Actually, I don’t dislike Keynes. I dislike certain aspects of his character, he was a bit of an intellectual bully and he was an unscrupulous debater. His treatment of Hayek (with whom he later became very friendly) and Pigou, in particular, was quite disgraceful. I don’t think that I said anything about him in this post that was offensive. And I don’t think that anyone would deny that he had an extremely high opinion of his own intellectual capabilities. Indeed, there is a famous saying attributed to him instructing people on the correct pronunciation of his name: “Keynes rhymes with brains.” For all that, there is very much to admire about him, and he was undoubtedly one of the greatest figures of the twentieth century.

    Steve, Soros’s point seems to be a little different from mine. I am talking about monetary policy for the eurozone, and Soros as you are quoting him is about policy toward the banks and keeping them solvent.

  9. 9 MG November 10, 2011 at 11:54 pm

    At this point in time, I’m totally uninterested in Keynes the person. I am interested, deeply so, in how best and quickest to get out of this mess. Along those lines, an intellectual bully might be quite useful, as long as he or she was bully enough.

  10. 10 Will November 11, 2011 at 10:13 am

    “Actually, I don’t dislike Keynes.”

    I was poking around in the General Theory the other day, and I was somewhat surprised to notice that in the preface Keynes gives thanks to R.G. Hawtrey (along with Joan Robinson and R.F. Harrod) for his help. My own annoyance with Keynes centers on his misleading use of the word “classical” (compounding the problem with the already-misleading term “neoclassical”) and his apparent indifference to the actual history of economics — sins easily attributable to the man’s healthy ego.

    MG is right, however, that his contributions (and those of Fisher and a hundred others) — and most importantly, what we know about their empirical application — are more important than questions of character, as we approach the precipice.

  11. 11 floccina November 11, 2011 at 11:43 am

    Yes in the midst of the debt crisis the Germans are worried about deflation. Yikes! Europe needs free banking now!

  12. 12 floccina November 11, 2011 at 11:47 am

    Oh and that is because having a well functioning monetary system with a central requires the median voter to understand the monetary system. That ain’t gonna happen. If the median German voter to understood the monetary system I think that they would give Greece and Italy a break.

  13. 13 David Glasner November 13, 2011 at 9:03 am

    MG, Well, I think that Keynes has some worthwhile things to teach us, but I do not accept that all wisdom emanates from him. As I have said often and will keep saying, Hawtrey had a better grasp of what was going on in the Great Depression and I think that we can still study his work with profit. So I am all in favor of pluralism in the search for knowledge and solutions to the crisis in which we now find ourselves.

    Will, Hawtrey graduated from Cambridege a year or two before Keynes entered. Both studied math as undergraduates and only studied economics later. Both served in the Treasury. They were friends for most of their professional careers and Keynes once called Hawtrey his grandparent in the paths of errancy. So it would be wrong to think that they were in fundamental disagreement. Keynes exaggerated the differences between himself and earlier economists partly because he was trying to enhance his own reputation but also because he felt that he had to discredit earlier approaches to discredit the laissez-faire approach to macroeconomic policy. In addition, although he was enormously well-read in many branches of knowledge, there were large gaps in his knowledge of the history of economics. So it is hard to know to what extent his distortions were purely self-serving or reflected gaps in his knowledge.

    Floccina, Free banking might work, but only in the context of a larger monetary reform that created a standard of value that eliminates monetarily induced fluctuations in GDP. Free banking would not do that automatically. If governments simply withdrew from supplying money, there would be a chaotic adjustment that would resemble the Great Depression. Free banking might be theoretically desirable under some conceivable circumstances, but it is very hard for me to imagine a transitional path from current monetary arrangements to a stable free banking system.

  14. 14 Anton November 13, 2011 at 3:12 pm

    The ECB for all intends and purposes is not accountable to any other European institution or person. If you want to learn more how the ECB operates you may read pages 17-18 of this paper http://www.neties.com/for%20whom%20tolls.rtf. In theory ECB president is appointed by the European Council for 8 years. They cannot be dismissed during that time even by an unanimous decision of EC. Merkel has absolutely no power in theory over the ECB. David, your description of the gold standard in relation to the current situation in Europe is quite applicable. Most people, most economists, most politicians (even in USA and UK, two proper sovereign countries) sadly still are under the impression that our economies operate under the shackles of a gold standard and thus we keep making mistake after mistake in Trying to solve this crisis.

  15. 15 David Glasner November 15, 2011 at 5:26 pm

    Anton, I was using Mrs. Merkel as a kind of proxy for all those responsible for economic policy in the eurozone. However, despite her lack of formal power over decisions taken by the ECB, I think that she does wield enormous influence and if she could bring herself to support aggressive expansion by the ECB, I have no doubt that the ECB would fall in line behind her. Could you give me an example of how you feel that economists and politicians in the US and UK believe that we are operating under the shackles of the gold standard?


  1. 1 If just David Glasner was ECB chief… « The Market Monetarist Trackback on November 9, 2011 at 11:09 pm
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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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