I will discuss the following two crucial questions about Greece and the euro:
Should Greece have become part of the euro? No.
Should Greece leave the euro? Not now, but probably in the future.
Greece initially gained many apparent advantages from becoming part of the euro zone. The Greek government could borrow on the international capital market at interest rates that were only a little above the rates paid by Germany, the strongest EU economy. These low rates probably reflected a belief among investors that the strong members of the EU would support investors in the weaker economies if these economies ran into financial difficulties. Being part of the euro zone also led to easier access of Greek goods and services to the markets of other euro members, especially France and Germany. As a result, Greek GDP grew at good rates until the financial crisis hit.
However, being part of the euro zone created many problems for the Greek economy that only surfaced after the financial crisis began to take its toll. Since the cost of borrowing was low, Greece borrowed a lot from banks in France and Germany, and also from domestic banks, to finance a bloated government sector that had too many employees who retired early and did not have to work hard. It also had an inefficient and ineffective tax system that did not raise enough revenue to finance its ambitious spending programs. The government continued to operate inefficiently railways, mining and vehicle companies, and enterprises in many other sectors. Moreover, little effort went into reforming labor and product markets to make them more competitive and flexible.
These fundamental weaknesses of Greece were hidden during the good times after the creation of the euro. When the financial crisis and the Great Recession hit in 2008, investors began to require much higher risk premiums for government bonds and other assets issued by Greece and other weak members of the euro zone. Tax receipts of the Greek government fell significantly, which made it still more difficult to meet interest payments on Greece’s large external debt.
If Greece had continued with the drachma instead of replacing it by the euro, Greece would not have been able to borrow so much on generous terms because support from the EU would not have backstopped Greek government bonds. After getting into economic trouble, Greece would have had to devalue its currency to increase exports, reduce imports, and cut its borrowings. Since Greek wage rates and prices are not flexible, devaluation would have substituted for direct reductions in the real wages of Greek workers through labor market adjustments. In addition, the Greek government would have defaulted on much of its debt, as Argentina did at the beginning of the 21st century. Greece would still have had to go through painful adjustments that would have significantly reduced the standard of living of the typical Greek family, but these adjustments would have been smaller and of shorter duration than what Greek is going through now with no end in sight.
I opposed the euro when it was created in 1999 because I believed it would prevent member countries from devaluing their currencies if they experienced negative shocks from the international economy. I expected the main shocks to originate in balance of payments problems instead of in capital accounts. After a while I began to believe that I had been wrong since the euro did very well during the early years of this century.
The past few years of major difficulties by the weaker members of the euro zone convinced me that the skeptics regarding the workings of a common European currency were right after all. Members of the euro zone with inflexible labor and product markets, the majority of members, have to endure painful and prolonged economic adjustments to negative shocks to their economies, such as Greece is experiencing, in part because countries in the euro zone are unable to devalue the international value of their currency. If it were not the financial crisis, other major shocks would have hit Greece and the other weak euro zone economies that would have badly stymied their economies.
To come more briefly to my second question, should Greece vote yes on a potential referendum to withdraw from the euro? The advantages of leaving are that Greece could greatly devalue its own currency, and default on much of its debt. The main disadvantage is that it would lose the substantial bailout assistance from the other EU members, especially France and Germany. Since Greek banks are also major creditors of the Greek government and Greek companies, default on the Greek debt would place these banks in unsustainable positions unless they received aid from the IMF or elsewhere. In addition, depositors would try to pull funds out of Greek banks to protect against losses from a depreciated drachma, and companies with euro-denominated debt would face financial ruin.
In light of this, the best solution for Greece would be to stay with the euro for the present while it receives additional aid from the EU and the IMF. But Greece should seriously contemplate pulling out of the euro zone later on, especially if by staying in Greece is forced to continue to undergo a painful and prolonged depression of its economy.