Two decades ago, when the European currency system was last on the brink of collapse, the ultimate question was how much Germany, the continent's economic powerhouse, would do to save it. The peripheral economies were hurting, weighed down by a monetary policy that was appropriate for Germany but too austere for weaker European countries. Germany's central bank, the Bundesbank, had to make a choice. It could continue to set high interest rates, thus upholding its commitment to stable prices. Or it could cut rates and accept modest inflation -- and so save the rest of Europe from a prolonged recession.
We know which option Germany chose then. The Bundesbank brushed off suggestions that it should risk inflation for the sake of European solidarity; speculators correctly concluded that this made a common monetary policy intolerable for the weaker economies of Europe; and in September 1992, the continent's Exchange Rate Mechanism, a precursor of today's euro, shattered under the pressure of attacks from hedge funds. Almost 20 years later, the world is waiting for a new answer to the same question. How far will Germany go to keep Europe together?
The economist Rudiger Dornbusch observed that in economics, crises take longer to come to a head than you think they will, and then they happen faster than you thought they could. By the time you read this, the eurozone may have splintered. But whether or not that has happened, or soon will, one thing is certain. Since the beginning of the crisis, Germany has had the power to save the monetary union if it wanted to. The union's disintegration would be an optional catastrophe.
SUPERMAN CENTRAL BANKERS
To see why the euro's failure could be averted, one must first grasp the awesome power of today's central banks. Until World War I, the advanced economies were tethered to the gold standard, meaning that central banks could not print money in unlimited quantities. Likewise, for almost all the years since World War II, the power of the
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