30th Sep 2022


The unsound doctrine of sound money

So it's hello M Trichet and goodbye Mhr Duisenberg, a man who will be remembered for presiding over the successful launch of the euro, though hardly for his stirring oratory and pro-active monetary policy.

As a former President of the Dutch Central Bank, he replicated the fiscal orthodoxy of the Bundesbank. The first President of the ECB was a very conventional banker.

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Contrary to popular myth, Wim Duisenberg is not a Conservative; in the 1970s he served as Finance Minister in the PvdA Government of Joop den Uyl where his brief was to contain the inflationary pressure generated by the 1973 oil price rise. He is a passionate European who believes above all in 'sound money'.

His parting shot was to warn us that any tinkering with the Stability and Growth pact would be a "disaster for Europe" and would weaken the currency as well as the cohesion of the eurozone. I happen to believe the SGP should be scrapped, but then I am an economist, not a banker.

Sound Money

Professional economists tend to forget that the paradigms of 'Keynsianism', 'monetarism', 'rational expectations' and so forth have little purchase on bankers. Nor do bankers have much time for discussing the pros and cons of the social market or the discontents of globalisation. The business of banking is above all the business of making prudent loans and keeping the books balanced so that your creditors, mainly the man in the street who entrusts you with his savings, will feel safe.

Bankers worry in essence about three things. First, they are concerned about customers, particularly governments, who borrow excessively. Such customers may be unable to pay back their loans, hence leaving the bank with a non-performing asset.

Secondly, bankers worry about inflation, which erodes the real value of a bank's assets. In this their views are different from those of businessmen and householders who hold debt, the value of which is comfortably eroded by mild inflation. Finally, bankers believe in a sound domestic currency, particularly where they borrow from international money markets in order to on lend to domestic customers.

The Woes of the Eurozone Core Economies

When an economy is growing healthily and inflationary pressure must be kept under control, a policy of sound money is perfectly acceptable. Unfortunately, market economies do not grow at a healthy pace all the time; rather, they suffer from cyclical downturns, bouts of 'irrational exuberance' and external shocks. At present, the core economies of the EU are experiencing a cyclical downturn. Germany's GDP has been falling for more than three successive quarters; technically, Germany is in recession, as is Italy and (nearly) France despite a low nominal interest rate of 2 percent.

The problem of EU recession is aggravated by some further factors. Growth in Germany and France has been anaemic for a decade while inflation, which has been falling steadily, is in danger of turning negative. Negative inflation, or 'deflation', is a very serious condition requiring prompt monetary expansion - as the sad case of Japan illustrates all too clearly.

Equally, while the core Eurozone economies require certain structural reforms, such reforms take time to implement. Closely related is the fact that core-country Eurozone unemployment has been high and remains so, thus exacerbating social tensions and explaining in part the EU's recent rightward political drift. Finally, the euro has appreciated strongly against the US dollar, making manufacturing exports less competitive. Countries like Germany rely on export growth to prosper.

The cost of sound money

Under such circumstances, to argue that the EU must pursue 'the economics of sound money' is bad advice. Both monetarists and Keynesians agree that extreme monetary prudence can plunge an economy into depression and that the way out of depression is to pursue expansionary policies. More than half a century ago Keynes explained the `paradox of thrift'; when the economy is depressed, uncertainty leads consumers to increase their savings, thus lowering consumption and aggregate demand still further.

Luckily, the US Federal Reserve Bank is bound by statute to consider both inflation and unemployment. By contrast, the drafters of the ECB statutes to which the 1992 Maastricht Treaty gave rise failed to mention unemployment.

One might add that the IMF, which has promoted independent Central Banks for two decades, dislikes employment targeting. I say 'luckily' because Mr Greenspan, unlike Mhr Duisenberg, was willing to back an enormous (if very badly designed) fiscal stimulus to the US economy that now shows signs of kick-starting growth---according to the latest figures at an annualised quarterly rate of over 7 percent!

Mr Greenspan, quite unlike the outgoing ECB President, relies on economic principles (and some quite sophisticated econometric forecasting of growth and employment) rather than on the principles of `sound money'. Nor is Mr Greenspan fixated by the notion of a `strong currency'. Let us hope that Monsieur Trichet will recognise that what the Eurozone needs is policy informed by sound economic principles, not banker's orthodoxy.

George Irvin is UHD Professor of Economics at ISS, The Hague


The views expressed in this opinion piece are the author's, not those of EUobserver.

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