Nothing lasts forever. The fall of the dollar continues to strengthen the euro, while there are signs that financial turbulence will put the euro-zone under stress for some time to come. Given this, exit from the euro is now conceivable – if not very practical, as Barry Eichengreen has argued – especially where economic pressure meets a political climate for change, as in Italy. The closest match in history appears to be the exit of European economies from the gold-exchange standard in the wake of the Great Depression. Can a look back help us to assess the current risks for a break-up of the euro? Yes, it can help. But mind the gap. The euro is different and will be with us for a while.
In 1929, tightening monetary conditions in the US reduced capital outflows to the rest of the world and forced deficit countries to tackle their imbalances. This put countries on the gold-exchange standard between Scylla and Charybdis. On the one hand, adherence to the system – neither imposing capital controls nor devaluing the currency – implied a painful increase in real factor costs and reduced international competitiveness. On the other hand, unilateral steps towards devaluation or capital controls risked diminishing confidence in the stability of the national currency. And such confidence was highly valued in European countries that had just experienced a hyperinflation, had not yet established any track record of monetary policy, or just badly needed foreign capital for domestic development.
However, the pattern of exit from the gold-exchange standard in the 1930s was quite peculiar and suggests that more than that simple trade-off affected the monetary regime choices of European countries. Germany left gold in July 1931, soon followed by the Habsburg successors Hungary, Austria, Czechoslovakia and also Sweden in September 1931, only the latter two being net-capital exporters. In contrast, Italy left gold only in 1934, while (capital-rich) France in the west and (capital-poor) Poland in the east adhered to the gold-exchange standard until the bitter end in 1936. In recent research, I analyse exit probabilities using a large new set of monthly panel data for Europe over the period January 1928 through December 1936. Briefly, the key determinants were national institutions, cross-border economic integration, and the stability of the financial sector (Wolf 2008).
Why did they leave?
While every European country faced the same basic trade-off in the decision whether to exit the gold-exchange standard, those with a strong, independent central bank and stable democratic institutions were quicker to leave. They were less willing to suffer through a domestic-adjustment crisis as advocated by monetary orthodoxy because the extension of the franchise after 1918 gave a political voice to those who cared about unemployment. And they were better equipped to risk an independent monetary policy with a strong independent central bank that may have helped to limit the loss in credibility associated with exiting from gold. This mattered especially because adherence to the gold standard in the 1920s was not universally beneficial. For today, there is no question that all European governments are concerned with growth and the reduction of unemployment, but only few could claim that their national central banks have a track record good enough to replace the ECB. This suggests that good performance by the ECB over the next few years will significantly reduce the probability of a euro break up.
The analysis of the interwar experience also shows that neighbours matter: countries tended to follow their main economic partner in their monetary regime choice, ceteris paribus. For example, Sweden’s decision to exit in September 1931 was clearly driven by its commercial interest in trade with England, which had just announced its exit. But some neighbours were better liked than others. Poland was eager to tighten its economic and political links with France in order to distance itself from Germany, in stark contrast to Austria, Hungary, or Czechoslovakia in the early 1930s. The new Polish state that had re-emerged on the European map in 1918 needed France to limit its massive dependence on Germany and Austria, inherited from 123 years of occupation. In this respect, the euro is certainly different: all members of today’s euro area are part of one tightly integrated market for goods and capital (and increasingly also for labour and services), with the monetary union merely part of a multidimensional economic network. Leaving the euro to help competitiveness would not be a very promising strategy because of the large negative side effects, as argued in Eichengreen (2007). Among other things, an exit would imply political costs, such as possible exclusion from other EU-related decisions.
But what about the financial sector? The empirical evidence for the interwar years suggests that financial turbulence was an additional trigger for exit (as suggested in “third generation models of currency crises”). For Austria, Hungary and Germany, one can make the case that efforts to rescue struggling banks eventually made the exit from gold inevitable. Could a similar financial crisis force a country out of the euro? The answer is not that simple. Pan-European banks whose activities span several euro-countries are rapidly emerging, while financial market supervision remains largely national. If problems emerge in a large pan-European bank, the current institutional framework would not be suited to a timely and quick intervention. Financial turmoil has a growing potential to challenge the monetary system, and a European banking crisis could put existing European institutions, including the euro, under massive stress. Hence, the question is not so much whether any country could be forced to leave the euro in reaction to a banking crisis, but whether the euro could be weakened to such an extent that exit became an option again. The mismatch between a monetary union and national financial market supervision needs to be addressed.
A reassuring history lesson
The euro will be under pressure over the next years, but there is good reason to believe that it will prove more robust than the interwar gold-exchange standard. Every year of good performance relative to other key currencies and every further deepening of integration within the euro- area will increase its chances of living a long life.
Barry Eichengreen (2007), The Breakup of the euro Area, NBER WP 13393.
Nikolaus Wolf (2008), Scylla and Charybdis. Explaining Europe’s Exit from Gold, January 1928-December 1936, CEPR DP 6685.