One of the most memorable trips that I have ever taken was a train ride between Paris and Brussels during which I read Barbara Tuchman's The March of Folly. As the train crossed the killing grounds of the Great War, I thought of the tragic sequence of events that led to the mobilizations of August 1914 and the folly of those who led a generation of young Europeans (and Canadians, Australians, Americans and others) to their deaths.
In her book, Tuchman defines folly as the consistent – some might say determined – pursuit of policy contrary to self-interest. To qualify, the policy had to have been supported by a group, as opposed to a single individual; and, importantly, the policy had to have been pursued contrary to advice available at the time.
I was reminded of that trip and Tuchman's book reading the comments reportedly made by Klaus Regling, the head of the European Financial Stability Facility, defending the strategy of internal devaluation for euro zone countries.
"There is a new way of adjustment inside monetary union that is not covered in the textbooks," Mr. Regling said. "The textbooks say that nominal incomes cannot fall, but we are proving that this is no longer true."
He said that with cuts in nominal wages and entitlements in much of the periphery, adjustment is happening far faster than foreseen by many economists, and that they will regain competitiveness and return to growth faster than is now widely expected.
Of course, while it is entirely possible that nominal wages (and incomes) will decline as envisioned, such a strategy is likely to entail significant costs unless wages and prices are perfectly flexible. As argued elsewhere, the Great Depression levels of unemployment that already prevail in some European countries should be convincing evidence that this condition does not hold.
All this leads me to ask: Could it be that the architects of the euro zone have not read Keynes; or, if they have, failed to grasp what he was saying? That seems to be the inescapable conclusion. Indeed, in their efforts to defend the euro, they apparently seek a return to the 19th century and the gold standard of the pre-war period, in which wages and prices were in fact highly flexible and in which labour bore the full burden of economic adjustment through changes in wages and incomes. But what was possible before the Great War became much more difficult to achieve afterwards, as wages and prices became far less flexible.
What could account for such a fundamental change in behaviour?
The answer may be the March of Folly and the deaths of all those who perished in the trenches of Flanders. The survivors of the carnage returned home and demanded a new social contract –the working class would no longer tolerate being the sole bearer of the burden of adjustment. Workers mobilized not for war, but for better working conditions and for a parliamentary voice. In the labour market of the post-war years, Keynes argued, workers would accept lower wages only if they were convinced that other workers and other groups were also sharing in the adjustment effort. If these relative wage concerns were not addressed, individual rationality dictated that they should resist downward pressure on their own nominal wages.
Eventually, nominal wages would fall after unemployment increased to a sufficiently high level that workers accept lower wages rather than face unemployment. However, the obstacles to coordinating wages across an economy and the potential fraying of the social fabric that could result from sustained high unemployment led to the prescription: if real wages are too high owing to some shock, inflation that raises the general price level may be a less divisive way of facilitating the real wage adjustment needed to maintain full employment. Of course, higher inflation would represent a tax on bond holders. But the fact that others in society are also being asked to share in the adjustment burden is what makes the lower real wages from inflation acceptable to labour.
Fast forward 80 years: having yielded monetary policy autonomy to a supra-national institution, Greece and other members of the euro zone lack the monetary instruments to inflate; as long as the ECB is determined to keep inflation low in the core of the euro zone, they will have no option but to follow the path of internal adjustment. But lest we forget, contrary to what some might claim, this mechanism is not new; adherence to it in the 1930s, in the face of a large financial shock propagated by the dysfunctional gold standard of the inter-war period, contributed to a decade of stagnation that ultimately led to social and political disorder.
It was that experience, of course, that led Keynes to write The General Theory in which he likened his intellectual adversaries, the classical economists who also invoked the adjustment mechanism of the pre-Great War gold standard, to Euclidian geometers who, discovering that supposedly parallel lines in fact meet, rebuke the lines for not keeping their assigned paths. Time will tell if the architects of the euro zone are guilty of the same folly.