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Late in 1958, Per Jacobsson, the very distinguished economist and then managing director of the International Monetary Fund, had a conversation with General de Gaulle. When he reported the talk later, he said he had given the general a vital piece of advice: “I do not think,” he said, “that there will ever be esteem for a country that has a bad currency”.
He went on to explain recent French monetary policy like this: “In 1802 Napoleon gave France the gold franc. And this gold franc remained unchanged until 1914 – to the outbreak of the First World War. It survived the two lost Napoleonic wars; the war of 1870-71; it survived the revolutions of 1830 and 1848; and all the changes of government during the Third Republic.”
The point he was trying to make was simple, and while he was referring particularly to the French (“an intelligent, hardworking and thrifty people” to his mind) it is one that stands for most populations: “If you give them monetary stability they can stand a great deal of political instability . . . but both political and monetary instability . . . that is too much.”
It makes sense. Think of what monetary instability (and hence a bad currency) means: it means capital flight – everyone dumping the bad currency for one they consider good; it means inflation; it means hoarding of real assets; and it usually means some kind of expansion of the state (as the government tries to control the side effects of having a bad currency with price controls and the like).
The key to stopping your currency slipping over from being an adequate one to being a bad one is keeping your supply of money relatively stable. You don’t want it to go up too fast (inflation) and you don’t want it to go down too fast (deflation – the thing that scares modern governments most of all).
But this is easier said than done. Why? Because much as they might like to think they are in charge, it isn’t really the central bank in a country that creates the money – it is the commercial banks.
Every time they expand their lending they increase the supply of money in the economy. And every time they contract lending they reduce it. After a financial crisis, lending always contracts as banks try to sort out their own balance sheets by calling in loans or not making new loans as old ones are paid back – so the supply of money in the economy tends to fall too.
The original point of quantitative easing (QE) – central bank money printing – then, was not so much to create growth or any such impossible nonsense, but to prevent money supply collapse and to prevent deflation.
Sir Mervyn King said in June: “The creation of money by the Bank of England has helped offset what would otherwise have been an extremely damaging contraction of the money supply.”
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The key thing to note now, said James Ferguson, chief strategist of Westhouse Securities and a man who has just spent three whole days in Edinburgh ignoring the Festival in favour of scaring the fund managers, is that, thanks to the fact that the banking crisis in Europe is now properly underway, you can begin to see the typical contraction of lending that follows the average crisis.
Commercial property transactions have completely collapsed, for example, as has most shipping finance, while cross border lending is falling fast.
This, says Ferguson, means that if the European Central Bank (ECB) wants to avoid a period of “extended depression” and by extension allow the euro to survive (and let’s not forget that the ECB is redundant if the euro does not survive), it will have to do something dramatic. It will have to find a way, whatever the naysayers think, to introduce its own quantitative easing. In order to cover the full funding gap left by the retreating banks - a gap Ferguson calculates at about €3trn - it will have to introduce it in vast quantities.
That amount of new money however, while it might well save Europe from depression, will also horribly debase its currency. So not only is QE “inevitable” but so is a sharp fall in the so far gravity-defying euro.
Ferguson isn’t the only person I’ve been discussing the euro with this week. I stopped in to see Alistair Darling, the former chancellor, between festival shows in Edinburgh the next day. Europe isn’t top of his worry list (I think Scotland and the state of the UK economy just about trump it). But he is increasingly concerned about it, and clear that austerity alone isn’t going to save the currency.
I also saw entrepreneur and fund manager Jim Mellon. His view? The same as Ferguson’s. I last wrote about the euro (suggesting that you swapped any you had for sterling or dollars) at the end of last year. If you didn’t do it then, history might be giving you another chance. The euro is clearly a bad currency by any definition. But the action the ECB needs to take to make it at least a bad currency with a chance of surviving, says Mellon, surely makes it “the short of the decade” too.
• This article was first published in the Financial Times
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