How much would a Greek devaluation help?

Arnold Kling is skeptical and while I am on board with the economics of the anti-Euro crew, and I think Greece should leave the Euro, I believe the anti-Euro argument is now being pushed too far.

For instance, contra Paul Krugman, I don't see Euro membership as, in this regard, the main economic difference between the British and the Greeks.  Who has the Elgin marbles and how did they get there?  What longer-run historical and cultural forces does this reflect?

Keep in mind there is nothing stopping Greece from cutting the nominal prices of its exports, right now, thereby altering its real terms of trade.  Those prices just aren't *that* sticky, especially if the business model of the country is falling apart.

You could say that the real problem is sticky wages and not sticky export prices.  Maybe so.  Maybe the Greek exporters are saying "I won't cut my price because if I did buyers would want too much and I couldn't meet the market without hiring more labor and even new labor will work for me only at the old prevailing wage rate and, given that elasticities of demand are not high enough, I can't manage the mix of the new lower product price and the old wage rate."

Yes, some of that is going on.  But it's also the case that the Greek economy is a mess, based on fiscal and sectoral delusions of various kinds.  In fact the Greek economy has been a mess — most but not all years — for a long time before joining the Eurozone.

Comments

Tyler,

Surely exporters couldn't cut their prices in half without a simultaneous (or at least guaranteed) 50% cut in domestic cost throughout their supply chain? How do you reasonably expect a sector to take this business risk unilaterally?

The government of Greece could stay in the euro but decree that from 1st of may the prices of all goods and services were halved, but this would be a political capital problem.

Under what terms would actors in the private market voluntarily lend to a Greece that decided it didn't want to pay back what it has borrowed? Has principle ever been paid back by a sovereign, other than just rolling the debt onto another lender? I am trying to understand what, exactly, is the ultimate incentive to not default- at least to money borrowed from foreigners. If Greece were to actually get its spending down to a surplus, why wouldn't they then default?

Greece can slash export prices (even domestic prices) and slash wages all through statute. Greece can eliminate its VAT tax and dramatically increase the income tax to compensate.

Greece can raise or collect taxes.

It is not the end of the world if they do. It's just that they don't.

Read my lips.

Greece has exports?

They can't do all these other things, but raising taxes is no biggie? How'zat?

Tyler, early in my career I thought that devaluation was a solution to a problem but later I learnt that devaluation was part of the problem because of it was an easy way for corrupt governments not to take responsibility for their fiscal policies. My early thinking was influenced by both the work of the late economist Carlos Díaz Alejandro (his Ph.D. thesis for MIT was about Argentina's experience with devaluations in the late 1950s and he spent a lot of time in Buenos Aires in the early 1960 --later MIT Press published an extended version of his thesis) and Robert Mundell's work on currency areas. Later, after years of studying devaluations, I concluded that indeed if world production were organized around millions of company towns, any good economist could show you that each town would be an optimal monetary area (studies of isolated company towns support this conclusion). I concluded also that under some circumstances, a devaluation could allow a corrupt goverment to collect a large tax revenue to deal with a fiscal crisis. These were the only conclusions I could draw from studying devaluations.
Unfortunately all the theoretical discussion of devaluations fails to take into account that existing monetary areas are determined by national governments --most countries have their own currency and a few have opted for using other country's currency. Since we economists don't have a theory of the state (I mean one that parallels our theory of the firm) and, despite the successes of public choice theory, we are still far away from having such a theory, it is not surprising that we have so little to say about both the world system of national currencies in a global economy and how governments have been using their currencies as one of many sources of revenue. More important, we economists know little about how the use of currency as a means of payments and as a store of value has been declining as a result of changes in systems of payments and financial services. We talk a lot about money but --sorry Milton and all monetarists-- we have yet to define it (for example if you take a look a ECB monetary statistics and analysis they are largely based on M3, an arbitrary definition of money that does not follow from any theory).
Despite our ignorance, devaluation has always been an important instrument of monetary policy in the open economy. Most economists --including, and I'd say especially, Milton Friedman-- have often argued that it was a good instrument because you can increase "once-and-for all" the nominal prices of goods (at least of most goods) and "reverse" some non-desirable changes in relative prices and real wages, so the post-devaluation relative prices and real wages would restore "equilibrium". A devaluation was then an opportunity for economists to become Walras' auctioneer. Of course, using the same models you could show that a reduction in nominal wages could produce the same reversals in relative prices and real wages (it will take me too long to explain the role this idea played in Chile's devaluation of June 14, 1982). In practice, as Diaz Alejandro showed for Argentina in the early 1960s, it was not so simple. To make things worse, in the 1970s and especially since 1980 we could not ignore the effects of a devaluation in the stocks of debts and capital flows as well as the growing appetite for speculating against the terrible fiscal policies of some governments. Larry Sjaastad summarized well the problem the auctioneer was facing: there was no systematic relation between the size of a devaluation and the change in relative prices and real wages (and even worse, the good intention of an auctioneer was often disrupted by compensatory actions, as it happened in Mexico in 1982 when a large devaluation was followed by a large increase in nominal wages to prevent a decline in real wages!).
Thus, whenever an economist suggests a devaluation as a solution to a problem, beware of his ignorance. And if the economist insists on a devaluation, ask him whether California could solve its fiscal crisis by introducing the Californian dollar (and if he says yes, then ask him how he would set the initial exchange rate).

One of the biggest red flags signaling me to beware an economist's ignorance is when he repeatedly universalizes about "we economists."

Hungary went off the peg when it accepted aid from the IMF. How's that worked out for them?

I could not meet the market without hiring more labour.New labour will work for me only at the old prevailing wage rate. Do i ever see global currency in lifetime ?

The suggestion of a devaluation in California was probably tongue in cheek, but it might be worth thinking about whether there are good reasons why a common currency would work better in the US than in the EU. For example, I think there is probably less interference in labor markets at state level in the US than in the EU. Despite high unemployment, labor costs in Greece are apparently 20 percent above those in Germany.

Here is some additional background on tax compliance, avoidance, and changes in the Greek tax system.

Show no mercy on those who choose to create their own problems, California included.

http://abcnews.go.com/Business/wireStory?id=9727034

In fact the Greek economy has been a mess -- most but not all years -- for a long time before joining the Eurozone.

Profound words Tyler, as several posters have mentioned above, leaving the euro is not a solution to the Greek crises because deep structural changes are required to that involve re-negotiating both the economic and social compact of the country. As in Thailand and other countries who left the one extreme of authoratarian rule only to find themselves swerving at the populist end of things Greece is bearing the costs indulgence.

BUT, luckily for greece, it has the euro and the EU as a tether forcing attendance at the "Intervention". Like addicts of all kinds, breaking the debt cycle, which is a sypmpton not the source of it's problems, requires pain that the addict will avoid at all costs. The strength of the EU, was this very aspect of forced external accountability. And although it was not foreseen at the time, it seems to be working well. The Europeans always lamented American strength as based on collectivized power. This is double edged, and both edges cut effectively both ways.

I guess tyler, if i was to buy the argument that a greece with an independant Drachma would have resolved it's economic problems, and then chastened changed it's lying cheating ways, then it would make sense to leave the Euro. But, having read your excellent analysis on the similar dynamics that engulfed the financial economy, it's un-realistic to expect the kind of transformative change to come without a real rock bottom being encountered. Although having known a few addicts, it could still be a ways from here, a la, folks at Zerohedge believe.

Comments for this post are closed