Understanding the euro — and the German dilemma

The European Union’s efforts to save the euro dominated the news last week. By Friday, all the EU member countries, except for the United Kingdom, agreed to negotiate a new treaty that would set limits on member nations’ budget deficits and expand the existing bailout fund for countries such as Greece and Ireland.

Why did the Europeans expend so much effort to save a currency that has only been around for about a decade? Answering this question involves some economic history, and a realization that the euro is as much a political and historical statement as it is a currency.

1870 to 1913: Industrialization and rise of Germany
Industrialization spread from Great Britain to the European continent and North America from the 1840s through the 1860s. By 1870, the United States, Britain, France and Germany were the largest economies in the world (as measured by real GDP).

The graph above uses a logarithmic scale. This means that the steepness of each curve tells us the growth rate of each country; a steeper line means that country is growing faster.
Source: Angus Maddison, “The World Economy: Historical Statistics”
The graph above uses a logarithmic scale. This means that the steepness of each curve tells us the growth rate of each country; a steeper line means that country is growing faster.

The United States moved to the head of the pack after 1870 and has maintained its lead ever since. As shown in the graph above, the German growth rate, which had been same as Britain’s, accelerated in the 1880s so that by 1913 Germany became biggest economy in Europe.

The late 19th century also witnessed the greatest movements of goods and people that had ever taken place in human history. In fact, relative to production and population, these flows were far greater than what we observe today. To top it off, Germany’s biggest trading partner was Britain, and vice versa.

Yet, this system crashed and burned in the inferno of World War I. The international trading system was shattered. The German economy, which had been at the heart of continental Europe’s industrial system, was in ruins.

1919 to 1945: The Humpty Dumpty period
“All the king’s horses and all the king’s men couldn’t put Humpty together again.” The industrialized countries of Europe and the United States tried to put the pre-war system back together, but there were two insurmountable problems.

First, France and Britain were determined to restrain the growth of German economic power, which threatened to overtake them again, and to punish Germany by extracting large war reparations. Yet most of the European economies, especially France, had relied on trade with Germany as an engine of growth. Since the engine was set to idle (at best), the rest of the European economy sputtered as well.

Second, the conventional wisdom was that before World War I, economies prospered and trade exploded because of the spread of the gold standard. Most policymakers thought that putting that system back together would go a long way toward repairing the damage of the war.

These were fatal mistakes. In particular, it’s now clear that the gold standard operated as well as it did because of the relative stability of the international economy from 1870 to 1914, not the other way around. By forcing themselves back into these “golden fetters” — to borrow a phrase coined by John Maynard Keynes — the industrialized economies made it impossible to deal with a serious recession when it came in 1929.

The policies of the gold standard required economies to do exactly the opposite of what we would today prescribe for an economy in recession. Today, we would recommend monetary expansion via lowered interest rates. Then, the monetary authorities — especially the Bank of England and the Federal Reserve Board — raised interest rates in order to protect their exchange rates. This drove economies down even further, from recession into depression and ultimately into another world war.

1945 to 1990: The Cold War
In 1944, the United States and Britain convened a conference in Bretton Woods, N.H., to plan the post-war international system. The assembled leaders decided that the malfunctioning of the international economy had played an important part in causing the Great Depression and the war. They believed that international institutions needed to be constructed in order to keep the international economy functioning smoothly. The resulting institutions, the International Monetary Fund and the World Bank, are with us today. 

However, no one at Bretton Woods foresaw the most important dynamic that would affect the international economy: the Cold War.

The Bretton Woods architects assumed that countries would specialize according to their comparative advantages, just as predicted by economic theory. Thus, countries would decide with whom to trade and what to trade on the basis of the question: “What can another country do for me economically?”

The Cold War moved this question to second place and put another question first: “Whose side are you on?” If the answer was “the West” you were invited to join in the Bretton Woods system. If it was “the East” you were barred from participation. If your answer was “why do I have to choose?” you became part of the new Third World and you had to negotiate an international economy that was sometimes favorable and sometimes hostile to your interests.

This created a peculiar international economy that the Bretton Woods institutions were not designed to handle. Countries such as West Germany and Japan were built up as economic powers in order to protect the West from communism.

Germany: A European dilemma
So the Cold War presented a dilemma. Fighting the Cold War required a strong West German economy. But how could West Germany’s economy be unleashed without making them the dominant power in Europe? France was especially keen on avoiding a re-run of the 1920s and 1930s. 

The solution evolved gradually from the late 1940s through the early 1990s.

The United States took the first step through the Marshall Plan. The Americans decided that rather than work with each country individually, Europeans would have to cooperate as a group and create continent-wide proposals for how the aid was to be used. (The British did not like this, but given their need for aid they were in no position to oppose the Americans.) In 1948, western European governments set up an institution called the Organization for European Economic Cooperation to coordinate economic plans across national lines and work together in allocating Marshall Plan funds.

The French and Germans made the next move by creating (along with Belgium, Luxemburg and the Netherlands) the European Coal and Steel Community in order to harmonize these industries across national lines. This led directly, in 1957, to the creation of the European Economic Community (EEC), in which tariffs on almost all goods and services were eliminated among the six states. The EEC continued to expand over the years with Britain, Denmark and Ireland joining in 1973, Greece in 1981, and Spain and Portugal in 1986.

Then came the fall of the Berlin Wall and the unification of Germany, and with it the reappearance of the German dilemma. With the end of the Cold War, how could France and other countries prevent Germany from resuming its place as the dominant power in Europe?

The answer came in two parts. First, the EEC, now renamed the European Union (EU), decided that they would continue to add new members and expand the free-trade zone so that it stretched across the entire continent. This would integrate Germany’s economy with all of its neighbors (both east and west) and link its economic fortunes with theirs.

Second, the EU’s leaders hit upon a clever way to take advantage of Germany’s strong currency, the Deutsche Mark (DM). Starting in the 1960s, the DM took its place as an international reserve currency, and one possibility arising from German unification was that other countries might simply adopt the DM as their own. (This was not a far-fetched idea, as a number of countries have eliminated their own currencies and adopted the dollar.) 

Instead, the EU countries negotiated the Maastricht Treaty, under whose terms economies would first fix their exchange rates relative to Germany’s, and then later the individual currencies would be removed in favor of a common currency for everyone. This is exactly what was done between 1991 and 2001 as the DM, French Franc, Spanish Peseta, Greek Drachma and other currencies disappeared and Germany, France, Spain and Greece (along other countries) adopted the euro.

So the euro is the product of a long political struggle to tie Germany securely to the rest of Europe. Allowing the euro to collapse would be equivalent to giving up on a 60-year effort at European integration. Only Britain was willing to put this at risk, and they found themselves alone when the other 26 EU countries agreed to negotiate a new treaty.

Impact on Minnesota?
Why should Americans in general and Minnesotans in particular care about all this? The short answer is that our economy is tied to Europe’s through trade and finance. Any disruptions caused by a breakup of the euro will certainly affect our economy. The long answer will have to wait until next week’s post.

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Comments (8)

  1. Submitted by Jeff Pricco on 12/14/2011 - 11:40 am.

    Good article, the European situation is definitely important as it has derailed world economic recovery for the time being. some farmers and companies in Minnesota no doubt are affected by the collapse and scandal of MF Global which is directly related to the European problems.

    Noting the “problem” of Germany’s peaceful integration as an economic power in Europe is well taken. However it seems at the present point that the social gains for the rest of Europe in terms of a peaceful Germany versus the real German economic gains from the euro system are not so appreciated by Ireland, Spain, Italy and Greece right now (and certainly not David Cameron’s Britain). Germany continues to preach its prudent ministry to the rest of Europe somehow without the acknowledgement that Germany prospered significantly from the cooperation and purchasing power of its EC partners which directly benefit Germany’s export oriented economy. In the end I continue to have a hard time seeing how economic union is possible without political union. The United States learned that quickly from 1781 to 1789; and it could be argued it had its more serious lesson from 1861-1865. If I were Spanish, or Italian or Portuguese right now I might want to study the return of my own currency to allow for a quicker return out of recession than the austerity diet of bread and water prescribed by Ms Merkel.

    Finally I would beg to differ on the period of 1870 to 1913 as one of relative stability. The world economy had a very serious depression from 1873-1879 which is sometimes mentioned as comparable to our current situation, and financial recessions also afflicted much of the world for prolonged periods in 1893 and 1903 as well.

  2. Submitted by Paul Udstrand on 12/14/2011 - 11:43 am.

    What is it about Germany that makes their economy so strong all the time anyways?

  3. Submitted by dan buechler on 12/14/2011 - 03:29 pm.

    Nnaill Ferguson at the end of his book on WWI, states that even with losing both world wars Germany in the end has won. What do you think of using some inflation to support intergration?

  4. Submitted by Ray Schoch on 12/14/2011 - 04:14 pm.

    Hmmm. It would certainly be more difficult than our experience, and the long histories and different languages of the states involved might well make it impossible, but I’m inclined to agree with Jeff’s point that it’s hard to conceive of an economic union without an accompanying political union. THERE’s an idea that should get the gears whirring in brains all over the political spectrum.

    What would it mean for the U.S., for China, for Japan, if “Europe” became a single political entity?

    I’m not sure they could pull it off – some of those animosities go back centuries – and I’m not at all sure very many are even interested in trying it, but if, against the odds, “Europe” were to emerge in the relatively near future as a single political as well as economic entity, it would present some interesting challenges – and opportunities – for the United States, and I think those would apply both economically as well as politically.

    Conversely, if they not only don’t pull it off, or don’t want to become a single political entity, and the current economic crisis deepens enough to split the EU back into its component parts, what does THAT mean for our foreign and economic policies?

    I’m looking forward to Mr. Johnston’s “long term” answer next week…

  5. Submitted by Bob Sebo on 12/14/2011 - 07:30 pm.

    This article was fascinating…thank you very much. I mean…I knew that WWI reparations were a factor in the brewing of WWII…but I never knew the larger political foundation of the reparations. And I was amazed to learn that US GDP outstripped both Britain and Germany as early as 1870! Wow! I do agree that the euro crisis is as political as it is economic. That Britain sat out the whole thing surprises me not. I hope the others can figure it out. Norway I think is also on the sidelines…is Sweden? I think Finland is in.

  6. Submitted by Richard Schulze on 12/14/2011 - 08:20 pm.

    The German attitude makes sense if you believe that those countries in trouble now should never have shared a currency with Germany, and the reforms they need to enact to achieve Teutonic standards of economic health will only happen after default and exit from the Euro. Bailing out countries through the ECB benefits nobody if it only puts off the inevitable failure by a few months or years.

  7. Submitted by Jon Kingstad on 12/14/2011 - 08:38 pm.

    This was an excellent article. But I’m still unclear on two thing. One, I’ve often heard, usually without explanation, that Nixon ended the Bretton Woods system in 1971 by “closing the gold window” at the Federal Reserve. What that accomplished was to prevent foreign governments from redeeming their holdings of US currency for gold at $35/oz. This would have caused an outflow of gold from the US. While this might have been a bad result for the US, I’ve never heard that this was not intended to happen or that the system was otherwise broken because of it. In fact, it is my impression that this was exactly how free international trade was supposed to work. I’d like to hear more about this Bretton Woods System, which was a modified gold standard system, really did not work.

    Second, and related to the first, is why it would necessarily end European integration into a free trading zone? The US never really had a single currency until after 1913 when Federal Reserve notes were made legal tender. Before that we had a multitude of currencies. Every bank could issue its own notes which could be accepted as legal tender for payment. (It was interesting to me to see in the Titanic exhibit the variety of US notes and currencies which American passengers had with them in 1912).

  8. Submitted by John D Sens on 01/05/2012 - 07:57 am.

    The Germans, French, Italians, and Spaniards live in a region not much larger than the US state of Texas. All are highly literate countries. Yet, Germany has consistently outperformed them in terms of productivity. Even after Germany was devastated by WWII the French still feared Germany’s possibility of revival. I’d like a detailed article explaining what the Germans have that allows them to outproduce these other countries.

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