Thursday, February 23, 2012

Europe and the Rules of the Game

The Lehmann Letter (SM)

Readers know that this letter believes that Europe will work through its debt crisis and emerge stronger and more united in the long run. That would be consistent with Europe's record since the end of World War II.

A historian could go back even further, to the days before World War I, to find a precedent for current events. A century ago Europe was on the gold standard. Each nation pegged the value of its currency to gold. A British pound was worth a certain amount of gold, a German mark a different amount, and so on. This arrangement determined what every participating currency was worth in terms of all the other participating currencies.

The gold-standard nations believed that these arrangements facilitated world trade and investment. As an analogy, think of how a single currency facilitates trade and investment within the United States. A resident of California can do business in New York without worrying about the fluctuation in the value of those states' currencies. They both use the dollar.

Occasionally, however, events strained the pre-World War I gold standard. If a nation faced difficulty (think of the Greek debt crisis) and holders of its currency began selling the currency, those holders might not be able to find buyers at the pegged price. No problem: They could go to the central bank of the nation in difficulty, redeem the currency for gold and exchange the gold for whatever other currency they desired.

Here is where the Rules of the Game came in. Any nation facing a run on its currency of the kind described in the paragraph above was expected to deal with that run with a deflationary policy. Its central bank was supposed to force interest rates upward thereby reducing borrowing and spending and also reducing prices. Lower prices would make its goods more attractive, raising exports and increasing demand for its currency. The increased demand for its currency would offset the sales of its currency to the central bank. The nation in difficulty could remain on the gold standard.

Europe's current approach to Greece is reminiscent of these Rules of the Game. Europe expects Greece to pursue a deflationary policy in order to remain on the euro standard. Europe demands Greece reduce government expenditures and raise taxes. Greece's economy will shrink and unemployment rise, but Europe hopes that this contraction in the government sector will enable Greece to repay its debts and remain in the Euro community.

On February 21 this letter compared Europe's policy to pre-World War I gunboat diplomacy: Europe would take over a nation's finances until that nation repaid its debts to European bondholders. The new Rules of the Game expect each European nation to endure economic contraction rather than risk default.

We'll see if it works.

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© 2012 Michael B. Lehmann

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