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Options for Europe – Part 93

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).

Part III – Options for Europe


Chapter 1 – Introduction


The ‘snake’ came under immediate pressure because there were huge capital outflows from the US, which forced European central banks, particularly the Bundesbank to sell large volumes of their currency to defend the fixed parity. Ultimately, the Bundesbank was forced to suspend further foreign exchange market intervention in May 1971 and they closed the foreign exchange market. This action provided on a temporary reprieve but demonstrated very clearly that nations with very different economies and export strength would always find it difficult tying their exchange rates together unless they were prepared to accept politically unpalatable choices regarding fluctuations in domestic economic outcomes, particularly rising unemployment for external deficit nations and threats of inflation for the stronger currencies.

While world leaders tried to stitch the fixed exchange rate system back together again (for example, the short-lived Smithsonian Agreement), the inevitability was that the US would float to allow it greater domestic policy options. Trying to defend an exchange parity tied up monetary policy and meant that the domestic economy had to adjust to trade imbalances. With a freely floating exchange rate, the governments could concentrate on assisting employment and output growth and let the parity adjust should there be trade surpluses or deficits. The US finally abandoned the Bretton Woods system and its residue in 1973 when it floated the dollar after a full blown currency crisis, which occurred because central banks could no longer maintain the agreed parities in the face of widely diverging trade performance and the speculative attacks on the weaker currencies.

The Europeans, driven by their desire to reduce currency fluctuations so as to avoid destabilising the CAP funding mechanisms, has introduced their own system of fixed exchange rates as a result of the Basel Accord in April 1972. Their devotion to the impossible, given the circumstances, was persistent to say the least. The central bankers of Europe wanted the allowable fluctuations between their currencies to be much smaller than were specified, for example, under the Smithsonian Agreement. They wanted the ‘snake’ to traverse a much narrower tunnel! The Basel Accord formalised the ‘snake in the tunnel’ system, which allowed for small variations in the European currency parities only and was seen as the first specific element of the otherwise vague Werner implementation process. It soon became obvious that the system was not viable as the US stimulus in 1973 designed to provide a favourable domestic climate as the federal election approached was met with higher interest rates in Europe to dampen any inflationary surge. In turn, the higher interest rates attracted massive capital outflows out of the US and put further strain on the European currencies.

The “ill-fated snake” (Howarth and Loedel, 2003: xv) started falling apart a few months after the Basel Accord with the British Pound floating in 1972, followed by the Italian lira in 1973. Speculative attacks on the weaker European currencies made matters worse. There was no way the agreed parities could be maintained by the central banks. The currency crisis in 1973 was a replay of the same forces that brought down the Bretton Woods system in 1971. The Bretton Woods system of fixed exchange rates had finally terminated despite the efforts to salvage it.

The trouble for Europe though was far from over. The underlying economic fundamentals in Europe meant that the currency pressures were unstable. Germany faced continual upward pressure and France the opposite. This meant that the Bundesbank was continually having to purchase the ‘snake’ currencies. Central banks, in general, were continuing to intervene on a significant scale to stabilise currency movements. Disruptions caused by the massive oil price hikes in 1973 as the Arab petroleum exporting countries started to flex their muscle led to a major recession and the outbreak of inflation – the twin evils, which became known as stagflation. The US dollar started to strengthen and this forced France out of the snake as the Banque de France faced a shortage of foreign currency reserves that were necessary to buy the franc with in currency markets in order to maintain the parity. Significantly, the ‘snake’ was looking decidedly Germanic by this stage leading to commentators to refer to the residual ‘snake’ system as a Deutsche Mark-zone.

As the oil crisis moderated, the German trade locomotive continued to build even bigger trade surpluses and it became difficult for the Bundesbank to prevent the Mark from breaking the upper limit of the allowable fluctuations without pumping massive quantities of their currency into the world markets, a move that set off all their worst fears of inflation. The system was unsustaianable without further discretionary realignments. It also meant that the first steps to create an economic and monetary union failed because of the vastly different approaches to economic policy by the French and the Germans. The latter prioritised inflation control and elevated monetary policy to the centre stage, whereas the French were willing to engage in traditional Keynesian counter-stabilisation policy using both monetary and fiscal policy. It was also clear that there remained significant hostility among the French to transferring fiscal policy sovereignty to the supranational European level.

Even the 1973 creation of the European Monetary Cooperation Fund (EMCF), which might have been considered Werner’s only legacy, was bedevilled with Franco-German conflict. The Fund was meant to help central banks with the necessary funds to progressively narrow exchange rate fluctuations within Europe. But the deliberations leading to its establishment were, as usual, vexed with both France and Germany adopting passive negative standpoints, albeit for quite different reasons. The French were reluctant to agree to any supranational authority, a consistent position that had hampered progress towards the economic and monetary union since the inception of the idea. The Germans were reluctant because they didn’t want to become the paymaster, especially if funds were being given to governments who were not disciplined in their economic management. Again, a consistent but, ultimately destructive approach in the context of advancing the union. The French and German resistance ensured that the pooling proposal didn’t see the light of day. The EMCF was poorly provisioned from the start and didn’t serve any useful function.

While the plan for economic and monetary union outlined, albeit vaguely, in the 1970 Werner Report optimistically talked about a monetary union based on the irreversible introduction of a new currency and eliminating the exchange rate fluctuations the planned three-stage implementation outlined in the proposal never materialised and was finally abandoned in 1977. The only artefact of the many meetings and interchanges between national leaders, high-level ministers, central bankers and others, was the European Monetary Cooperation Fund, which became nothing much more than an accounting organisation. The main mechanism implemented as a first step in reducing currency fluctuations within Europe – the ‘snake’ – shrank to become a Deutsche Mark-zone and the economic and philosophical differences between the aspirant nations showed no signs of diminishing.

There are many competing explanations as to why Werner’s plan failed to materialise but the basic reason relates to underlying motivation for the ‘European Project’. The French fear and disdain for German (military) dominance in Europe and their fierce notion of sovereignty that militated against delegation of power to supranational institutions remained, as did the German obsession about inflation. The two nations could clearly find ways to cooperate on a political level but trying to form an economic and monetary union with these disparities would prove nearly impossible. In 1972, the Governor of the Danish Central Bank said that “I will begin to believe in European economic and monetary union when someone explains how you control nine horses that are all running at different speeds within the same harness” (McAllister, 2009: 58). Wise words, which went unheeded. These reflections also resonate strongly with the views expressed at the time of the Maastricht deliberations by those who warned that the design being implemented for the Eurozone was flawed and would expose the system to failure.

In 1975, another group of experts were formed as Macdougall Committee to provide advice to the European Commission on what would be required to achieve a successful economic and monetary union. The Committee was advised by some non-European experts in how to organise effective federal systems and were told categorically that it was essential that a central, currency-issuing government assumed primary responsibility for the maintaining stability of spending using fiscal and monetary policy tools. It was clear that non-currency issuing levels of government (for example, state or local governments) did not have the requisite capacity to undertake these functions and ensure the economy maintain stable growth and high levels of employment. In other words, when a federal system is experiencing an economic downturn, perhaps due to a fall in private consumption or investment spending, which may be asymmetric in incidence (that is, affect states within the federation unequally), then the federal government must be able to use deficit spending to compensate for the loss of private spending. A close reading of the Macdougall Report will leave one wondering why the Eurozone was ever created. The major issues they highlighted were clearly still relevant in the 1990s as the European political elites rammed through their ill-thought out plan for a single currency. The Macdougall Report accepted that there had to be strong fiscal presence at the federal level to smooth out economic fluctuations at the sub-federal level and concluded that (p.11): “It is most unlikely that the Community will be anything like so fully integrated in the field of public finance for many years to come as the existing economic unions we have studied.” The factors that the panel of ‘experts’ considered in 1977 would have rendered monetary union then impracticable were subsequently built-in to the Maastricht Treaty. How did that apparent shift in thinking come about?

While the traditional rivalries between France and Germany and the desire to maintain fixed exchange rates were at the centre of the Eurocentric negotiations about increased economic and monetary union in the late 1970s, a new, even more insidious factor, entered the picture. This factor would prove to be a major catalyst for the sequence of events that took Europe to Maastricht and resulted in the flawed Economic and Monetary Union that exists today. The high inflation that followed the OPEC oil price hikes and the resulting high unemployment that accompanied it as governments tried to suppress economic activity to control inflation provoked a major shift in economic thinking – a paradigm shift.

The Keynesian macroeconomic orthodoxy, that had dominated in the post World War II period up until the mid-1970s, was predicated on the view that the level of unemployment was determined by the level of aggregate demand or spending in the economy. Firms employed people if they had sales orders. Accompanying this approach was a view that inflation would only result if the spending outstripped the capacity of the firms to produce goods and services, leaving them no option but to increase prices. So if unemployment became very low as levels of economic activity became high, we might expect inflation. So the stagflationary combination mystified the popularised version of the dominant Keynesian macroeconomic paradigm. Of-course, macroeconomists schooled in this tradition understood that inflation could also emerge as a result of sudden cost pressures (for example, imported raw material price rises such as oil) which then squeezed existing profit margins and the real value of the workers wages, and under certain circumstances, could trigger a struggle between labour and capital over who would bear this loss. However, this understanding was lost on policy makers when responding to the OPEC oil price hikes and they sought to stifle the accelerating inflation by suppressing aggregate spending using policy measures we now refer to as fiscal austerity (public spending cuts and/or tax increases) and tight monetary policy (increasing interest rates). The result was rising unemployment and persistent inflation (once the expectations of higher inflation drove behaviour independently of the state of the labour market). The stagflation created a perception that the Keynesian policy era had failed and bestowed a sense of legitimacy on the free market approach, that had been wholly discredited during the Great Depression by the work of John Maynard Keynes and others, but which was still alive and well in the more conservative academic departments.

The 1970′s thus saw the long-standing dominance of so-called Keynesian macroeconomic theory and policy abandoned by a large number of economists, particularly those in academic institutions in the United States. The resurgence of the free market approach, which we now rather roughly refer to as neo-liberalism manifested initially as Monetarism, and Milton Friedman and his University of Chicago colleagues championed the entry of these ideas back into the mainstream policy debate. Margaret Thatcher’s government was the first to really embrace this conservative academic resurgence. A significant part of the rejection of Keynesian macroeconomics reflected the ideological disdain among a growing number of academic economists of government involvement in the economy. Economics has always been fractured by the ideological division between those who consider that state intervention, regulation and spending is crucial for the achievement of a balanced and equitable economy, and, those who eschew state involvement and believe, with religious passion, that a self-regulating free market can provide increasing wealth and opportunity for all.

The Monetarists rgued that a free market would deliver a unique unemployment rate that was associated with price stability and that government attempts to manipulate that rate using fiscal and/or monetary policy would be futile and would only leave a legacy of accelerating inflation. The policy makers thus should just fight inflation and let the unemployment settle at this natural rate. By this time, any Keynesian remedies proposed to reduce unemployment (such as, increasing the fiscal deficit) were met with derision from the bulk of the economics profession who had wholeheartedly embraced Monetarism, which was adopted with religious zeal despite there being scant evidence presented to substantiate their policy approach. This major shift in macroeconomic policy paradigms was going on as the ‘snake’ was slithering into dysfunctional oblivion and the political elites in Europe were seeking their next strategy in the pursuit of the ‘European Project’.

Big changes were also underway in French politics, which significantly altered economic policy, not only domestically, but also with respect to the ‘European Project’. Valéry Giscard d’Estaing was elected as President in 1974. In the traditional policy struggle within France between the Planning Ministry (under Jean Monnet), who were disposed to Keynesian solutions and the technocrats in the Ministry of Finance, who were more amenable to the German position on integration and economic management and who would later embrace the neo-liberal resurgence with relish, Giscard d’Estaing was in the latter camp. Giscard d’Estaing appointed Raymond Barre as Prime Minister and Minister of Economy and Finance in 1976 and the pair promoted a powerful anti-Gaullist position with respect to domestic economic policy, reflecting their neo-liberal views, and moved the French perspective on ‘Europe’ closer towards the German ‘economists’ viewpoint.

The Barre plan, unveiled in 1976 abandoned the Keynesian emphasis of the past and involved a combination of tax increases, wage freezes to fight inflation, fiscal austerity, attacks on trade unions and industrial restructuring, particularly in the steel industry. The French government was now focused on ensuring the currency was strong and that domestic costs, including wages were suppressed. The policy focus shifted from regarding the fiscal balance as a reflection of the pursuit of functional ends (like a strong domestic economy with low unemployment) to one where the balance became an objective in its own right. The claim was that by imposing harsh fiscal austerity the necessary economy would emerge stronger with lower unemployment. The Barre Plan bore striking similarities with the austerity imposed by the Troika in 2010. He disregarded the unemployed, telling them to try harder and, just like in the current period, the austerity plan caused economic growth to falter and unemployment to rise. Inflation was also not reduced substantially and the French franc continued to depreciate.

Further, German monetary policy was caught in a contradictory bind given its long-standing prioritisation of domestic price stability and the obligations of the central bank under the Bretton Woods agreement. The Bundesbank was required to defend the exchange rate (principally by expanding the money supply through the sale of Deutsche Marks to keep its value down) despite the basic charter of the Bank being to maintain price stability. Rising inflation as the currency strengthened in the latter part of the 1960s was a manifestation of this compromised position. Inflation further accelerated in 1973 as the oil price rises impacted – a common trend across the advanced world. Helmut Schmidt succeeded Willy Brandt as German Chancellor in 1974 and there were clear signs that the policy position was hardening to a more conservative ‘fight inflation first’ strategy. The ‘Das Modell Deutschland’ (the German Model) was advanced as the way forward, a mix of hard-line attitudes to inflation with social policies to take the pressure off the collective bargaining process. The Bundesbank was playing its usual role and hiked interest rates to quell the inflation. This strategy led to widespread criticism, particularly from the US, who wanted Germany to ease rates and thus reduce the incentive for capital flows to move out of US Dollars into Deutsche Marks.

Helmut Schmidt and Giscard d’Estaing both came to office at a time the global economy was in chaos as a result of the oil crisis, stagflation and on-going currency speculation. For the first time, the Germans found a French ally who was willing to advance the ‘European’ issue. Once again the heightened motivation for monetary integration was directly related to the weakening of the US Dollar. Throughout the 1970s, the Deutsche Mark was appreciating against the US Dollar and the French Franc. The strains reached breaking point when the Deutsche Mark appreciated strongly against the US Dollar in 1977 and early 1978 and the French Franc simultaneously weakened against the Mark. The perverse currency movements were imposing costs on the German export industries and provided the motivation for Germany to seek a better way of shifting some of the adjustment burden from its economy onto the weaker currencies in European trade partners. In other words, it wanted to reduce the asymmetry in the system that was biased against Germany. The Bundesbank feared that a lack of discipline in the weaker currency nations would force it to take responsibility for maintaining the parities and, in the context of an appreciating Deutsche Mark, this would compromise their capacity to reduce inflation. Conversely, the weaker currency nations (France, Italy, the United Kingdom) were concerned that they would have to accept the restrictive Bundesbank monetary policy settings or else face major capital outflows.


Additional references

This list will be progressively compiled.

Barbash, J. (1982) ‘The Guilds of Academe’, Challenge, 25(1), March-April, 50-54.

Blanchard, O. (2008) ‘The State of Macro’, NBER Working Paper No. 14259, National Bureau of Economic Research, August.

Democracy Now (2007) ‘The Conscience of a Liberal: New York Times Columnist Paul Krugman on Healthcare, Tax Cuts, Social Security, the Mortgage Crisis and Alan Greenspan’, October 17, 2007.

European Commission (2014) ‘History of the CAP’,, Accessed May 26, 2014.

Independent Evaluation Office (IEO) (2011) ‘ IMF Performance in the Run-Up to the Financial and Economic Crisis: IMF Surveillance in 2004-07’, Washington, International Monetary Fund.

Janis, I.L. (1972) Victims of Groupthink, New York, Houghton Mifflin.

Janis, I.L. (1982) Groupthink: Psychological Studies of Policy Decisions and Fiascoes, Second Edition, New York, Houghton Mifflin.

Goodacre, H. (2014) ‘Economics Departments have fallen behind’, Financial Times, May 23, 2014.

Gordon, D.M. (1972) Theories of poverty and underemployment, Lexington, Mass: Heath, Lexington Books.

Grim, R. (2009) ‘Priceless: How the Federal Reserve Bought the Economics Profession’, Huffington Post, May 13, 2009.

Gross, C.C. (2008) ‘Three before their time: neuroscientists whose ideas were ignored by their contemporaries’, Experimental Brain Research, 192(3), January, 321-34.

Kazin, M. (2006) A Godly Hero: The Life of William Jennings Bryan, New York, Alfred A. Knopf.

Krugman, P. (2009) ‘How Did Economists Get It So Wrong?’, New York Times, September 2, 2009.

Kuhn, T.S. (1996) The Structure of Scientific Revolutions, Third Edition, Chicago, The University of Chicago Press.

Lakatos, I. (1970) ‘Falsification and the Methodology of Scientific Research Programmes’, in Lakatos, I. and Musgrave, A. (eds.) (1990) Criticism and the Growth of Knowledge, Cambridge, Cambridge University Press, 91-195.

Ludlow, N.P. (2005) ‘The Making of the CAP: Towards a Historical Analysis of the EU’s First Major Policy’, Contemporary European History, 14(3), August, 347-371.

Schiller, R.J. (2008) ‘Challenging the Crowd in Whispers, Not Shouts ‘, New York Times, November 2, 2008.

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.

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