What follows is the slightly revised first part of remarks I gave at the Estoril Political Forum, in Estoril, Portugal, on 28 June 2011.
Of course the euro is flawed. It is not, after all, a monetary standard evolved by the invisible hand of the marketplace from the decentralized choices of millions of users. Nor is it the next-best thing, divinely ordained. Instead, it is the brainchild of politicians and economic technocrats, assembled in committees.
Google the two terms “euro” and “flawed” together, and you receive back more than 2 million results. And that is only for the commentary in English.
Nearly all commentators agree that the euro is flawed in some way. I say “nearly all” but not “absolutely all” because officials of the European Central Bank sometimes join the discussion. They have yet to identify a flaw in the euro or in the European Central Bank that issues it.
There is much less agreement about how the euro is flawed, or about what a more ideal currency system would look like.
When the currency speculator George Soros says that “the euro is a flawed construct,” as he did in a widely reported speech in Berlin last year, he means that in his view it needs a stronger political union behind it, a single pan-European-Union welfare state, so that one fiscal policy (one set of taxing and spending decisions) could be made for all of Europe together with one monetary policy. The ECB’s head, Jean-Claude Trichet, has similarly begun to complain in recent weeks about the ECB’s lack of a companion Eurozone finance ministry to centralize member countries’ fiscal policies. Europe should resist the siren call that greater centralization of power will solve its problems. As a matter of fact, two or more countries can readily have a common money while keeping fiscal independence. They did so under the classical gold standard, a system to which I will return. Soros hopes that with one pan-European government, financially conservative Germany would no longer rule the roost. The ECB could then pursue looser monetary policy, which he supposes would cure the ills of the countries with weak economies and mounting public sector debts. This view, I fear, is widely shared.
When retired Dutch central banker André Szász says that the euro was flawed from the start, as he did earlier this year, he means almost the opposite, that it is a mistake to have “a monetary policy of one-size-fits-all” because such a monetary policy will be too loose for some countries and too tight for others, or as he puts it, interest rates will be “too low” for some countries and “too high” for others. Paul Krugman has registered the same complaint, as has Marine Le Pen of France’s National Front. This criticism is linked to the so-called “optimum currency area” analysis, which holds that to share a single currency, two or more economies should have “harmonized” business cycles so that a single monetary policy (interest rate) fits them all. Otherwise devaluation or exchange rate depreciation is supposed to help a weak economy dampen unemployment by lowering real wages or by stimulating real growth through greater real exports.
I think that both of these diagnoses begin from false premises. They both rest on the wishful thinking of Keynesian economics, in particular on the fond hope that an artfully timed discretionary monetary policy will improve or stabilize an economy’s real performance by improving or stabilizing real variables. That is to say, these arguments take for granted the ability to exploit the Phillips Curve (to lower unemployment by cheapening the monetary unit), alternatively known as exploiting the “money illusion” of the workforce. I think it is the supposed ability to exploit “money illusion” that is the real illusion. A policy regime of printing more money and devaluing does not in fact improve real economic performance, or dampen business cycles, but the does the reverse. The historical evidence on that question is clear.
A better start to understanding the fundamental shortcoming of the euro is to begin with the simple fact that the euro is a fiat currency, a paper money standard. A former business partner of George Soros, but of very different political persuasion, the investor Jim Rogers, has it right when he notes that “generally … paper money is flawed.”
The time-inconsistency problem
Economists have a technical term for the fundamental flaw in fiat money. They call it “the time-inconsistency problem” or “the credible commitment problem.”
The classical allegory for the time-inconsistency problem is the episode in the Odyssey in which Odysseus wants to hear the beautiful singing of Sirens, but knows that without some binding constraint to keep him from the ship’s tiller, he would give into the temptation to steer the ship in the direction of the Sirens and end up smashed on the rocks. Solution? He has his shipmates tie him to the ship’s mast, and plug all of their own ears with wax. By constraining himself against temptation, Odysseus achieves a better outcome than if he had left himself with moment-by-moment discretion. In light of today’s news, how ironic that this man who know to bind himself against short-sighted behavior was Greek.
When central bankers who issue fiat money have the discretion to alter monetary policy from month to month, to do whatever seems desirable at the moment, they also have a problem of the same sort. (Kydland and Prescott brought this problem to the economics profession’s attention, and received a Nobel Prize in large part for doing so.) Central bankers will find themselves pressured to promise low inflation and then to deliver something else that is inconsistent with low inflation, namely rapid money growth to lower unemployment or to buy up bad debts. They face no penalty for breaking their promises. As a result, the private citizens who use euros (for example) don’t know what the euro will be worth 5 or 10 years out, unless there is some binding commitment to a steady policy path. Without a binding commitment, inflation is unnecessarily high and variable.
The European Central Bank has a commitment on paper, of course, to keep inflation below 2 percent. But in the face of
pressure to buy the bonds of heavily indebted governments, to delay the day of reckoning for the sovereign debt crises of Greece, Ireland, and Portugal, the ECB’s commitment to low inflation is crumbling.
Contrast a free-market silver or gold standard. Under such a monetary standard, the private mining firms that dig up the precious metals, the mints that produce coins, and the banks issue redeemable notes and transferable account balances are all constrained by contract and by competition. There is no time-inconsistency problem in monetary policy because there
is no monetary policy. Nobody has discretion over the quantity of money.
The challenge, for those who believe in the rule of law, is to reintroduce such constraints on money creation. If not a gold standard, a serious and enforceable limit on fiat money. You can’t believe in the rule of law and also believe in discretionary rule by central bankers.
The time-inconsistency problem was known to the designers of the ECB constitution and to some of the bank’s early officials, in particular the German economist and ECB board member Otmar Issing and the ECB’s first president, the Dutchman Wim Duisenburg. To their credit, they tried to tie the ECB to the mast, to institute a quasi rule of law, to give to give the euro a binding pre-commitment to a steady policy path. The ECB constitution specified that the ECB is to have an exclusive commitment to “price stability,” and a board statute early on that “price stability” means inflation no higher than 2%. The ECB website continues to declare: “The ECB aims to maintain annual inflation rates as measured by the HICP [Harmonized Index of Consumer Prices] below, but close to, 2% over the medium term.”
In 2000, I participated in a published exchange with Prof. Issing, then a member of the ECB board. In a lecture to the Institute of Economic Affairs (London), Issing emphasized that the ECB constitution had solved the time-inconsistency problem by tying the ECB irrevocably to the single goal of price stability. In my commentary I said it was too soon to tell whether the constitution’s commitment on paper would actually bind the ECB in practice when pressure arose to pursue some other goal. For a commitment to be a binding commitment, there must be some penalty for going astray. The ECB constitution unfortunately does not specify any penalty for ECB officials who deviate from an exclusive focus on price stability. They do not lose their jobs. This is a fundamental design flaw. The euro performed well for a decade, but now the sirens are singing.
Today the leadership of the ECB, under pressure from the EU and the national fiscal authorities, is violating its constitutional duty by filling the ECB portfolio with junk bonds from Greece, Ireland, and Portugal, in order to keep prices on those bonds high and yields low. It is trying to support government bond prices generally, to make debt rollovers cheaper, by holding interest rates at a record low level, a level that is inconsistent with keeping inflation at or below 2 percent.
The result of the new monetary policy is becoming evident. In 2011, the euro inflation rate has been persistently above the promised 2 percent ceiling. The HICP has risen from 110.6 in November 2010 to 113.1 May 2011, six months of inflation at an annual rate of 4.5 percent, more than double the constitutional rate. How much higher will the ECB let it go?