Europe's terrible blunder can be rectified. Remember 1931

I write from America, where those who care about Europe ask one question only. What the hell is going on? What is this "euro crisis" that never seems to end? What has happened to Greece, Portugal, Italy, Spain, Holland and now France? Have we all gone insane?

The economist Paul Krugman has one answer. He suggests that Europe is now replicating the 1930s "in ever more faithful detail". Governments, he says, are "committing economic suicide". When every economic tenet cries for treasuries to restore growth, spend, stimulate, inflate and rebuild confidence, they are advocating ever more austerity and balanced budgets, forcing their economies towards recession. They are doing so not because they believe austerity will generate growth. They are doing it because they are imprisoned in a defunct dogma, the propping up of the euro.

Nothing is more eerie than to read accounts of Europe's economy between the world wars, notably the idealistic "Locarno spirit" year of 1925. It was then that the chancellor of the exchequer, Winston Churchill, returned Britain to the gold standard. Wages would be forced down to compete with America, and Europe's prewar economic stability would recover. Keynes pleaded that this was madness. The pound was 10% overvalued against the dollar and the outcome would be "crippled exports, unemployment and strikes".

Churchill was wrong and Keynes was right. Six years later, a minority Labour government hit financial collapse and failed. In the summer of 1931, with capital fleeing the country and bankers wailing for austerity, a coalition national government was formed and abruptly came off the gold standard. The pound slid from $4.85 to $3.40. Despite forecasts of catastrophe, Charles Mowat's classic history of the period records that "hardly a leaf stirred". There was no revolution in the streets, and devaluation aroused no more interest "than that of a passing sneeze". Within four years British industrial production had risen 25%, while unemployment fell from 3 million to 2 million.

History rarely repeats itself, but its lessons do. The Bank of England and Treasury are trapped in similar orthodoxy to that of their prewar forebears. They hold that inflation is the greatest curse that can afflict the British economy, even as they mastermind the greatest collapse in demand that Britain has suffered since the war. When they do agree to print new money as quantitative easing, they dare not let it leak into consumption for fear of inflation. They do not flinch even when a quarter of high street shops close. They are like doctors laying the sick in the snow to see who will survive. Yet they hurl cash at friendly bankers and watch it vanish into the maws of directors and offshore speculators. And they dole out billions to prop up a euro of which they are not even members.

Keynes was right in 1925 – and proved right in 1931. Flexible exchange rates are a more painless way of forcing down labour costs and promoting trade than government austerity. Inflation is a better way of easing debt. The remedy for depressed demand is increased demand, simple as that. The risk of inflation in Britain at present is trivial compared with that of deflation and recession. And at least Britain's currency can float. Imagine if it were part of the euro and trade had to cope with a pound probably 20% higher in value than now.

Hardly a month passes without another euro crisis and more imposed austerity. It is as if Keynes had never lived. Yet water still refuses to flow uphill. Heavily indebted countries certainly need to restructure their public sectors in the long term – and have plausible plans to do so – but they cannot repay debt, short or long term, when they are in recession. Increasing unemployment and suppressing demand impedes growth and is no use to anyone.

Worse, Europe's drawn-out austerity is undermining the very authority required to enforce it. When governments fall, no package can be enforced. Greece was forced last month into de facto default. Who would now buy a Spanish bond? What is the value of a Dutch finance minister? What price Nicolas Sarkozy's signature on a bailout deal? As long as the euro shackles the continental economy in austerity it will never achieve political stability or a return to growth.

The euro was a Locarno dream. It was the last cry of the 20th century, envisaging a brave new order in which bankers and businessmen, workers and peasants, would stand arm in arm, singing Ode to Joy. All labour costs would become equal. There would be fiscal and regulatory integration across the entire continent. The euro would unlock the door of a united states of Europe. Ireland and Greece would be to Germany what Nevada is to New York. The euro would squeeze and stretch the peoples of Europe until they were one.

This concept of union must rank among the great mistakes of history. Like other pan-continental visions, it has proved no match for the crooked timber of European mankind. Its acolytes cannot bear revisionism or tolerate dissent. They have driven Greece into chaos and Spain into severe depression, with half its youth now unemployed. The Eurocrats do not care. Their incomes are secure. They dance only round the euro and claim its blood sacrifice. They will do anything but admit they were wrong.

The one salvation on the horizon is democracy. Last week the French electorate said no to more austerity and the Dutch government fell for the same reason. Spain faces a similar crisis, and the streets of Athens hold untold dangers. Even in Britain polls suggest an electorate unconvinced by the longevity of what by any standards is mild austerity. The peoples of Europe have had enough. The prospect of imposing on its nations the budgetary disciplines required for more German bailouts is unthinkable.

Europe needs a simple, overnight, collective reordering of debts, defaults and currencies, along the lines of the postwar Bretton Woods deal. Euroland must shrink drastically, and floating currencies be restored. The slate must be wiped clean. A terrible mistake was made, but it can be corrected as in 1931. As then the pundits will predict disaster, but I would bet the opposite. After the adjustment, "not a leaf would stir … no more than a sneeze". We would then return to sanity.

Simon Jenkins is a journalist and author.

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