What Hath Merkel Wrought?

In my fifth month of blogging in November 2011, I wrote a post which I called “The Economic Consequences of Mrs. Merkel.” The title, as I explained, was inspired by J. M. Keynes’s famous essay “The Economic Consequences of Mr. Churchill,” which eloquently warned that Britain was courting disaster by restoring the convertibility of sterling into gold at the prewar parity of $4.86 to the pound, the dollar then being the only major currency convertible into gold. The title of Keynes’s essay, in turn, had been inspired by Keynes’s celebrated book The Economic Consequences of the Peace about the disastrous Treaty of Versailles, which accurately foretold the futility of imposing punishing war reparations on Germany.

In his essay, Keynes warned that by restoring the prewar parity, Churchill would force Britain into an untenable deflation at a time when more than 10% of the British labor force was unemployed (i.e., looking for, but unable to find, a job at prevailing wages). Keynes argued that the deflation necessitated by restoration of the prewar parity would impose an intolerable burden of continued and increased unemployment on British workers.

But, as it turned out, Churchill’s decision turned out to be less disastrous than Keynes had feared. The resulting deflation was quite mild, wages in nominal terms were roughly stable, and real output and employment grew steadily with unemployment gradually falling under 10% by 1928. The deflationary shock that Keynes had warned against turned out to be less severe than Keynes had feared because the U.S. Federal Reserve, under the leadership of Benjamin Strong, President of the New York Fed, the de facto monetary authority of the US and the world, followed a policy that allowed a slight increase in the world price level in terms of dollars, thereby moderating the deflationary effect on Britain of restoring the prewar sterling/dollar exchange rate.

Thanks to Strong’s enlightened policy, the world economy continued to expand through 1928. I won’t discuss the sequence of events in 1928 and 1929 that led to the 1929 stock market crash, but those events had little, if anything, to do with Churchill’s 1925 decision. I’ve discussed the causes of the 1929 crash and the Great Depression in many other places including my 2011 post about Mrs. Merkel, so I will skip the 1929 story in this post.

The point that I want to make is that even though Keynes’s criticism of Churchill’s decision to restore the prewar dollar/sterling parity was well-taken, the dire consequences that Keynes foretold, although they did arrive a few years thereafter, were not actually caused by Churchill’s decision, but by decisions made in Paris and New York, over which Britain may have had some influence, but little, if any, control.

What I want to discuss in this post is how my warnings about potential disaster almost six and a half years ago have turned out. Here’s how I described the situation in November 2011:

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. . . .

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.

Greece did default, but the European Community succeeded in imposing draconian austerity measures on Greece, while Italy, Spain, France, and Portugal, which had all been in some danger, managed to avoid default. That they did so is due first to the enormous cost that would have be borne by a country in the Eurozone to extricate itself from the Eurozone and reinstitute its own national currency and second to the actions taken by Mario Draghi, who succeeded Jean Claude Trichet as President of the European Central Bank in November 2011. If monetary secession from the eurozone were less fraught, surely Greece and perhaps other countries would have chosen that course rather than absorb the continuing pain of remaining in the eurozone.

But if it were not for a decisive change in policy by Draghi, Greece and perhaps other countries would have been compelled to follow that uncharted and potentially catastrophic path. But, after assuming leadership of the ECB, Draghi immediately reversed the perverse interest-rate hikes imposed by his predecessor and, even more crucially, announced in July 2012 that the ECB “is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough.” Draghi’s reassurance that monetary easing would be sufficient to avoid default calmed markets, alleviated market pressure driving up interest rates on debt issued by those countries.

But although Draghi’s courageous actions to ease monetary policy in the face of German disapproval avoided a complete collapse, the damage inflicted by Mrs. Merkel’s ferocious anti-inflation policy did irreparable damage, not only on Greece, but, by deepening the European downturn and delaying and suppressing the recovery, on the rest of the European community, inflaming anti-EU, populist nationalism in much of Europe that helped fuel the campaign for Brexit in the UK and has inspired similar anti-EU movements elsewhere in Europe and almost prevented Mrs. Merkel from forming a government after the election a few months ago.

Mrs. Merkel is perhaps the most impressive political leader of our time, and her willingness to follow a humanitarian policy toward refugees fleeing the horrors of war and persecution showed an extraordinary degree of political courage and personal decency that ought to serve as a model for other politicians to emulate. But that admirable legacy will be forever tarnished by the damage she inflicted on her own country and the rest of the EU by her misguided battle against the phantom threat of inflation.


7 Responses to “What Hath Merkel Wrought?”

  1. 1 EugenR March 15, 2018 at 11:33 pm

    The major threats to economy comes from the accumulated debts of currency regions either of the public sector or the private sector. It is important to define economy according to currency region and not anymore national economy.

    While the private sectors debt have their natural limitations, meaning limited to the capacity of the private entity, either businesses or households to repay contractual interest and principle liabilities, the public debt seems to be immune to this problem. The exception is the Euro region with some individual countries, namely Italy with more than 130% debt out of GDP, without sovereign currency, have no capacity to cover payments of these debts by printing money. This may cause major disruption in the whole European economy in the future.

    Yet the public debt is not immune from causing other economic problems, like increased inequality in income and wealth by enriching non-monetary assets holders as compared to monetary asset holders (wages and pension incomes). As well it causes propensity to more intensive volatility in assets prices and tendency to boom and bust states in the economy.

    It seems, to little attention is given to the new reality of decreasing gap between the nominal and the real GDP since 2008 due to relatively low inflation. If in the past this gap could have been significant, in the last decades, the price index of consumers basket has hardly changed and with it the nominal GDP is close to the real GDP. Since loans and their repayment are in nominal terms, it may seem as good news for the lenders and bad news for the borrowers. But this also adds instability and unsustainability to the system. Stagnant prices and low nominal GDP growth, cause less tax income and higher debt burden of the business and private households. So no good news here. But it doesn’t mean good news for the lenders too. Increased debt exposure, due to not inflating economy together with the intensity in non-monetary assets prices volatility will cause necessarily unstable economy.

  2. 2 B Cole March 16, 2018 at 5:09 pm

    Excellent blogging.
    The fetish with microscopic rates of inflation…is poor monetary policy.

  3. 3 Nanikore March 20, 2018 at 2:02 am

    Always wonderful to read your blogs – many thanks. I see a lot of criticism of German policy from Anglo-Saxon commentators (I am also Anglo-Saxon), but many make their assessments based on classical theory and just assume that Germany works the same way as the US. I know something about the Japanese economy, which was modelled on the German economy including the ideas of Freidrich List and later Ordoliberalism.

    One thing about these systems is heavy involvement of government in resource allocation. Friedman greatly misunderstood this when he conflated tight controls of monetary growth by the Bank of Japan and Bundesbank and strict budget deficit ceilings with small government. Government capital expenditure is controlled on different accounts that separate operational expenditure (the primary budget) and long term expenditure (in Japan this is the FILP).

    The German position is this: unless there is an adequate fiscal set up where they can channel German surpluses into capital expenditure in the EU periphery they are not prepared to accomodate. Otherwise they just see a repeat of the credit boom that led to this problem in the first place. In fact one reason that the peripheral countries like Greece and Spain have wanted to hang on to the single currency is they remember the pre Euro days of booms and busts – that was the consequence of relying on inflation to get out of problems. The result was they never really industrialised and able to solve their terms of trade and balance of trade problems (able to export sufficient value added to import crucial inputs) – and finally get on a sound growth curve.

    Piketty talks in his blog about the need of a proper institutional fiscal set up in the EU. This is partly related I think.

    One other thing. Prices and incomes policies. You cannot understand the success of these countries without considering their collective bargaining systems. Classical theory says this should not work. But the reality is that it has been a crucial part of inflation control (and preferred to changes in monetary growth or interest rates), including during the 1970s and these economies were praised for their performance.


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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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