Harold James

Stable money foundation of order

The purpose of creating a common currency has been largely and surprisingly forgotten in crisis-torn Europe. Instead, there seem to be more pressing concerns: gloomy speculation about the eurozone's impending collapse and desperate attempts to find institutional fixes to its extensive governance problems.

But the euro was not just the outcome of an idiosyncratic quest to reduce the wear on pockets stuffed with odd national coins, or to facilitate intra-European trade. The bold European experiment reflected a new attitude about what money should do, as well as how it should be managed. In opting for a "pure" form of money, created by a central bank independent of national authority, Europeans self-consciously flew in the face of what had become the dominant monetary tradition.

In the 20th century, the creation of money - paper money - was usually thought to be the domain of the state. Money could be issued because governments had the power to define the unit of account in which taxes should be paid. This tradition went back well before paper, or fiat, currencies. For many centuries, even while metallic money circulated, the task of defining units of account - livres tournois, marks, gulden, florins or dollars - remained a task of the state (or of those with political power).

Abuse of this role, with governments addressing excessive debt by inflating it away, was deeply destructive of political order in the first half of the 20th century. After World War II, the liberal politicians most committed to European federalism saw this point clearly. The economist, central-bank governor, finance minister and president of the Italian Republic, Luigi Einaudi, pleaded the case in the immediate aftermath of the war: "If the European federation takes away from the individual states the power of running public works through the printing press, and limits them to expenses that are financed solely by taxes and voluntary loans, it will by that act alone have accomplished a great work."

But monetary abuse is no less dangerous in political systems with multi-layered authority, and in the past often led to the breakup of federal states. That is because inflation is not a benign cure for economic ills, in which beneficent and stimulatory effects are spread equally over the entire region under the inflationary monetary authority. Making inflation depends on the central bank's decision to monetize specific debt instruments.

After all, the monetary authority never decides simply to convert every obligation into money. Instead, it decides that some industries, banks or political authorities need to be sustained for the general good. Those industries, banks, and political authorities that are not so privileged are inevitably resentful, and view the central bank's actions as an abuse of power. In federal systems, in particular, the businesses and political authorities far removed from the center are most likely to be excluded from the monetary stimulus and hence are inclined to be resentful.

Hyperinflation in Germany in the 1920s fanned separatism in Bavaria, the Rhineland, and Saxony, because these remote areas thought that Germany's central bank and central government in Berlin were discriminating against them. The separatists were politically radical - on the left in Saxony, and on the far right in Bavaria and the Rhineland.

There are also more recent cases of the same effect. In late-1980s Yugoslavia, the monetary authorities in Belgrade were inevitably closest to Serbian politicians such as Slobodan Milosevic and to Serbian business interests. As a result, the Croats and Slovenes wanted to be out of the federation. In the erstwhile Soviet Union, inflation appeared as an instrument of Moscow bureaucrats, and there, too, more remote areas sought to break away.

The makers of modern Europe saw that unstable and politically abused money would be a European nightmare, and lead to destructive national animosities and antagonisms. They were supported by the 20th century's two most influential economists, Friedrich von Hayek and John Maynard Keynes.

Hayek was the most consistent critic of state-produced money. His proposal, competitive currencies produced by "free banking" in which numerous private authorities would issue their own money, was more radical than the solution adopted by Europeans in the 1990's. But the Hayekian element of a money-issuing authority that was extensively protected against political pressures, and consequently against political opprobrium, was a key part of the European Union's Maastricht Treaty. Keynes, too, in planning for the post-World War II order, proposed a synthetic global currency that would guarantee stability and prevent deflation.

The vision of central-bank independence as a necessary part of the constitution of a sound and stable political order was not simply a European construct in the 1990s. It was also reflected in legislative changes affecting other central banks, and in central bankers' growing prestige.

That view is now seriously challenged. In the aftermath of the worst financial crisis since WWII, central banks are once again being called on to monetize securities issued by some debtors, but not others. That task of selecting between debtors is highly political, and poisons the idea of monetary stability.

Jean-Claude Trichet, until recently the president of the European Central Bank, liked to claim that money was like poetry, before adding that both give a sense of stability. That unusual but accurate formulation is reminiscent of General August Neidhardt von Gneisenau's famous reply to the Prussian king, who dismissed as "nothing more than poetry" von Gneisenau's patriotic concerns in the early 19th century. "Religion, prayer, love of one's ruler, love of the fatherland, what are these but poetry?" von Gneisenau asked. "Upon poetry is founded the security of the throne."

Stable money, too, is the foundation of political order. We should not allow ourselves to be so overwhelmed by today's crisis that we forget that.

The author is professor of history and international affairs at Princeton University and professor of history at the European University Institute, Florence.

Project Syndicate

(China Daily 12/12/2011 page9)