How a Fragile Euro May Not Survive The Next Crisis
A big US monetary inflation bang brought the euro into existence. Here’s a prediction: It’s death will occur in response to a different type of US monetary bang — the sudden emergence of a “deflationary interlude.” And this could come sooner than many expect.
The explanation of this sphinx-like puzzle starts with Paul Volcker’s abandonment of the road to sound money in 1985/6. The defining moment came when the then Fed Chief joined with President Reagan’s new Treasury Secretary, James Baker, in a campaign to devalue the dollar. The so-called “Plaza Accord” of 1985 launched the offensive.
Volcker, the once notorious devaluation warrior of the Nixon Administration (as its Treasury under-secretary), never changed his spots, seeing large US trade deficits as dangerous. The alternative diagnosis — that in the early mid-1980s these were a transitory counterpart to increased US economic dynamism and a resurgent global demand for a now apparently hard dollar — just did not register with this top official.
Hence the opportunity to restore sound money. But this comes very rarely in history — only in fact, where high inflation has induced general political revulsion (as for example after the Civil War) — was inflation snuffed out. In the European context this meant the end of the brief hard-Deutsche-mark (DM) era and the birth of the soft euro.
The run-up of the DM in 1985-7 against other European currencies, as provoked by the US re-launch of monetary inflation, tipped the balance of political power inside Germany in favor of the European Monetary Union (EMU) project. The big exporting companies, the backbone of the ruling Christian Democrat Union (CDU) under Chancellor Kohl, won the day. The hard DM, an evident threat to their profits, had to go. The monetarist regime in Germany tottered towards a final collapse.
Around the globe, there was the inevitable run-up of inflation in the aftermath of the Plaza Accord and Volcker’s capitulation, given that many countries (crucially Japan) sought to limit the dollar’s fall against their own countries by following the US monetary lead. The inflation was evident in asset markets and good markets. Out of that new monetary chaos come an onward journey to the next stabilization experiment on both sides of the Atlantic: the “2 percent inflation standard”.
Volcker in the pre-launch publicity for his new book (Keeping At It: The Quest for Sound Money and Good Government) now criticizes the Federal Reserve and leading foreign central banks for pursuing a 2 percent inflation target. One must wonder where he has been the last 20 years. It seems that as a monetary bureaucrat he follows the timeless rule of not in any way blaming himself for the emergence of subsequent trouble, in this case the deeply flawed 2 percent regime.
Yes, the real evil genius behind the new standard may well have been Stanley Fischer, the intellectual leader of the neo-Keynesian assault, perfectly politically timed, on monetarism. But Volcker provided the opportunity.
Birth of the ECB
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