The European: Mr. Eichengreen, if it is true that history doesn’t repeat itself but certainly rhymes, what can we learn about today’s economic crises from studies of the past?
Eichengreen: Crises are not all cut from the same cloth, so the first fundamental task is to identify earlier crises with the capacity to shed light on current problems and to distinguish them from earlier crises that were, by their nature, very different. In the U.S., there is controversy at the moment about whether 1920 to 1922 or 1929 to 1931 is a more appropriate historical precedent for thinking about 2008-9 and the future. I’m strongly of the view that 1929 to 1931 and 2008 to 2010 were cut from the same cloth, broadly speaking, whereas 1920 to 1922 was a fundamentally different animal. The 1920 to 1921 downturn, like the 1980 to 1981 recession, was caused by monetary tightening by the Federal Reserve designed to wring inflation out of the economy, not by deeper economic and financial imbalances like those that set the stage for 1929 to 1931 and 2008 to 2010. The economy recovered quickly from the 1920 to 1921 downturn, despite an absence of monetary and fiscal stimulus, because of the delayed resumption of ocean shipping after World War I and resulting availability of cheap imported inputs to U.S. production. So inferring from 1920 to 1921 that the economy can recover spontaneously from a serious downturn would be erroneous.
The first task, then, is to test historical analogies and cases for fitness, something that John F. Kennedy did when contemplating how to respond to the Cuban Missile Crisis but Harry Truman failed to do when deciding to intervene in Korea.
The European: Ben Bernanke was a scholar of the Great Depression before he was Fed chairman. How has this expertise shaped responses to the 2008 crisis?
Eichengreen: Bernanke’s reading and scholarship alerted him to the importance of the central bank’s lender of last resort function. It caused him to be vigilant about problems in the banking system, bank failures in the 1930s having been a central focus of Friedman and Schwartz’s influential “Monetary History of the United States.” But that focus also led U.S. officials to neglect problems in the shadow banking system until very late in the game – until after the failure of Lehman Bros. That neglect, too, reflected the “lessons of history,” there not having been a comparably important shadow banking system in the 1930s.
“Keep your fiscal powder dry.“
The European: Some sources of financial stress – the impact of a currency union on Europe’s economic stability, or the idiosyncrasies of highly complex and highly voluminous financial markets – are historically unprecedented. How can governments and regulators deal with situations for which there is no guidebook?
Eichengreen: Even where there don’t exist historical parallels, there still may be useful historical analogies. The interwar gold standard system differed from the euro system in that countries in the 1920s and 1930s still retained their own national currencies. But there were important similarities in how the two systems operated. They both created the illusion that exchange and credit risk had been eliminated. They both set on foot large capital flows from one half of Europe to the other. One wishes that this earlier history had been more prominent in the minds of European policy makers before 2010.
The European: If you were to re-write the guidebook for central bankers and treasury secretaries now, what novel advice would you include in it?
Eichengreen: I’d start by saying: this guidebook needs updating! The structure of the economy and financial system is always changing, so the guidebook always needs revision. For treasuries, I would say “keep your fiscal powder dry.” The crisis is a reminder that governments need to run budget surpluses in good times in order to have room to run deficits in bad times. For central banks I would say “multiple targets require multiple instruments.” We’ve just had a reminder that central banks are responsible for not just price stability and financial stability. Hitting two targets requires two instruments, just like you can’t hit two birds with one bullet unless you’re exceptionally lucky. In central banking the two instruments are interest rate policy and macroprudential policy. The immediate challenge for central banks is to give content to the latter.
“Greece and its creditors have to compromise“
The European: You have argued that “success became the mother of failure.” After initial attempts to stabilize a dire financial system were successful, significant reforms were shelved in favor of austerity. What far-reaching reforms would you have liked to see?
Eichengreen: Three: much higher capital requirements for banks; forcing derivative securities onto exchanges where they can be cleared without counterparty risk; and disconnecting the rating agencies, whose pronouncements have been shown to be unreliable, from the regulatory process.
The European: You have argued for “unconventional” monetary policies to deal with unprecedented economic circumstances. Does this apply as well to the debt-reduction proposals of the new Greek Syriza government?
Eichengreen: Certainly, the proposal to exchange the country’s outstanding obligations for GDP-indexed bonds, where what the creditors receive is a function of how well the Greek economy is doing, and therefore of Greece’s capacity to make debt service payments, is an excellent idea.
The European: Where do you see Greece in the near future? Inside the Eurozone or outside? Trying to repay its debts, or as the beneficiary of a (partial) debt cut?
Eichengreen: Greece has made clear its strong preference to remain in the Eurozone. Unfortunately, Germany has not stated with quite the same force and lack of ambiguity that it prefers having Greece stay inside. Both Greece and its creditors will have to compromise for this outcome to be sustained. So both sides will have to agree on the priority. In the short run, Greece needs a continuation of its program with the Troika (if under another name) and agreement that it can run a somewhat smaller primary budget surplus. Debt reduction will become an issue when interest payments on the official debt are scheduled to resume some years in the future. It doesn’t have to be addressed now.
“Financial systems have always been fragile”
The European: What is your verdict on Germany’s role since 2008? Few important fiscal and monetary decisions are made in Europe without support from Berlin – but has Merkel’s government wielded its influence wisely?
Eichengreen: I would have liked to see Germany contribute more to rebalancing within Europe. If Southern Europe has to export more, then it would help for Northern Europe to import more – and for Germany to address the problem of its chronic current account surplus. If Southern Europe has to lower its relative wages, then it would help for Germany to raise its relative wages – so that the solution doesn’t have to come about via deflation. I’m still hopeful that Germany might contribute more.
The European: The German sociologist Ulrich Beck argued that we live in a “risk society” in which immanent sources of instability and crisis – especially within capitalist economies – threaten the stability of modern societies. Do you agree with the assessment that systemic financial risk has increased to historically unprecedented levels?
Eichengreen: Financial systems have always been risky and fragile. The issue is that a growing share of the population is intimately connected to the financial system – as opposed to the situation, say, 200 years ago. The era of modern democracy has coincided with a 250-year period of relatively constant economic growth. We tend to talk at length about the social consequences of recession and stagflation, but what are the consequences of (prolonged) economic crisis for the political system? There’s plenty of evidence, from the 1930s and recent experience alike, that a prolonged economic crisis that remains unaddressed puts strain on democratic political systems. We saw this with the rise of anti-system parties of both the left and right in the 1930s. We see it again today. The implications are obvious.