Will Today’s Insanity once again Trump the International Financial System?

With Europe officially entering a deflationary moment at the end of February, issues surrounding austerity and the nature of deflation on the international economic system are once more an interesting topic of discussion.  How, you may ask, are these issues related to the key paradigms that underpinned Bretton Woods?

Bretton Woods was a quintessential compromise created from the orthodox monetary views of Von Hayek’s classical liberalism and Keynesian notions of cyclical counter state intervention to support economic downturns in the economy.  All caught by John Ruggie’s catch phrase of ‘embedded liberalism’ to devise a form of multilateralism that is compatible with the requirements of domestic stability, or if you will, by Karl Polanyi’s understanding that the role of the state is to mediate between the market and society.

Eric Helleiner observes that the stability of the pre-1914 international monetary financial order was dependant on a very specific domestic political context: governments were strongly committed to the classical liberal idea that domestic monetary policy should be geared to the external goal of maintaining the convertibility of the national currency into gold at a fixed rate.  This commitment stemmed not just from liberal ideology, but also from the fact that governments before 1914 were less responsive to domestic popular pressures.  Deflationary policies required to maintain the fixed currency peg in the face of a trade deficit or capital outflows could be very painful for domestic groups, particularly the poor whose wages were forced downwards.After WW I, the wheels fell off as governments had to be far more responsive to domestic pressure.  But in spite of these domestic pressures, governments still insisted on clinging to a re-created gold standard, and indeed we can argue that not a single country left the gold standard voluntarily. Countries went off the gold standard when adverse circumstances forced them to do so.  For example, Great Britain went back on the gold standard in 1925 at its pre-war parity, which was totally overvalued, and the attempt to reduce prices and wages to support the overvalued Pound provoked a general strike.   In attempting to revert to the orthodox monetary views of classical liberalism, and ultimately failing, Great Britain confirmed Gustav Cassel’s view that countries would eventually leave the gold standard rather than endure the economic distress caused by deflation. 

Bretton Woods, as an adaption of the gold standard, therefore allowed liberal orthodoxy to prevail internationally while attending to the pressures of domestic stability.  Only later, after Reagan and Thatcher did away with capital controls, do we once again see that growth becomes problematic, and the world has been challenged by policies of austerity and a possible new financial death spiral.

Which leads me to a second theme: Mark Blyth, asserts that:

Austerity as economic policy simply doesn’t work. In the cases where it looked like it worked, something else was really doing the work.  

 What we have done over the past thirty years is to build a creditor’s paradise of positive real interest rates, low inflation, open markets, beaten-down unions, and a retreating state — all policed by unelected economic officials in central banks and other unelected institutions that have only one target: to keep such a creditor’s paradise going.

 In such a world, why would you, the average worker, ever get a pay rise? Indeed, is it any wonder that inequality is everywhere an issue? 

 Austerity is strongly linked, to Von Hayek, possibly erroneously, as Von Hayek was not that far removed from Keynes.  Nonetheless, classical monetary policy, as espoused by conservative factions in the world body politic, reveres Von Hayek, deploring statist intervention and any hints of reflation. 

As a result, the world economy is currently heading back to the future, as it begins to resemble the shambles of the interwar gold standard more and more.  Policies that would benefit society are now ignored, sacrificed on the alter of conservative monetary policy.  And by turning to Europe, which should be a leading driver of growth in the world economy, Matthias Morys has found some startling similarities to the financial system between the wars, and the very issues that Bretton Woods attempted to deal with.

In both cases, a major global recession coupled with financial turmoil brings a system of fixed exchange rates under severe pressure.  Countries follow austerity policies to make the existing monetary system work:  they cut spending in the face of declining tax revenues even further.  New austerity policies are the answer, but they only result in a self-defeating circle of ever dwindling output.  This description not only matches the experience of France in the 1930s, but also the experience of Greece since 2010.  Gold bloc countries eventually abandoned gold; will countries on the European periphery leave the Euro at the same point?

Both episodes also share the reasons behind policy-makers’ determination to maintain fixed exchange rates.  In the 1930s, hostility to devaluation was driven by fears of inflation.  While little systematic research has been done on why countries on the European periphery cling to the Euro, anecdotal evidence suggests the same: a return to the Drachma, for instance, is portrayed as ‘chaotic’ and likely to result in considerable inflation, a view not very different form the gold bloc countries.

There is always an alternative policy of reflation, based on a Keynesian-style view of economics.  Unless and until Europe begins to move away from its policies of austerity, Greece, as an example, will simply languish in a deflationary spiral until the workers rebel. 

Paradoxically, I now believe that the Euro will remain for some time despite the pain, as events in the 1920s and 1930s prove that states will only defect if forced to, and I believe that the ECB (European Central Bank) will do just enough to keep the boiling oil at a tolerable level in the southern European states.  In the meantime, change may arise due to political fallout and the rise of radical parties on both the right and left.  And that is a debate that I shall leave for a later date.