They conclude that debts matter and that the stability of the European gold standard depended on the underlying price trend. Deflation prior to 1895 resulted in rising public debt burdens, which forced some countries to leave the system. Once gold was discovered and deflation gave way to inflation, real interest service fell, debts grew more slowly and a high degree of convergence allowed most countries to return to gold. For EMU, this result implies that stability will hinge on the ECB’s policy not being too restrictive. Other lessons concern the fragility of institutions in the face of deep public finance difficulties, the risks for the single market of leaving out countries that have not fully converged, and the existence of a virtuous cycle including low interest rates, fast growth and debt reduction.

The gold standard heyday was a rather limited period, extending from the late–1890s or early–1900s to World War I, not the whole 1880–1913 era, as is often believed. This evolution, so far little noticed, conveys several interesting lessons.

 

• First, market-imposed discipline was a very important aspect of the gold standard and will certainly matter under EMU. However, it cannot be relied upon exclusively to provide borrowers with appropriate incentives. Incentives even become destabilizing when unexpected deflation adversely affects public finances. This lesson supports formal limitations on debts or deficits. On the other hand, debt ratios above 60% are not a hindrance provided they are on a declining trend. The European gold standard could survive with high and varied debt levels, but its consolidation coincided with a period of general decline in debt ratios.

 

• The second lesson for EMU is that denying admission into the euro zone may not be the best way to solve the systemic risk of debt over-accumulation. Externalizing that risk may create other problems. Left to themselves and to the imperfect discipline of financial markets in the early–1890s, southern European countries borrowed too much and were found high and dry when the cost of borrowing surged. Depreciation in turn created protectionist pressures in those countries of the European core which still had a large agricultural sector, such as France. This is a clear reminder that the benefits of externalizing fiscal discipline by limiting the euro zone to a small number of countries must be balanced against the costs of endangering the single market.

 

• The third lesson concerns the successful record of eastern and central European peripheries. Even under the most lenient application of optimum currency area criteria, these relatively backward countries could not have qualified for gold area membership. Yet the exceptional growth that Russia and Austria-Hungary experienced after 1900 suggests that continued adherence to the gold standard provided them with all the benefits of low interest rates, including declining debts and better growth prospects. It might well be that, by the same mechanism, some countries of the current European periphery will be among the big winners of EMU.

Finally, the authors’ analysis highlights the importance of finding a proper balance between discipline and incentives. The gold standard turned out to be a hostage to the exogenous evolution of prices. Over the period 1873–96, the declining price trend exacerbated the public finance problems of the periphery to breaking point. After 1896, by contrast, inflation made convergence and steady participation in the gold zone much more attractive. Governments became more eager to conform to the discipline that markets required. The clear implication for EMU is that its stability will hinge on the ECB’s policy not being too restrictive.

In the end, the heyday of the European gold standard was an accident of history. It came about when steady gold inflation moderated national incentives to extract seigniorage and brought about a reduction of debt burdens that contributed towards lower interest rates. This in turn facilitated growth and the convergence process. Exchange stabilization and the spread of central bank independence followed. To what extent could such a regime survive? The whole construct was quite dependent upon features such as price trends that in a gold standard would have to be reversed over the long run. It was not well equipped to face the major shock that the wart and its aftermath represented. The bad and the good fortunes of the gold standard should, in fact, serve as a reminder that we are all accidents of history.

EMU: Prospects and Challenges for the Euro is a special issue of the review, Economic Policy: A European Forum. It contains revised versions of the papers presented to the Twenty-Sixth Economic Policy Panel Meeting held in Bonn on 17/18 October 1997, with the support of the Zentrum für Europäische Integrations-forschung. The Economic Policy Panel meets twice annually to discuss papers that are specially commissioned by the editors to provide timely and authoritative analyses of the choices confronting policy-makers. The articles use the best of modern economic analysis, but are easily accessible to a wide audience and highly readable. Each paper is discussed by a rotating Panel of distinguished economists whose comments are published to provide the reader with alternative interpretations of the evidence and a sense of the liveliness of the current debate.

Economic Policy is published in association with the European Economic Association for the Centre for Economic Policy Research, the Center for Economic Studies of the University of Munich and the Département et Laboratoire d’Economie Théorique et Appliquée (DELTA), in collaboration with the Maison des Sciences de l’Homme.

Marc Flandreau is a Research Fellow at the Ecole des Hautes Etudes en Sciences Sociales, Pais. He is also a Research Affiliate in CEPR’s International Macroeconomics programme. Jacques Le Cacheux is Professor of Economics at the University of Pau and Director of the Economic Research Department at Observatoire Français des Conjonctures Economiques, Paris (OFCE), Paris. Fréderic Zumer is a Research Fellow at the Observatoire Français des Conjonctures Economiques (OFCE), Paris. He also teaches economics at the Institut d’Etudes Politiques de Paris.

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