Why it’s hard for Greece to back out of the Euro

by on February 8, 2010 at 10:29 am in Economics | Permalink

Talk of Euro abandonment would trigger an immediate run on Greek banks, sending the country into an even deeper hole.  Who wants a Euro deposit to be converted into a drachma deposit?

You could imagine keeping current Euro-denominated deposits and adding new drachmas to the system, circulating at a flexible exchange rate.  That still might trigger a bank run (who expects the parallel currencies to last forever?).  Furthermore the new drachmas would bring seigniorage only if the law forces their overvaluation in some manner; refer back to the earlier discussion of the bank run.

You could imagine a surprise freeze on all bank deposits, thereby preventing an immediate bank run but leading to a later bank run.  Plus in the meantime there is no working banking system.  And if this doesn't come as a true surprise, you end up with the immediate bank run.

What is the chance of a bank run very soon — if only driven by "sunspots" — thereby forcing the Greek government to suspend redemption and devalue those deposits, effectively turning them back into drachmas?

Looking to history, there are plenty of countries which break pegs or leave currency zones.  But they all seem poor enough, banana republic enough, or insulated from "currency competition" more than a new Greek drachma would be insulated from competition with Euro-denominated banking.

Have I mentioned that currency substitution models do not in general imply stability or well-behaved quantity theory relations?

Can you see any coherent scenarios in which Greece (or other EU countries) can leave the Eurozone?  The forcing, immediate bank run is the only option I see and that is not a pretty one.  It also implies that the "policy decision" is up to Greek account holders and not up to the Greek government.  At best, the Greek government is making decisions about the fiscal side of the equation.

Are the nominal interest rates rising on Euro-denominated accounts in Greek banks?  (Are they allowed to rise?)  That is one good barometer for Greek depositor discontent.

1 E. Barandiaran February 8, 2010 at 11:57 am

Tyler, you don’t say how Greece would benefit from abandoning the Euro. Actually, given the openness of the Greek economy and the fact that Greece’s sources of foreign exchange are diversified, Greece cannot solve its fiscal problem with a devaluation as Argentina did at the end of 2001. In Argentina, the devaluation was necessary for the government to tax the main exports and therefore to reduce significantly the fiscal deficit. Since Greece faces a serious fiscal problem, it needs a fiscal adjustment that cannot rely on an increase in tax revenues from a devaluation (directly as in Argentina or indirectly as a result of a large increase in exports). The fiscal adjustment will have to be negotiated between the government and the unions of civil servants, and it is a distraction to talk about the abandonment of the Euro. And as long as there is no agreement, the government will have no choice but first to delay payment of the servants’ wages and then to cut temporarily their wages by issuing a fake currency.

2 Ed February 8, 2010 at 12:10 pm

Whatever happened to gold? In the days of my youth any rumour of financial instability caused a parade from the bank to the jewelry stores.

3 dearieme February 8, 2010 at 12:31 pm

Isn’t the solution for the Greek government to pay its employees in neodrachmas, but leave the euro in place for everything else?

4 londenio February 8, 2010 at 12:53 pm

Germany does not mind some devaluation of the Euro because it is an export economy. France would also enjoy a devaluation of the Euro. The Greek crisis is driving this devaluation and the bigger economies have no incentive to pay dearly to save Greece from default. Germany and France have to make sure that Spain and Italy stay afloat.

5 E. Barandiaran February 8, 2010 at 3:12 pm

Kerub, you’re right and your point further highlights that the discussion of Greece abandoning the Euro deflects attention from the serious fiscal adjustment that Greece must undertake. As serious as the one that California must undertake.

6 Don the libertarian Democrat February 8, 2010 at 4:05 pm

I asked this question about Spain to Edward Hugh, and here’s his reply:

“@ Don,

I hope, in passing, I have answered your question. Basically, getting its own curerncy back wouldn’t help at this point, since all the debts would need to be repaid in another currency, or you default, and become a cross between Argentina, Cuba and Serbia.

Flat broke, and no one willing to lend you any money.”


7 Veracitor February 8, 2010 at 6:10 pm

Tyler, as you pointed out it would be difficult for the Greek government to stiff its creditors by devaluing its currency. Greece doesn’t control the Euro and replacing it with a new drachma for the express purpose of devaluing that drachma would be messy.

However, a very different approach might be both feasible and fruitful. Instead of issuing a new fiat currency and promptly devaluing it, Greece could issue a new currency which was hard as hell and use it to promote economic growth.

Greece should issue a new gold drachma (at some convenient price, say Δρχ 100 = 1 troy ounce fine gold) and promise never to devalue it– indeed, Greece should embed that promise in its constitution (Sýntagma). (It would probably still take a while to build public confidence.)

New drachma coins and notes should be issued with a modest rate of seigniorage: 1%. The new drachma should circulate alongside the Euro with a floating exchange rate (based strictly on the Euro price of gold, since the price of gold in drachmae would be perpetually fixed). The new drachma should be 100% backed with bullion, and notes or base-metal convenience coins should be convertible on demand either to Δρχ100 (1 oz.) gold coins or Δρχ40,000 (400 oz.) gold good-delivery bars (the government could mint other gold coins for convenience, it doesn’t matter). The Greek government should buy gold to back all drachmae notes and coins demanded.

The Greek government should continue to budget, collect taxes, and accept and make payments (including bond payments) in Euro (this is key), except that it should make certain payments and accept any taxes or other payments in drachmae at special exchange rates.

First, the Greek government should accept payments/taxes offered in drachma at a 5% discount. Second, in special cases– strictly upon request– it should make payments in drachma at a 10% (or greater) discount.

That is, suppose the Euro:Drachma (€:Δρχ) exchange rate were 10:1 and you owed €1000.00 of taxes to Greece. You could satisfy that debt by paying only Δρχ95.00. The rate would float.

If you were a Greek bureaucrat, at the start of each year you would choose whether to accept your salary in Euros or drachmae during the coming year at the start-of-year exchange rate (the rate would then be fixed for a year and you could not switch until a year had passed)– however, salaries paid in drachmae would be 10% less (suppose your monthly salary was €4000.00. If the €:Δρχ rate at the start of the year was 10:1 you would be paid only Δρχ 360.00 each month.) All government contracts would be bid for and denominated in Euros, but for contracts extending more than six months the contractor could elect– in advance, irrevocably– to take payment in drachmae at a 10% discount from the initial Euro value of the contract. The discount rate might be modified from 10% in future years.

Finally, everyone receiving or expecting (that is, not yet retired) a Greek government pension should be given a year to elect to convert permanently (for the rest of their lives) to drachmae at a 30% discount from Euros, based on a synthetic exchange rate which would be an average rate over the year of decision. Additionally, you would accept that pensions paid in drachmae would not be adjusted for “inflation,” because there would never be any (monetary) dilution or inflation of the drachma (I disregard any possible revolution in gold mining).

Private contracts (including bank deposits) could be written in Euros or drachmae and debtors would be legally liable to pay in the specified currency (though private parties could voluntarily accept alternate currencies at any exchange rate they thought suitable).

The goal of this scheme would be to stimulate the Greek economy by: attracting foreign economic investment by eliminating currency risk (for private investments denominated in drachmae); reducing taxes on private parties (by 5% across the board, though more like 4% the first year due to seigniorage); reducing costs of government (as a proportion of government workers and other payees took a 10% cut to bet against the Euro); reducing current pension costs while increasing pensioners’ confidence (many would be happy to buy off future inflation risk by taking a permanent cut in payments); insulating Greeks from Euro inflation; and most importantly, imposing new discipline on Greek government spending.

Announcing this plan wouldn’t incite a bank run, because guaranteed convertibility (albeit at a floating rate) would leave people currency- indifferent over the short term.

In the longer term the €:Δρχ rate might (probably would) change, producing one of the following effects:

1. Euro becomes more valuable (price of gold in Euros falls)– Greek government saves money on Δρχ pensions and (temporarily) on salaries, etc. With respect to business done in Euros the government is no worse off, since it ran on € basis before and still does. Floating exchange rate means taxes in Δρχ keep up with € taxes.

2. Euro becomes less valuable (price of gold in Euros rises)– Greek government saves money on bond payments and on € pensions and salaries, etc. With respect to business done in Euros the government is better off, since it receives some taxes in Δρχ. However, it will have increasing trouble paying Δρχ pensions, offset by increased tax receipts from economic growth (and from consumption taxes on Δρχ payees). I consider this the most likey scenario.

In any case, the Greek government can always wreck the Greek economy with excessive taxes and spending. A new gold drachma could not prevent that. What it could do is give the Greek economy a boost which would last as long as the government permitted it to, likely at least a few years. A new gold drachma would likely enable the Greek government to pay off its existing Euro-denominated debt at a discount (thanks to increased domestic revenues along with decreased pension payments plus possible Euro inflation/devaluation) after a few years. Even as a one-time thing that would be valuable, and it could be accomplished without confiscating Greeks’ current savings. A large portion of the money would come from cutting pensions in the near term, but while I think Greeks would be very angry to have their pensions cut unilaterally, I also think many of them would gladly trade reduced pensions for reduced pension-devaluation risk. Since the government would be taking the other side of that bet (surrendering some of its power to devalue pensions in future in return for immediate cuts) Greek legislators might be more willing to discipline government spending.

When the gold drachma had become so popular that little domestic business was conducted in Euros any more, the Greek government could consider dropping out of the Euro. However, I suspect it would be best if it never did that… so that bankers promoting schemes to “manage” the economy by manipulating the currency would always have to go to Frankfurt and take ECB jobs, leaving the gold drachma undisturbed. If Greece were to go entirely off the Euro ambitious Greek bankers would soon take control of the drachma and destroy it.

8 Veracitor February 9, 2010 at 10:39 am

In the unlikely event that the Euro were to rise against a new gold drachma, so that Greeks preferred to pay taxes in drachmae to get a small discount but take payments in Euros, that would not force Greece to borrow. Greece could simply raise taxes to remove the effect of the drachma discount.

The goal of the gold-drachma scheme is to promote Greek economic growth by establishing a sector which is not subject to fears of Euro devaluation and which has at least a temporary tax advantage. The price of that is twofold: creating a new currency for the new economy and giving it initial impetus, and restraining expansion of Greek government liabilities. The Greeks cannot, evidently, do the second in the pure Euro economy, but might be able to in a mixed-currency economy. The scheme would provide initial savings (on pensions and payments) greater than its initial expenditures (on tax relief), after that, if the scheme didn’t produce good effects, the Greek government could easily move away from it. Of course obligations in drachma would remain inviolate, but in the event that the Euro rose against drachma those would be easy to satisfy.

9 Dr. Mitsos February 17, 2010 at 2:38 pm

I think that what Mogens indirectly suggests (i.e., reduction of the public sector and making the tax system efficient) is the best way for Greece to solve its problems.

10 Christina May 7, 2010 at 8:33 am

Look Anna Moore I’m Portuguese and you have no right to treat me like that, please apologise because you don’t know nothing about us, about history, about politics, about economy, look at yourself bloody hell and finally you are not welcome here, don’t even try, thank you

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