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Europe Is Not Out of the Woods


Europe Is Not Out of the Woods

July 23, 2014

The recent Eurozone crisis has all the hallmarks of a repetition of history. A regime of fixed exchange rates (the Euro) came under intense pressure from a group of economies that ran astounding fiscal and balance of payments deficits. Such a phenomenon contributed to the collapse of the Bretton Woods system in 1971. Several people have compared the Bretton Woods collapse to the current Eurozone crisis. The world economy could not sustain the Bretton Woods system--is the same fate in store for the Eurozone?

According to a new NBER working paper by Rutgers University professor Michael Bordo, a member of the Shadow Open Market Committee, the Bretton Woods system does not predict the destiny of the Euro. Bretton Woods and the Eurozone are two fundamentally different systems. Both include some form of exchange rate fixing, but that is where the similarities end.

An economy cannot simultaneously have fixed exchange rates, autonomy over monetary policy, and open capital markets. Individual Eurozone countries have given up monetary autonomy, since the European Central Bank controls their money supply. However, the exchange rate is perfectly fixed, and European capital markets are open for business.

The Bretton Woods system, in contrast, tried to have a little bit of each. Exchange rates were fixed, but could be adjusted if necessary. Using monetary policy might put pressure on the exchange rate, but governments could use monetary policy if they wanted to, with some abusing it more than others. Capital controls were present and substantial, but not absolute.

Such a system paved the way for the irresponsible use of monetary policy by the government of the United Kingdom. Expansionary monetary policy and a balance of payments deficit put pressure on the pound sterling to devalue, which it eventually did in 1967, breaking the regime of fixed exchange rates. Germany, however, was so conservative in its economic policies that the Deutsche Mark was revalued in 1960, again changing the exchange rates fixed by the Bretton Woods system.

There is no such "escape valve" in the Eurozone. A Eurozone country with a balance of payments imbalance cannot change the value of its currency to repair that imbalance, since its currency is not its own. This gives individual governments less power, but Europeans do not have to change currencies when they travel within the zone, and funds can be more easily moved between countries.

Bordo highlights a lesser-known feature of the Eurozone, the Trans-European Automated Real-Time Gross Settlement Express Transfer (TARGET) system, created in order to facilitate funds transfers between banks in the Eurozone.  The Eurozone has now moved to a new system, TARGET2. Bordo sees TARGET2 as instrumental in sustaining liquidity during the 2008 financial crisis and the 2010 debt crises in Greece and other troubled countries.

TARGET2 is the fulcrum on which Bordo's proposed analogy turns. He suggests that it is more appropriate to compare the Eurozone not to Bretton Woods, but to the United States during the Great Contraction of 1929-1933.  Similarities are obvious--both regions have a single currency run by a single central bank. However, unlike the ECB, the Federal Reserve did next to nothing to sustain liquidity during the Great Contraction. In the absence of an effective TARGET-like payments system, the liquidity crunch during the crisis sent banks into default and the country into the Great Depression.

The Eurozone was able to avoid that grisly fate by allowing countries with strong balance of payments surpluses, such as Germany, to extend liquidity to ailing deficit countries, such as Greece and Spain. The ECB was more successful at managing its currency than the 1930s Fed, which failed to buoy the dollar when liquidity was needed most.

But the existence of TARGET2 does not mean that Europe is out of the woods. Papering over the crisis with monetary accommodation has resulted in slow growth and high unemployment. Large payments imbalances persist, with Germany accruing heavy exposure due to the 2011 bailouts and the countries of southern Europe indebted to their powerful northern neighbor. Should Greece or another country default, the consequences would spread to the rest of the continent.

While the ECB has cleared its first hurdle--sustaining liquidity--this does not mean that the Eurozone will survive.


Preston Cooper is a rising senior at Swarthmore College and a contributor to Economics21. You can follow him on Twitter here.

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