The Battle For The Eurozone Is NOT Between Countries, It Is Between Classes: Syriza And The French Indemnity Of 1871-73

Today’s Financial Times has an article discussing the travails of Greece’s new Finance Minister, Yanis Varoufakis as he takes on Germany:

In a small but telling sign of the frosty relations between Berlin and the new Greek government, the German finance ministry last week criticised Mr Varoufakis for failing to follow through with a customary courtesy call following his appointment. Mr Schäuble, meanwhile, has warned Greece not to attempt to “blackmail” Berlin with demands for debt relief.

This is absurd. The European debt crisis is not a conflict among nations. All economic systems— and certainly an entity as large and diverse as Europe— generate volatility whose balance sheet impacts are mediated through different political and economic institutions, among which usually are domestic monetary policy and the currency regime. With the creation of the euro as the common currency among a group of European countries, monetary policy and the currency regime could no longer play their traditional roles in absorbing economic volatility. As a result, for much of the euro’s first decade, a series of deep imbalances developed among various sectors of the European economy. Because Europe’s existing economic and political institutions had largely evolved around the national sovereignty of individual countries, and also because the inflation and monetary histories of individual countries varied tremendously before the creation of the euro, it was probably almost inevitable that these imbalances would manifest themselves in the form of trade and capital flow imbalances between countries.(1)

We have a great deal of experience in modern history with the kinds of imbalances from which Europe suffered and continues to suffer, and from the historical precedents three things are clear. First, the imbalances that led eventually to the current crisis had their roots in hidden transfers between different economic sectors within Europe, and not between countries. It is only because of deep institutional differences among the member countries that these imbalances manifested themselves largely in the form of trade imbalances between the different countries in Europe. These hidden transfers artificially forced up the savings rates in some countries and, for reasons that I have discussed elsewhere, it is a matter of necessity, well understood in economics (although too often forgotten by economists), that artificially high savings rates in one part of an economic system must result in higher productive or non-productive investment (in advanced countries usually the latter) or artificially low savings in another part of that system.

Second, deep distortions in savings and investment historically have almost always led to an unsustainable increase in debt, and Europe was no exception. For many years European debt has risen faster than European debt-servicing capacity, but the gap between the two has not been recognized and written down, and instead manifests itself in the form of excessively high and rising debt burdens whose costs have eventually to be assigned.

Third, and most worryingly, it has always been easy for extremists and nationalists to exploit the grievances of the various economic groups to distort the meaning of the crisis. One way is to transform it into a class conflict and another way is to transform it into a conflict among member states. Resolving a debt crisis involves nothing more than assigning the losses. In the current crisis these costs have to be assigned to different economic sectors within Europe, but to the extent that the assignation of costs can be characterized as exercises in national cost allocation, it is easy to turn an economic conflict into a national conflict.

Most currency and sovereign debt crises in modern history ultimately represent a conflict over how the costs are to be assigned among two different groups. On the one hand are creditors, owners of real estate and other assets, and the businesses who benefit from the existing currency distortions. One the other hand are workers who pay in the form of low wages and unemployment and, eventually, middle class household savers and taxpayers who pay in the form of a gradual erosion of their income or of the value of their savings. Historically during currency and sovereign debt crises political parties have come to represent one or the other of these groups, and whether they are of the left or the right, they are able to capture the allegiance of these groups.

Except for Greece, in Europe the main political parties on both sides of the political spectrum have until now chosen to maintain the value of the currency and protect the interests of the creditors. It has been the extremist parties, either on the right or the left, who have attacked the currency union and the interests of the creditors. In many cases these parties are extreme nationalists and oppose the existence of the European Union. If they succeed in taking control of the debate, the European experiment will almost certainly collapse, and it will take decades, if ever, for a European union to revive.

But it hasn’t been clear why distortions in the savings rate are at the root of the European crisis. Until now an awful lot of Europeans have understood the crisis in terms of differences in national character, economic virtue, and as a moral struggle between prudence and irresponsibility. This interpretation is intuitively appealing but it is almost wholly incorrect, and because the cost of saving Europe is debt forgiveness, and Europe must decide if this is a cost worth paying, to the extent that the European crisis is seen as a struggle between the prudent countries and the irresponsible countries, it is extremely unlikely that European will be willing to pay the cost. As my regular readers know, I generally refer to the two groups of counties seen as being on the opposite sides of the barricades as “Germany” and “Spain”, the former for obvious reasons and the latter because I was born and grew up there, and it is the country I know best. I will continue to do so in this blog entry.

It is a horrible irony that while the view that the European crisis is a conflict between prudent Germany and irresponsible Spain could easily tear apart the European experiment, it terribly muddles Europe’s actual experience and may create a false impression of irresponsibility. To see why, it is useful to start with a little history. Nearly 150 years ago Spain’s “Glorious Revolution” of 1868 saw the deposition of Isabella II and the collapse of the first Spanish Republic. More importantly for our purposes it also unleashed within continental Europe a conflict over the succession to the Spanish throne which ultimately, through a series of circuitous events, resulted in France’s declaration of war on Prussia in July 1870, which was widely seen in France as a chance partially to even the score over Prussia’s victory during the Napoleonic wars. France’s’ revanchist fantasies were frustrated, however, and by early 1871, the French army  was roundly defeated by Prussia, which during that time had unified the various German states as the German Empire under the Prussian king.

There were at least two important results of France’s military defeat. Of minor importance for the purpose of my blog entry but interesting nonetheless for those obsessed with modernism and with France’s late 19th Century cultural history, like me, the Franco-Prussian War will always be remembered for its role in the subsequent creation and collapse of the Paris Commune. This event left its mark on the thinking of many cherished artists, from Manet to Rimbaud.

But the other, to me, very interesting and far more relevant consequence was the French indemnity. As part of the privilege of conquest and as a condition for ending the occupation of much of northern France, Berlin demanded war reparation payments originally proposed at 1 billion gold francs but which eventually grew to an astonishing 5 billion, at least in part because of an explicit decision by Berlin to impose a high enough burden permanently to cripple any possible French economic recovery.

To give a sense of the sheer size of this payment, usually referred to in the literature as the French indemnity, this was equal to nearly 23% of France’s 1870 GDP.(2) Germany’s economy at the time,according to Angus Maddison, was only a little larger than that of France, so Germany was the beneficiary of a transfer over three years equal to around 20% of its annual GDP. I believe the French indemnity was the largest reparations payment in history — German reparations after WWI were in principle larger but I don’t think Germany actually paid an amount close to this size, and certainly not relative to its GDP.

Transfer beneficiary

Astonishingly enough France was able to raise the money very quickly, mostly in the form of two domestic bond issues in 1871 and 1872, which were heavily over-subscribed. One of the most complete studies of the French indemnity, I think, is a booklet by Arthur Monroe published in 1919.(3)  According to Monroe, the first issue of 2 billion in perpetual rentes was issued in June 1871, a mere 48 days after the treaty was signed, and was heavily oversubscribed.

Thirteen months after announcing the first loan the government opened subscriptions for a second, this time for three billions, again in 5 per cent rentes, but issued at 842. The response to this was astounding, for more than twelve times the amount desired was subscribed, more than half of the offers coming from foreign countries.

Monroe goes on to note that “it is no small compliment to the credit of France at this time to note that about one-third of the foreign subscriptions were from Germany,” so when we think about the net amount of the transfer to Germany, it was less than 5 billion francs.

The payments were made in the form of bills of exchange and to a lesser extent gold, silver, and bank notes, and Berlin received the full payment in 1873, two years before schedule. It was during this time that Germany went fully onto the gold standard, and obviously enough the massive indemnity made this not only possible but even easy. It also guaranteed currency credibility almost from the start, and it may jolt modern readers to know that at the time monetary credibility was not assumed to be part of the German DNA.

What does all of this have to do with Syriza? A few weeks ago I was discussing with a group of my Peking University students Charles Kindleberger’s idea of a “displacement”, and I proposed, as does Kindleberger, that the 1871-73 French indemnity is an especially useful example of a displacement from which we can learn a great deal about how financial crises can be  generated.(4)  It then occurred to me that the French reparations and their impact on Europe could also tell us a great deal about the euro crisis and, more specifically, why wage policies in Germany at the beginning of the last decade would have led almost inexorably to the balance of payments distortions that may eventually wreck the euro.

It is a nice accident that the French indemnity allowed Germany to go onto the gold standard because massive transfer payments from Germany to peripheral Europe were probably necessary for many of these countries to adopt their own version of the gold standard when they abandoned national currencies and adopted the euro. Before jumping into why I think the French indemnity is relevant to the Greek crisis, I want to make three quick points:

1.  I went into more detail on how France raised the money than might at first seem necessary for the purpose of this blog entry because it actually illustrates a potentially useful point. In the first third of my 2001 book,(5) I discussed extensively the historical role of global liquidity on the evolution of national balance sheets and sovereign debt crises. One important point is to distinguish between financial crises that occur within a globalization cycle and those that end a globalization cycle. Whereas the latter are often devastating and mark the end for many years of economic growth, the former — like the 1994 Tequila crisis or the 1997 Asian crisis, or even the 1866 Overend Gurney crisis — may seem overwhelming at first, but markets quickly recover. When markets are very liquid and in their leveraging stage, they can absorb large debt obligations easily and even turn them into “money”.

The 1858-73 period was one such “globalization period”, and I would argue that this is why, despite Berlin’s expectation that the indemnity would cripple the French economy, it was surprisingly easy for France to raise the money and for its economy to continue functioning. Germany, similarly, struggled over many aspects of the WWI reparations, but after 1921-22, when global markets began their decade-long liquidity boom driven by extraordinarily high US savings, Germany found it relatively easy to raise the money that famously became part of the reparations recycling process — until, of course, the 1930-31 global banking crisis, after which Germany was forced to default. This may be relevant as we think about possible European sovereign bond restructuring. Any attempts to assess the impact of Greek or other sovereign debt restructuring based on historical precedents must distinguish between periods of ample liquidity and the radically different periods of capital scarcity.

2.  I explain in my book that the French indemnity actually increased global liquidity by expanding the global supply of highly liquid “money-like” assets. Of course Germany’s money supply increased by the amount of the transfer (not the full amount, because one-third of foreign bond subscriptions actually came from Germany), but this was not offset by an equal reduction in France’s money supply. The creation of a huge, highly liquid, and highly credible instrument, the two French bond issues, involved the creation of “money” in the Mundellian sense. While the transfer of money from France to Germany might have seemed systemically neutral, in fact it resulted in a systemic increase in global “money”.