The recent European currency crisis did more than raise questions about the path to monetary union. With more immediate implications, it would seem to facilitate a shift toward more expansionary policies in Europe.
And none too soon, given the weakened state of major industrial economies.
European countries no longer need to contort domestic policies to hold together a set of exchange-rate relationships that were out of tune with reality.
Loosening the Gordian Knot
They can now shift attention toward the need to galvanize lagging domestic economies. The partial breakup of the exchange rate mechanism has untied - or at least loosened - a Gordian knot.
The currency crisis may have been surprising in its timing and virulence, but some sort of crisis was clearly in the offing.
A system of essentially fixed exchange rates (permitting only a modest range of fluctuation) simply cannot last forever without a readjustment of parities.
Inflation, productivity growth, and the fiscal-monetary policy mix change within the several countries in differing ways. And so must the exchange rate relationships that reflect these conditions.
Strains within the mechanism were exacerbated by a political decision in Germany to finance unification mainly by drawing on capital from abroad rather than by raising taxes.
The resulting mix of tight monetary and easy fiscal policies drove up German interest rates and the exchange value of the German mark.
Other countries had to raise interest rates to maintain their currencies in fixed relationship (within limits of the exchange rate mechanism) to the German mark. This was hard on a number of countries, especially those with weak economies and large trade deficits.
Climate of Disbelief
The market simply did not believe that those countries could keep interest rates high enough to forestall the exchange depreciation that seemed to be called for by underlying economic conditions.
For one thing, international banking and credit markets have become less friendly to borrowers. As noted, capital has flowed out of the rest of the world into Germany. And Germany, through a tight monetary policy, has in effect "sterilized" much of that money.
Japanese financial institutions have become very conservative lenders in light of the financial problems resulting from the deflation of the "bubble" economy.
And, clearly, less credit is being generated by the U.S. banking system than is normally the case in an economy attempting to recover from recession.
Credit constraints around the industrialized world have been accompanied by a restrained growth in trade among the leading countries. The pace has not been sufficient to help the countries break out of their collective economic slump.
That the slump in the industrialized world has not turned into a full-blown depression can be attributed to a number of factors.
First, economies of the less-developed countries (outside Eastern Europe and the former Union of Soviet Socialist Republics) have expanded rather rapidly over the past year, and their import volume has risen more than those of industrialized countries.
Second, government has supported economic activity in the industrial economies. In addition to direct spending, financial safety nets (such as deposit insurance) have prevented financial problems from turning into systematic failures or panics.
But neither the performance of the nonindustrial world nor the cushioning effect of government will be adequate to achieve a satisfactory growth rate in the United States and other industrialized countries.
The currency crisis has brought us to the point where monetary easing can be anticipated in Europe. Japan has instituted a more active fiscal policy. The United States has been easing its monetary policy.
If these developments are not sufficient to revive the economies and expand trade within the industrialized world, fiscal expansion in the United States will be inevitable.