Better in their words…

The German Bundestag voted last week to expand the European fund established last year to bail out Greece—or, rather, Greece’s creditors. In doing so, it also moved the euro zone one step further away from the bloc’s founding principle that its members would share a currency, but be responsible for their own fiscal policies within that currency zone.
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In the current global environment of floating exchange rates, this idea seemed radical, and many people thought the experiment was doomed to failure. Yet historically speaking, the real novelty is our system of fiat currencies and floating exchange rates. The modern monetary era began 40 years ago, when U.S. President Richard Nixon closed the gold window. That act led to the collapse of the postwar Bretton Woods system, of which the U.S. dollar, convertible to gold at $35 an ounce, was the anchor.

The end of Bretton Woods led to floating exchange rates and a decade of inflation. For the first time in history, the entire global economy rested on paper currencies with no formal link to precious metals or, for the most part, to each other.

It’s true that countries had gone off the gold standard before: sometimes frequently, and most often because of war, which would drive spending beyond a nation’s ability to pay its bills in a hard currency. But these moves had always been temporary. What happened after 1971 was different, and it’s hard to argue that the results have been stellar. The past 40 years have seen inflation, government spending and government debt all rise significantly in much of the West.

The euro, in this context, was less a leap into the unknown than an attempt to return to an older discipline, one in which governments would not rely on plenipotentiary central banks to bail them out of their policy errors. Europe was attempting a return to a hard currency in which states were expected to pay their way, or pay the consequences.

Today the euro’s critics see vindication in Greece’s continuing collapse and the turmoil that it is causing in euroland. But if the euro unravels—a possibility that can no longer be ruled out—it will be because, when the test of its founding principles came amid this crisis, those principles were abandoned.

Joining the euro meant giving up independent monetary policy. The single currency’s critics argue that this is destabilizing, that it will lead to interest rates being too high in one country and too low in another, and so on. This objection would have more force if independent central banks had a better track record of getting monetary policy right even in one country. But they don’t.

The better question is whether the things that an independent monetary policy allows you to do are worth doing.

If the government controls the central bank, it can try to manipulate the supply and price of credit through open-market operations. But as we can see in Europe, Japan and the U.S. today, even near-zero or negative real interest rates do not guarantee robust growth or full employment. It’s surprising to see the degree to which self-described free-marketeers abandon their skepticism of government omniscience when it comes to the intractable problem of the right price of credit in an economy.

Next, a central bank can print money to help the government meet its spending plans without immediately raising taxes. But over time, this will drive up inflation to intolerable levels as the oversupply of money destroys its value. Think Weimar Germany or modern Zimbabwe before it dollarized its economy. Even in milder forms, as a kind of Keynesian stimulus, this facilitation of deficit spending can provide only a short-term economic boost.

The central bank can also try to manipulate the supply of money in circulation to drive up or (more often) down the foreign-exchange value of its currency, to the short-term advantage of its exporters and the detriment of those who depend on imports. This is the preferred remedy for those who believe that Greece’s salvation lies in exiting the euro, re-adopting the drachma, and promptly devaluing it.

In reality, this means making Greeks poorer by reducing the value of their assets and increasing the price of everything the country imports. In exchange, devaluation will make Greek exports, such as they are, cheaper on international markets. That might well flatter Greece’s economic statistics for a time, but at the price of an enormous destruction of savings and wealth. Economists call this “beggaring thy neighbor,” but it might better be thought of as beggaring thyself.

That the euro has denied its members the opportunities to perform these acts of economic vandalism is nothing to lament. These are not problems in the design of the euro. They were the objective.

The architects of the euro did recognize the serious potential problem with a free rider like Greece. Markets would price its debt as if the country would be bailed out, and so market signals like bond prices would be muted in a currency zone until it was too late. That’s why Europe tried to establish a mechanism, the Stability and Growth Pact, to constrain governments within the bloc.

But these rules were never enforced. Nobel economist Robert Mundell argued on these pages in 1998 that sanctions for breaching the deficit rules should be automatic, and that if they were subject to majority voting they would be gamed, as in fact they were.

The euro has thus obviously not been a perfect cure for governmental incontinence, but it has been a reasonably stable unit of account for the Continent for a decade. It could be one again—if the principle could be re-established that when a country can’t pay its bills, its creditors will take the losses.

If that can’t be done, then we will get either a fiscal union that merges national budget policies, or dissolution. The conceit is that fiscal union will, over time, make Europe more like Germany than Greece. But in practice the opposite is more likely, as the political pressure will always be for higher taxes, a little more inflation, a little more stimulus and increased transfers from rich countries to poor, or from successful economic models to the less successful.

Alternatively the currency bloc could break up. If Greece leaves, it would establish a precedent that countries in trouble will exit the bloc. The euro is a pure fiat currency without a fiscal authority behind it, and the perception of permanence is the only thing keeping it together so far. The costs of breakup would also be extremely high, as markets discount the chances that others will leave and recalibrate political and economic risks across the bloc.

The better solution would be to return to the euro’s original principles, this time with a system that can convince markets that there is genuine discipline. The various funds and ECB bond-buying plans are not such discipline. They may buy short-term confidence, but they will not assure lenders or taxpayers that the same cycle won’t repeat itself.

The first step toward imposing such discipline would be a Greek default with haircuts for creditors. This would allow Athens to reduce its debt burden and once again have the capacity to grow, assuming it changes its policies. This will be painful for Greece and the banks that lent to Greece, but not nearly as painful as a breakup of the euro zone or more years of continuing the current bailout patchwork.
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The Greek crisis hasn’t proved that the euro was a mistake. But the political reaction to it has placed the experiment in serious danger by abandoning the no-bailout principle and replacing it with a doctrine that sovereign default in a currency zone is unthinkable. This policy makes no more sense than saying that bankruptcy should be impossible, because no one will lend to a company if it might go bust. What’s worse is that Europe’s leadership has adopted this view for the sake of defending the Greek government from the consequences of its irresponsibility on spending and mendacity about its true level of deficit and debt.

The solution is not a return to monetary “sovereignty.” Countries don’t need unfettered monetary freedom. Only governments do, to bail themselves out of their own bad policies. If the euro should fail, it will be because those governments did too little to hold themselves to the discipline that a hard currency, albeit a paper one, demanded.
Review & Outlook: Europe and Its Money – WSJ.com.