Drachma's Return Means Instant Austerity, Whether Greeks Want It Or Not

by: Steven Bavaria

One nice thing about free markets is that they have a way of forcing economic reality on people, whether they prefer to face it or not. That's why a return to the drachma would be good for Greece and its citizens, given their inability to face up to the hard choices that their past political and economic decisions have now presented them with.

Returning to the drachma would mean that the drachma/euro (or drachma/dollar, drachma/pound/drachma/yen…name your currency) exchange rate would be a continual score card for whether Greece was carrying out the austerity program required to turn its credit and financial situation around. If it voluntarily reduces government expenditures, increases taxes, lowers pension and other entitlement payments, and generally tightens its belt as a government and as consumers, its currency will maintain its value among its trading partners, local interest rates and inflation will remain relatively modest, and the austerity pain - while very real - will be somewhat controlled and predictable.

But if voters try to take the "Hell No, We Won't Go!" approach to austerity evidenced in the recent election, then the currency market will react accordingly. The drachma will plummet versus other currencies, the price of imports will rise taking the cost of living up with it, and real earnings of Greek workers will fall. Interest rates will rise, making credit prohibitively expensive, which will further encourage the government and other entities to live within their means. Voila! Instant austerity. Some good things will happen too. Greek exports will become cheap. Earnings in other currencies, like the earnings of Greek shipping companies, will increase in value. High interest rates will actually attract investment, but only for worthwhile ventures whose value will rise in real terms, not merely in drachmas. Tourism, which has languished in recent years because of the political instability, will surge because Greece will become a bargain destination once again.

But as long as Greece stays in the euro Greek voters can hold the rest of Europe hostage: "Bail us out or we'll pull your house down!" Calling their bluff would be good for Greece, by forcing discipline and remedial action on a country whose citizens clearly are unable to take their medicine voluntarily.

(This last sentence has an ironic quality to it, given our political unwillingness here in America to get our act together to forestall our becoming like Greece in another decade or two. But that's another, longer article or two…or three…)

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