Greek Euro Exit: All Pain And No Gain?

Includes: GREK
by: Shareholders Unite

Simple economic theory does have its uses. According to the theory of optimum currency areas, Greece should never have joined the eurozone. Its economy is too different from most of the rest of the eurozone, increasing the chances of asymmetric shocks, for which few policy tools are available (no monetary policy nor changes in the exchange rate are possible). If its wages and prices were more flexible, competitiveness could be restored more easily. If labor migration was higher within Europe, labor could move from slump countries to growth countries.

If there would be a large enough central budget, it would automatically redistribute funds from booming parts of the eurozone to parts in a slump. This is what Federal budget in the U.S. achieves. We do have discretionary (and conditional) transfer of funds (the 'bailout money') and Target2, but we'll leave that for the moment.

But this is wisdom after the event. The reality is that Greece is within the eurozone. Should they leave?

Constraints of the eurozone
We wrote a couple of articles about the constraints of fixed exchange rate systems (here and here), forcing deflationary policies in already deeply depressed situations. Now, fixed currency systems all have this characteristic. Tinbergen's law argues that for two policy goals, you need two instruments-- and if the currency value is one of them, you lose an instrument of economic policy.

However, fixed exchange rate systems vary in the ease with which countries can leave them. If this is easier, countries tend to leave in times when they need less constraining macro policies. This is why Argentina gave up its peg to the dollar early this century, or why countries left the Gold Standard in the 1930s. And in these cases, history proved them right.

Should Greece leave the Euro?
Well, if it would be easy to leave the Euro, Greece would-- just like Argentina ten years ago, or those countries in the Gold Standard in the 1930s have left this arrangement by now. But opinions differ whether this would have brought the gains, and Greece is perhaps too much of a special case, so let's go through the advantages and disadvantages to see whether we can arrive at some kind of conclusion.

The benefits:

  1. Restoring competitiveness
  2. Freeing up policy

Greece developed a mighty big trade deficit over the first decade of euro membership. In part, this is due to the same forces that euro membership bestowed on other peripheral eurozone countries, large capital inflows as a result of the elimination of exchange rate risk.

However, despite some really drastic austerity, wages and benefits cut, the trade deficit has only budged a little. It is still close to 10% of GDP, very large indeed, extremely large if you consider the depressed state of the economy and the capital outflow.

One can argue that a currency devaluation would take care of that, but it's possible to come up with serious objections:

  • The Greek competitiveness 'deficit' is structural
  • Devaluation would unleash inflation
  • The debt burden would only increase

There is quite a bit to be said for this. The Greek economy is deeply dysfunctional. There are those famous Michael Lewis examples of the national rail having more employees than passengers, and revenues being just 10% of the wage bill, stuff like that. Professions and many product markets and services are heavily protected, tax collection is dysfunctional, etc..

All true, and indeed-- if nothing would have changed, this would indeed produce a situation in which the rigidities of the Greek economy are such that devaluation wouldn't be very productive and would tend to produce more inflation and less restoration of competitiveness.

Often, devaluing currencies in deep recessions do not tend to produce much inflation as there is too much spare capacity to take up the slack instead. The UK didn't experience a notable uptick in inflation after having been booted out of the exchange rate mechanism (ERM) in 1992, and the Argentinian inflation after the enormous devaluation following the events in December 2001 didn't start to run up until years later.

But Greece could be the exception to the rule. However, perhaps not for much longer, as many of the structural rigidities in the Greek economy are being addressed. Greece has, out of necessity, been the best pupil in the class lately under the OECD's structural reform program-- no doubt a little peer pressure and 'friendly' advice from the troika (ECB, EU, IMF) has egged them on as well.

Click to enlarge
Click to enlarge

In the country notes we can read interesting stuff about progress with structural reform in Greece. So, it's possible to make Greece the exception to our proposition that fixed currency regimes have a habit of forcing too much deflation in already deeply depressed economies.

For Greece, one could argue the exact opposite, eurozone membership forces structural reforms on them that they could very well have shirked outside the eurozone. Even so, we're pretty sure the accompanying austerity in the midst of one of the largest slumps of a relatively modern economy only makes things worse, but at least eurozone membership does bring some good to the country.

Debt burden
The large pro-cyclical austerity deepens the recession (now a full blown depression), which increases the debt/GDP level as the latter is declining so fast.
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Leaving the eurozone would leave much of the existing (private and public) debt much higher in new Drachma, so one could argue leaving the eurozone wouldn't be helpful on this count either. Well, yes-- or Greece could default. After all, they have already done so in all but name.

If they could manage a large enough primary surplus they could also just manage to service the debt, without the need to issue new debt, but this is a rather big if (even if Greece is already quite close to running a primary surplus, the primary fiscal deficit shrunk from 24.7B Euro in 2009 to 5.2B euro last year).

On balance, it's difficult to arrive at a firm conclusion. While being a eurozone member undoubtedly forces too deflationary policies upon Greece, on the other hand, it enforces very useful and necessary structural reforms. Without the latter, leaving the Euro would probably bring too few benefits. So Greece should probably not run the risk at present, and keep reforming its economy. The funny thing is, the more successful they become in doing that, the less reason they have to leave the Euro.

But it doesn't mean our general conclusion-- that fixed exchange rate generally force too deflationary policies upon countries experiencing deep recessions-- isn't valid. This is happening in Greece, despite the fact that it also enforces structural reforms.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.