Greece Should Dump the Euro

by Benjamin Studebaker

The Greek government has decided to hold a referendum on whether or not to agree to the austerity and neoliberal reforms demanded by the troika (the IMF, the ECB, and the EU). The Prime Minister, Alexis Tsipras, has implied that if Greeks vote for austerity, he might resign. I’ve written about the negotiations between Greece and the troika in the past. Since then, events have unfolded and it’s now time for Greece to make good on its threat and dump the Euro. Here’s why.

First, let’s briefly review where we are and how we got there.

In 1999, the euro was introduced, a single currency replacing the francs, drachmas, lira, marks, and other old European currencies. Each European country gave up independent control of its monetary policy (its interest rate and money supply) to the European Central Bank (ECB), which was intended to be roughly analogous to the US Federal Reserve. In the United States, the individual states (California, Alabama, etc.) are financially protected by the federal government. Foreign investors don’t have to worry about say, an Alabama default, because Alabama’s finances are guaranteed by the the federal government. When an economic crisis hits the US, the federal government takes action to rescue the states that are most adversely affected, even though this often means transferring large amounts of money from healthier states to sicker ones. Investors assumed that the Eurozone worked in this same sort of way, that it was just as safe to invest in Greece or Spain as it was to invest in Germany or the Netherlands. As a result, governments in the European periphery (countries like Ireland, Spain, Portugal, Italy, and Greece) were suddenly offered extremely attractive low interest rates by bankers living in the European core (countries like Germany). They succumbed to the allure of this cheap money, borrowing excessively.

The influx of cheap money into the periphery led to inflation. This pushed up wages in the periphery, making it difficult for goods and services produced in the periphery to compete with those produced in Germany:

This made it harder for goods produced in the periphery to compete with those produced in Germany. This gave Germany an economic boom driven by strong exports, but it slowly strangled the balance of trade in the exporting countries. When the global economic crisis hit, the cheap money dried up and the debt bubble burst. It suddenly became very clear that the underlying fundamentals of the peripheral economies were much weaker than German bankers had understood, and investors started to flee. Here’s Greece’s current account balance as a percent of GDP over the last 20 years or so:

 

Greece ran a small, manageable deficit until the mid to late 00’s, as the economy lost competitiveness and investment dried up.

Now, you’ll notice that the wage gap and the current account cap have been closing over the past five years or so. There were two ways to go about solving the crisis in the periphery:

  1. The Troika’s Preferred Solution–if Greece’s economy deflated and its wages were pushed down, this would restore Greece to competitiveness. This meant that Greece should be made to pay its debts and enact austerity policies to strangle its own economy until desperate Greek workers consented to take jobs at much lower wages than they enjoyed during the 00’s.
  2. Greece’s Preferred Solution–if Germany ran a higher inflation rate, this would restore wage competitiveness without forcing Greek workers to endure large scale unemployment. If the troika also forgave Greece’s debt, that would reduce the severity of the reforms required to make Greece’s balance sheet sustainable in the absence of all that cheap foreign money.

Essentially, Greece wanted the EU to act like the United States–to use the resources of the core to help the periphery recover. But the EU doesn’t have a strong independent federal government. Its policies depend on the consent of its member states, and German voters understandably had no interest in using their resources to help Greece and the rest of the periphery recover. Instead, the troika has consistently given Greece a series of ultimatums–unless Greece accepts austerity and pays its debts, the troika will cut off support to Greece’s banks. So for quite some time, Greece accepted the troika’s demands and did austerity. Since 2008, Greece has reduced government spending to 2003 levels:

In combination with the collapse in cheap foreign money, this has strangled the life out of the Greek economy. An immense number of people became unemployed as a result of this policy:

 

Greece’s per capita GDP has contracted almost consistently since 2008:

Greece’s GDP has fallen so rapidly that even though Greece’s spending has been cut to 2003 levels, its spending to GDP ratio is still higher than ever:

And the debt to GDP ratio remains virtually untouched:

Ordinary Greek citizens are fed up–they need jobs. So they elected Syriza, the Coalition of the Radical Left, to lead the government. Tsipras was its leader, and he promised to put an end to the austerity and get Greeks back to work.

The troika wants more of the same–the most recent proposal calls for Greece to run a surplus of 1% of GDP in 2015, 2% in 2016, 3% in 2017, and 3.5% in 2018, and give that surplus to its credits (i.e. bankers in places like Germany). This is a reduction from the original demand, which was 3% for 2015 and 4.5% for 2016, but falls short of what Greece is willing to accept, which is 0.8% in 2015 and 1% in 2016. Ideally Greece would like to see its debts forgiven completely.

As leader of a left wing party, Tsipras cannot enact the austerity the troika demands. His support would collapse. So he is now threatening to leave the Euro if his demands are not met, and the troika are threatening to cut Greece off if it does not meet their demands. It’s a game of chicken–both sides believe the other will cave.

The troika should cave, and if the troika does not cave, Greece should leave the Euro. Don’t get me wrong–a Greek Euro exit (or “Grexit”) will have severe short-term consequences for Greece. The new Greek drachma will immediately collapse in value against the Euro and imports from foreign countries will spike rapidly in cost.

But in the long-run, a new drachma works like a major currency devaluation. In a devaluation, the rapid fall in the value of the currency makes it much more expensive for consumers to buy foreign products, but the country’s exports become much cheaper and much more competitive. In the meantime, because imports become so expensive, there are boosts to domestic production in a wide array of sectors. Greece would also become a much cheaper destination for tourists and tourism revenues would spike. All of this rapidly puts people to work.

Consider Argentina. Argentina was in very bad fiscal shape in 2002, with spiking public debt:

So Argentina decided to stop paying its creditors and devalue its currency. Inflation briefly soared over 40%:

Not only did Argentina reduce its debt to GDP ratio from 160% to less than 60% in the ensuing years, but it also reduced its unemployment rate from over 20% to less than 8%:

And its annual GDP growth rate made a swift recovery:

How is this possible? The whole point of the economy is to put the country’s workforce to socially constructive purposes. When 20% or more of the workforce is sitting around doing nothing, this is wealth and human potential that is simply being thrown away. Yes, Greece needs to make a wage adjustment, but instead of having 20% unemployment and waiting for desperate workers to agree to work for less, Greece can introduce a weak new currency that will make the adjustment without inflicting anywhere near as much suffering on poor Greeks. By putting its people back to work, it will unlock its real potential. This will push up Greece’s tax revenues and reduce the need for further reforms. Greece will still need to weed out corruption and close its extensive tax loopholes, and it may need to make some cuts to its pension programs, but the severity can be vastly reduced if Greece’s workers are working and paying income tax. The only way to put Greeks back to work without undermining Greece’s wage adjustment or putting Greece further in debt is to sink the currency, and the only way Greece can sink its currency is by dumping the Euro and reintroducing a drachma it can control.

It won’t happen all at once. If and when Greece leaves the Euro, the initial pain will be very real and very severe for Greek consumers, who will see prices on all kinds of goods and services spike rapidly. But if Greece follows the Argentinian playbook and manages the transition effectively, Greece can relieve the misery and suffering of its poor and unemployed, increase its revenues, and restore itself to sustainable growth.