Countries run balance of payments deficits when their tradable goods are expensive on world markets because their producers are not sufficiently cost effective. These deficits cannot continue unless other countries are willing to help finance these deficits indefinitely by lending money to deficit-running countries. This is unlikely, unless either the deficits are small or a country has an excellent record on debt servicing. Otherwise,countries with balance of payments deficits must reduce their deficits. One option is to devalue their currency if they control its value. Devaluation makes exports cheaper to other countries and imports more expensive to domestic consumers and companies. These effects both tend to cut the trade deficit. Another way to improve international competitiveness is to have sufficient reductions in wages and prices that make the cost of goods more competitive internationally. Still another way is to lower production costs through improved efficiency.
I mention these types of adjustment as a background for discussing whether Greece should exit from the euro. There is no good solution for Greece, only least bad ones, given Greece’s extensive foreign debt, and lack of competitiveness of its goods in the EU and elsewhere in the world at the present international value of the euro. I have concluded that the better of the two basic dismal alternatives is for Greece to leave the euro zone, and return to the drachma. IMF estimates suggest that Greece needs a devaluation of at least 15-20% against the euro zone average, and much more against Germany just to balance its current account. A greater devaluation would be needed to stabilize its international debt. These are not firm estimates since needed currency adjustments are notoriously difficult to calculate, but there is no doubt that imports will become significantly more expensive to the Greek population.
Before the euro was launched I was skeptical that it could succeed (see my “Forget Monetary Union-Let Europe’s Currencies Compete”, November 12, 1995, reprinted in The Economics of Life). I said, among other things, “Competition among currencies helps discipline irresponsible governments by reducing their incentives to …finance budget deficits arising from dubious expenditures, such as inefficient state enterprises… and in order to penalize and discourage irresponsible government-based monetary and fiscal policies.” Not a bad description of what ails Greece! A single currency also makes it difficult for countries to restore competitiveness to their export sector, when they are subject to negative shocks that require their wages and prices to fall relative to those of other countries.
For the first 8-10 years of the euros’ existence, it appeared as if my concerns were misplaced since the euro performed very well. Many economists even claimed that it would eventually replace the dollar as the major international currency. The crisis of the past few years has crushed that optimism, and many now agree that it was not wise for Greece, and probably Italy, Spain, and Portugal as well, to have become part of the euro zone. Still, Greece is part of this zone. So the question now is whether Greece should abandon the euro, or make the fiscal and other adjustments demanded by other members, mainly Germany, in return for possibly continuing financial help?
If Greece stays in the euro zone, it will go through many additional years of painful adjustment that will mean indefinitely high unemployment and slow, if any, growth in the Greek economy. Over these years Greece’s standard of living- even with the cushion of aid it receives from Germany and the IMF- will continue to fall relative to that of Germany and other countries in the euro zone since its real income will fall further behind incomes in these countries.
If Greece leaves, the initial adjustment would be drastic. Greece would have to default on pretty much all its international debt denominated in euros, including loans from the ECB, since the value of the drachma relative to the euro would be too low to enable Greece to repay the debt. Greece would be unlikely to receive further aid from euro zone countries, and certainly Greece will not have access to the international capital market for some years to come. There would be a run on Greek banks as depositors try to get euros and lose confidence in the viability of these banks. Already, many depositors have withdrawn their deposits, as they fear Greece’s exit and a devalued drachma. Greece might be thrown out of the EU itself, which would carry great costs if it happened (I do not think it will).
The adjustment to the drachma would take a minimum of 18 months and possibly longer, and during this period the real income and prestige of Greeks would slide a lot. But countries like South Korea and Indonesia came back strong after their defaults and currency depreciations due to the Asian crises of the late 1990s.
I said earlier that Greece has no good choices, and exit from the euro would carry large costs. Nevertheless, I believe Greece in the long run would be better off through having the additional flexibility from controlling its own currency. My major concern is that this flexibility will not be used properly because the added flexibility through devaluations might take away the urgency of reforms in its government sector and labor markets. Greece really needs these reforms to become a more effective economy in the longer run.