Lessons from History – Fixed Exchange Rate systems under strain

The ongoing collapse of the economy and the financial system in Argentina – which is now threatening to become the biggest destruction of national wealth since the Great Depression – is not just a disaster for the Argentine people. It is also a major embarrassment for all the international economists and advisers who have urged ever more austerity on the government in Buenos Aires as the price for successive rounds of support.

But is it merely embarrassing for the international community, or are they guilty of the far more serious crime of failing to learn from earlier mistakes? For the student of history it is impossible to avoid a strong sense of déjà-vu. Argentina’s spiral into recession and debt, and the collapse of the exchange rate, is all too reminiscent of the crises that rocked the world financial system in the 1930s.

The period between the two world wars was a period of budgetary orthodoxy – a near universal belief that countries and their governments should run balanced budgets – and monetary internationalism. Exchange rates were largely fixed (to gold), and countries had very limited interest rate freedom.  Moreover, even for those countries not on the gold standard, it was widely agreed to be “the ideal”, and great efforts were made to stay on or return to gold (eg the UK in 1926).

In the absence of either monetary or exchange rate autonomy, the dominant policy tool used by governments in this period was trade tariffs – a uniquely dangerous policy instrument, both because the act of raising tariff barriers against another country almost invited retaliation, thus ensuring mutual impoverishment, and because once raised, they were for domestic political reasons almost impossible to lower, thus ensuring that trade, and the national economies that depended on trade, could only sink further.

This economic model, with its highly limited monetary and fiscal flexibility and dangerous reliance on trade policy, was always challenging to governments, even in the warmer financial climate of the 1920s. But as the colder economic winds started to blow after 1929, the task of maintaining international confidence became progressively more difficult.  Countries experiencing difficulties were subject to gold outflows, and the universal solution imposed by foreign lenders was further budgetary restraint.  Governments facing fiscal shortfalls – usually due to economic slowdowns – were told to cut their deficits as the price for ongoing support.  The tools at their disposal to do this, such as increases in taxes and reductions in government expenditure and public sector wages, merely exacerbated the economic slowdown and the weakness of fiscal revenues.

In country after country this downward spiral was played out. No country seemed to have the magic solution which would restore confidence and prosperity.  One after another the countries of central Europe (Hungary, Austria, Germany), western Europe (UK, France), Asia (Japan) and the Americas (USA, Argentina) faced these problems and in every case the currency link to the gold standard had to be surrendered.  Only then could deficit spending – most notably Roosevelt’s New Deal in the USA – begin to rescue economies from the mire they had become entrapped in.

In central Europe the position was extreme, as weak banking systems, large overseas debts and weak domestic economies combined to produce “the perfect storm”.  Fiscal problems begat exchange crises, and exchange crises begat financial and banking panics, and they in turn exacerbated the government’s deficits as the authorities struggled to bail out their banking systems.  Each of these countries experienced all three panics, though in different order, and in each, the pain for the population and the anti-government feelings from the intensified unemployment and ever-growing sacrifices eventually exploded into the collapse of democracy and the installation of dictatorships and command economies.

Such was the miserable record of the 1930s. And such, to an uncanny degree, has been the fate of Argentina over the last 4 years.  The cocktail of overseas debt, domestic recession and externally-imposed fiscal stringency has wrought havoc with both government finances and the national banking system, just as it did in central Europe 70 years ago, and the result – a chaotic departure from a fixed exchange rate – is entirely consistent with the 1930s as well.

Economic historians may not have been bold enough and quick enough in drawing the parallels with the 1930s to save Argentina from its fate.  But there are other countries, closer to the heart of the developed world, where the same spiral may be about to start.  For the various countries of Euroland, there is the same 1930s combination of fixed exchange rates (to the euro), and so no independent interest rate freedom, and international commitments, via the Stability and Growth Pact, to ensure countries run balanced budgets.  And for countries facing fiscal shortfalls, the pressure is on to cut their deficits, to rein back their public expenditure, to reduce the imbalances in their economy – all likely to exacerbate the economic slowdown that every country is currently facing.

The test of the Euroland system may be just beginning, as external economic slowdown meets internal budget deficits and rising unemployment in some of the EU’s most populous states.  There are of course many differences between the position now and the unique combination of problems that caused the 1930s Great Depression, and no-one seriously predicts another Great Depression at the heart of Europe.  The core countries of Euroland in 2002 are stronger than the central European countries of the 1930s.  And, despite recent attacks on globalisation, the commitment to open trade and the consensus on the positive benefits from global trade are much stronger than they were then.  And European banking systems are stronger now, and governments less indebted (despite the unfunded pension liabilities), and democracy in Europe is stronger than it was in the inter-war period (if one overlooks the democratic deficit at the European Commission and the ECB).

But for Euroland countries faced with rising unemployment, and with neither monetary nor fiscal freedom to act, it would be unwise to draw too much comfort from the fact that this time it is different, that political leaders would never make those mistakes again, that the euro is not the gold standard, and that anyway it couldn’t happen to us.

History does repeat itself for those who allow it to.  Ask the people of Buenos Aires.

This essay was first published by State Street Global Advisors as part of their Insight programme