The Gold Standard, the Euro, and the Origins of the Greek Sovereign Debt Crisis

The planners of a European monetary union would be well advised to study the reasons the pre-World War I gold standard was a successful monetary regime. --Anna J. Schwartz (1993) The entry of Greece into the eurozone in 2001 was widely expected to mark a transformation in the country's economic destiny. During the decade of the 1980s, and for much of the 1990s, the economy had been saddled with double-digit inflation rates, double-digit fiscal deficits (as a percentage of GDP), large current-account imbalances, very low growth rates, and a series of exchange rate crises. Adoption of the euro--the value of which was underpinned by the monetary policy of the European Central Bank (ECB)--was expected to produce a low-inflation environment, contributing to lower nominal interest rates and longer economic horizons, thereby encouraging private investment and economic growth. The elimination of nominal exchange-rate fluctuations among the former currencies of members of the eurozone was expected to reduce exchange rate uncertainty and risk premia, lowering the costs of servicing the public sector debt, facilitating fiscal adjustment, and freeing resources for other uses. And that is precisely what happened--at least for a while. In the years immediately prior to and immediately after Greece's entry into the eurozone, nominal and real interest rates came down sharply, contributing to high real growth rates. From 2001 through 2008, real GDP rose by an average rate of 3.9 percent per year--the second-highest growth rate (after that of Ireland) in the eurozone. Inflation, which averaged almost 10 percent in the decade prior to eurozone entry, averaged only 3.4 percent over the period 2001-08. Then, beginning in 2009, everything changed as Greece became the center of a major financial crisis. Interest rates on long-term government debt soared from the low single digits prior to the crisis to a peak of 42 percent in early 2012; the country had to resort to two successive adjustment programs (in May 2010 and March 2012) with official international lenders; and the Greek government restructured its debt. Between the end of 2008 and mid-2012, the economy contracted by a cumulative 20 percent (and it continues to contract), and the unemployment rate jumped from less than 8 percent to about 25 percent. Like Odysseus's return trip home from the Trojan War, the road to Ithaca led to a Tartarean hell. What happened? And why did it happen? To answer these questions, we begin by describing the origins of the Greek financial crisis, highlighting the crucial role of growing fiscal and external imbalances. Next, we identify what we believe was a key factor that abetted those imbalances--namely, the absence of an automatic eurozone adjustment mechanism to reduce members' external imbalances. To illustrate our argument, we compare the adjustment mechanism in the eurozone with the adjustment mechanism for the participants of the classical gold-standard regime of the late 19th and early 20th centuries. Are there major differences between the working of the gold-standard adjustment mechanism and that of the eurozone? What are the lessons that can be drawn from a comparison between the gold standard and the eurozone? We address these questions in what follows. [FIGURE 1 OMITTED] The Years of Living Dangerously As mentioned, Greek interest rates came down sharply in the years immediately prior to, and immediately after, the country's entry into the eurozone. Figure 1 shows the monthly interest-rate spread between 10-year Greek and German government bonds for the period 1998-2012. (1) The spread fell steadily, from over 600 basis points in early 1998 to about 100 basis points one year prior to Greece's eurozone entry. By the time Greece entered the eurozone in 2001, the spread had fallen to around 50 basis points; it continued to narrow subsequently, declining to between 10 and 30 basis points from late "2002 until the end of 2007. …