Europe Charges toward Second Great Depression

Europe Charges toward Second Great Depression

Europe is making the mistakes of the 1920s all over again, hoping this time to avoid another Great Depression—and world war.

According to Hegel, “the only thing we learn from history is that we learn nothing from history.” The current crisis in the eurozone suggests an even more pessimistic reading. Having learned, after World War II to avoid the mistakes made in the aftermath of World War I, policy makers in Europe are now in the process of repeating those very mistakes.

At the end of what was then called the Great War, the victorious allies were faced with the need to reconstruct the global economic system. The decisions they took were disastrous, paving the way for the Great Depression and the renewed outbreak of war in 1939.

The punitive and ultimately unenforceable Treaty of Versailles, which called forth John Maynard Keynes’s polemic The Economic Consequences of the Peace was one such decision. Even more catastrophic, if less well remembered, was the decision to return to the gold standard at the parities prevailing in 1914, effectively reversing the inflation associated with the war.

Keynes returned to the fray with his book The Economic Consequences of Mr. Churchill, which correctly predicted the disastrous repercussions—in terms of unemployment and reduced economic activity—of the British Bulldog’s attempt, when he was UK Chancellor of the Exchequer, to depress prices and wages to prewar levels.

Keynes was ignored, and by the late 1920s the champions of fiscal orthodoxy were congratulating themselves on the successful restoration of prewar normality. But their apparent success had set the scene for the Great Depression that began in the US in 1929.

As the Depression wore on, national governments, one by one, abandoned the gold standard that had been restored with such effort. The sooner they acted, the sooner the recovery from the Depression began. But recovery came too late to prevent the rise of Hitler and the outbreak of world war.

Nearly one hundred years later, many of the mistakes of the 1920s are being repeated. The crisis that brought the global financial system to the brink of collapse in 2008 exposed unsound lending on a massive scale, primarily to finance real-state bubbles in the United States and a number of European countries. In the process of bailing out the financial systems and responding to the sharp downturn in economic activity, European governments guaranteed private debt and took on substantial debts of their own. Now the bondholders are demanding that full repayment of their claims should be ensured by the adoption of “austerity” measures that are virtually certain to produce a renewed recession.

But unlike the pre-1914 bondholders, today’s bondholders made bad loans with their eyes open, counting on the bailout they correctly anticipated. In some cases, as in the Greek loans organized by Goldman Sachs to cheat the criteria for entry to the eurozone, lenders were actively complicit in the deception. In other cases, they simply counted on the EU to carry the can for their own lack of due diligence.

Either way, bondholders deserve to take a substantial loss. The resistance to this necessary step has come primarily from the European Central Bank, and particularly from ECB President Jean Trichet.

As with his US counterparts, Trichet’s career has been one of repeatedly rewarded failure. Charged with maintaining economic stability in the eurozone, Trichet and the ECB failed monumentally to foresee the global financial crisis or to support a coherent policy response. Rather than seeking a sustainable basis for economic recovery, the ECB has focused entirely on defending the interests of the financial system and on defending the system of inflation targeting it still sees as its own greatest achievement.

Since its inception, the ECB has sought to hold the rate of inflation at or below 2 percent, on the assumption that low and stable inflation is the best basis for sustainable long-run growth. The target has mostly been achieved, but the assumptions on which it is based have failed. It is now widely recognized that low inflation can increase the risk of asset-price bubbles, and that the resolution of debt-driven contractions like those in the US and EU requires higher, rather than lower inflation.

The ECB has sought by every means possible to maintain the role of credit-ratings agencies and to resist any measure that would lead the agencies to declare a default by any EU government. The EU leadership appears finally to have bitten this particular bullet, giving up the attempt to find a way around the Greek debt problem that would prevent a declaration of default by the credit-rating agencies that helped to cause the problem in the first place.

However, a broader solution seems as far off as ever. The ECB, like its predecessors in the 1920s, is doing its best to achieve a return to precrisis “normality,” complete with inflation targeting, central-bank independence and a total separation between fiscal and monetary policy. This is a recipe for disaster.

The euro experiment has shown beyond reasonable doubt that the combination of independent national fiscal policies and a powerful central bank, imbued with a pure focus on price stability, cannot be sustained. Popular resistance to the combination of austerity and bailouts is strong and only likely to intensify. If current policies are maintained, the ECB may preside over the destruction of the currency it was created to manage.

But what is the alternative? In the short run, the problem is to stabilize the European economy and put the euro back on a sustainable footing. This can only be done by reducing the massive debt generated by the rescue of the financial system, and this in turn requires putting most of the cost of the rescue back onto that system through a combination of restructuring (the necessity of which has finally been recognized in the Greek case) and acceptance of a temporary increase in inflation. The resistance of the ECB to both courses of action will be vigorous but must be overcome—throughout this crisis, the ECB has been part of the problem not part of the solution.

The answer is that short-term stimulus must be combined with long-run targets substantially more ambitious than those of the Maastricht agreement on which the euro was based. This "hard Keynesian" approach starts from the premise that, if governments are to stabilise the macroeconomy in times of crisis, they must maintain the fiscal capacity to do so.

This offers something for everyone. The Franco-German core will not be endlessly responsible for bailing out feckless spenders. For the EU periphery, this is a positive alternative to destructive policies of austerity.

It remains to be seen whether the EU will be true to the vision of co-operation on which it was founded.