Europe’s Monetary Sins

“Sin” is not a word normally associated with the ostensibly highly technical area of monetary policy. It was, however, the word employed by the prominent 20^th-century French monetary economist Jacques Rueff (1896-1978) to explain why Western countries have had such difficulty maintaining stable currencies following the world’s abandonment of the gold standard after the outbreak of war in August 1914.

In one of his last collections of essays, Le Péché Monétaire de l’Occident (1971), Rueff sharply criticized Western governments’ apparent inability to put their currencies in order. The root causes of the inaction, in Rueff’s view, did not lie in prudential disagreements about the technicalities of securing monetary stability. Instead the “sin” lay in the constant manipulation of monetary policy by politicians pursuing short-term and, in many instances, self-interested goals, while simultaneously claiming to be deeply concerned about monetary stability.

Rueff knew what he was talking about. In 1958, Rueff engaged in a more or less singlehanded and ultimately successful struggle against the French political establishment to balance France’s budget and secure the franc’s convertibility. This followed the French economy’s near collapse after years of dirigiste policies and lost colonial wars in Vietnam and Algeria. Successful reform, Rueff stressed, involved being absolutely honest about the policy changes needed and their associated costs. Fortunately, Rueff was able to persuade the one man who mattered—France’s new head of government, General Charles de Gaulle—that the achievement of monetary stability was worth the pain of austerity in the form of dramatic social security cuts, drastic reductions in government subsidies to industry, and the dismantling of trade barriers.

Contemporary Europe could well use far-sighted monetary economists such as Rueff when it comes to addressing some of its present economic problems. Sound monetary policy could not, Rueff understood, be premised on falsehoods. Yet this is precisely the sin presently wreaking such havoc in the euro system today.

Since euro coins and banknotes entered circulation on January 1, 2002, many benefits have flowed from their adoption by many EU member states. The euro has helped them integrate their financial markets, facilitated price transparency across national boundaries, and reduced exchange-rate risks and the costs of currency conversions. The associated creation of the European Central Bank in 1998 with a clear mandate for fighting inflation has aided nations with long histories of monetary instability—such as Italy, Greece, Spain, and Portugal—in escaping the inflation spirals to which they were once susceptible.

But from the euro’s very beginning, it was tarnished by a high degree of fudging of public finances by EU member states anxious to be admitted to the currency. Member states seeking admission were required to have a budget deficit level of less than 3 percent of GDP and a debt ratio of less than 60 percent of GDP. To meet this requirement, some governments employed what might be generously described as “creative accounting” or simply misrepresented their fiscal position. In 2004, Greece’s then-finance minister George Alogoskoufis confessed, “It has been proven that Greece’s budget deficit never fell below 3 percent since 1999.” In the end, most applicant countries were admitted to the euro despite having debt levels exceeding 60 percent. Italy and Belgium, for example, were permitted entry despite having debt ratios of over 120 percent.

Over the long term, the European Stability and Growth Pact (SGP) was supposed to maintain fiscal responsibility in the euro zone by limiting government budget deficits to 3 percent of GDP and their debt to 60 percent. These provisions were, however, quickly violated by countries such as Italy and Portugal but also, ironically, by those nations (Germany and France) who had lobbied the hardest for rigid adherence to these thresholds. The European Commission continues to act as if violation of the SGP is a serious matter. But as Alberto Alesina and Francesco Giavazzi wrote in their book, The Future of Europe (2006), today “the large countries in Europe can do just about anything they please with deficits.”

The effects of this mishmash of untruths, fiscal fudges, misrepresentations and the refusal of sovereign states to be bound by their freely undertaken international obligations are only likely to be magnified by Europe’s present financial and economic problems. This is especially true when it comes to the European Central Bank, its independence, and its role of maintaining the euro’s stability.

Ever since its foundation in 1998, the ECB has been a whipping boy for European politicians from the left and right who argue that the ECB’s legally mandated priority of maintaining price stability has kept productivity and economic growth rates in the EU far below those of America. In reality, these problems have little to do with monetary policy and everything to do with low rates of entrepreneurship, unsustainable levels of welfare expenditure, an aversion to competition, high rates of public sector employment, and structural rigidities associated with some of the world’s most inflexible labor markets. Indeed, it is probable that the ECB’s avoidance of the low interest-rate policies adopted by the Federal Reserve in the 2000s may have made the 2008 recession in Europe more bearable than it might otherwise have been.

Against considerable political pressures, the ECB has hitherto doggedly defended its independence. All that, however, changed when the European Union decided to set up its 750-billion-euro bailout fund in early May 2010 to stabilize financial markets and rescue not only the holders of Greek government debt, but also, implicitly, the holders of any EU government debts that seemed shaky.

One of the more obvious difficulties associated with this package is that it further deepens the moral hazard problem that governments in Europe and America have at best paid lip service to over the past two years. In the long term, protecting governments from the consequences of their failed economic policies by socializing their losses is unlikely to deter the same governments from fiscal irresponsibility in the future. And while the rescue package might give some breathing space to countries such as Greece, it may also result in their governments putting off the harsher but essential elements of the austerity measures they need to take to reduce their sovereign debts.

But the more serious and longer-term damage of the package has been to the independence of the European Central Bank. As the economist John Taylor astutely pointed out in a recent Financial Times article (May 11, 2010), part of the deal involves the ECB buying “the debt of the countries with troublesome debt burdens, just days after it said it would not engage in such purchases.” Clearly the ECB was pressured by EU governments to follow a line similar to that adopted by the Federal Reserve over the past two years.

At present, the ECB is not engaging in “quantitative easing”—i.e., printing money—to fund these purchases. But it is difficult to imagine that the ECB will be able to continue to buy such debt over the long term without engaging in what some European government leaders now call “money creation” (yet another euphemism for printing money). That’s why the ECB’s decision to buy the government debt of some weaker economies amounts to a stunning volte face on the part of a central bank famed for its tough anti-inflation stance. The shock was such that it provoked a rare public criticism of the ECB’s decision by Germany’s central bank president, Axel Weber, in Börsen-Zeitung, a German financial newspaper.

As a result of these decisions, the ECB now has a serious credibility problem. No doubt, the ECB and some European politicians will insist that it remains as independent as ever. This, however, is surely one of those instances of promoting a falsehood about the economy that Jacques Rueff warned against. For the truth is that the ECB’s independence has been compromised. Hence we have every reason to expect those European politicians who have argued for precisely such a diminution of the ECB’s autonomy to view this as a precedent for further compromises.

Even more seriously, there is a question as to whether the ECB’s recent actions are compatible with its legally mandated priorities and responsibilities. No doubt the ECB will argue that its particular role in the implementation of the EU’s very own TARP for bankrupt governments is in the interests of long-term monetary stability.

This, however, would constitute yet another misrepresentation. The more the ECB involves itself directly in supporting European governments’ fiscal policies, the less independent it will be in appearance and practice, and the less it will be able to resist exhortations to adjust monetary policy to fit goals dictated in part by the short-term horizons of elected officials. As the Economist (May 11, 2010) recently stated, “The central bank’s credibility relies in part on a reputation for living up to its pledges and partly on its disdain for political expediency. On both counts, then, [the ECB] has lost something.”

Like politics, economic policy is a messy affair. This is especially true in mass democracies like those of Western Europe, in which permanent economic security is now regarded as a God-given right. Inevitably, there will be compromises. But this is all the more reason for those formulating EU monetary policy to resist being economical with the truth or claiming they are not doing something that everyone knows they are doing.

In his most important book, L’Ordre Social (1945), one of Jacques Rueff’s last exhortations to his readers was: “Be liberal, be socialist, but do not be liars.” It’s advice that Europeans directing monetary policy would be wise to listen to today.