Friday, May 25, 2012

Leaving the Euro again

Yesterday's coverage of the latest European summit seems designed to reinforce my view of basic confusion expressed yesterday pretty clearly.

For example, the Wall Street Journal's "Europe Girds for a Greek Exit" reports that the talk was all about eurobonds, stimulus, or bailout as a way to avoid Greek exit from the Eurozone, repeating the senseless mantra that sovereign default cannot occur in a currency union.
"We want Greece to remain in the euro zone," German Chancellor Angela Merkel told reporters after nearly eight hours of talks. "But the precondition is that Greece upholds the commitments it has made."
I salute Ms. Merkel for not giving in to the camp that wants endless wasted spending disguised as stimulus, to be followed by inflation. But really, why would Greece not "upholding its commitments" mean it has to "leave the eurozone?" Why is it impossible to turn off the bailout spigot, and let Greece default and stop running deficits, while it stays in the euro?

Actually, the article, quotes, and other coverage is deliberately vague on a central question: Are we preparing for Greece to decide to leave the Euro, or are we preparing that the rest of Europe will try to kick it out? The quote reads a lot like the latter!

How do you kick a country out of a currency union? Greece has every right to say "the euro is legal tender in Greece," no matter what the rest of Europe does. Sure banking will be a bit harder if the ECB cuts off the Greek central bank, but unilateral use of another currency is an economic possibility. Kosovo and Montenegro do it.

The mantra continues,
...fears mount that Greece won't be able to carry out the painful surgery to its public finances and its economy needed to stay in the currency zone.
 At least the fact is dawning that a currency switch is the same as default:
In addition, euro-zone members would likely have to take a large hit on governmental and central banks' loans to Greece. There is a risk that some euro-zone commercial banks could face heavy losses on their exposure to the Greek economy. 

A lot of coverage concerned "eurobonds," an idea that has been stuck for years on just who is going to pay for them.

News flash: eurobonds have already been issued. They are called euros. ECB reserves are just particularly liquid floating-rate debt. The ECB issues reserves in return for sovereign debt and lends reserves to banks who load up on sovereign debt. This action is functionally the same as issuing Eurobonds to buy sovereign debts. What happens of the ECB's holdings of sovereign debt or its bank loans turn out to be worthless? If the ECB needs to be "recapitalized," it has the explicit right to call up the member states and demand funds, which means the member states have to kick in tax revenues. This is exactly a eurobond. For better, or, likely, worse. 

The ECB has propped up Greek banks for months through its lending operations and, increasingly, its emergency-lending program, known as ELA.

Under ELA, banks borrow from their national central bank, in this case the Bank of Greece, with approval of the ECB's governing council. The default risk resides with the Greek central bank and, ultimately, the Greek government.
This is a great case of wishful thinking, I'd say. Oh sure, the ECB doesn't have credit risk...if the banks collapse because the Greek government defaults on its debt, the Greek government will pay us back!
To ease the fallout on Spain and others, the ECB could issue more three-year loans to banks, analysts say. More than €1 trillion in these loans have been doled out since late last year. 
A trillion here, a trillion there, and pretty soon you're talking real money -- real debt. 


A quick response to some emails and comments. Yes, I understand that devaluation can change a trade balance towards exports. (I try to avoid the mercantilist implications of writing "improve the current account" or "raise competitiveness.") 

If the US Fed were to say "we buy and sell Euros at $2 per Euro," US prices and wages would not instantly adjust; our exports would become cheaper and imports more expensive, and we would import less and export more for a while.

The reason is superficially clear: prices and wages are a bit sticky. The precise mechanism of such stickiness is the subject of a huge academic investigation and is, I opine, still a little unclear. But it's not really controversial what would happen in the US.

But nominal prices are not always sticky. For example, when countries joined the euro, nominal prices changed by orders of magnitude, overnight, with no output or trade effects whatsoever.

The challenge for theory -- and for predicting what would happen to Greece if it left the euro -- is to figure out which kind of experience applies.

For a small country to suddenly leave a currency union, adopt its own currency, and instantly devalue that currency,  along with likely capital, exchange, trade, and other controls, is a quite different experiment than for a large country, with a well-established currency to devalue.

Does the price and wage stickiness that applies to a US company with longstanding contracts in dollars apply to Greek contracts that expect 10 euros, suddenly told that's going to be 10 drachmas, which are now worth 5 euros? Or do people in that circumstance focus on the euro value and treat the event exactly as they would being told that they are going to get 5 euros? Just how "sticky" will Greek nominal prices and wages be? Will the political constituencies be who don't want explicit euro cuts be mollified if they are paid in Drachma instead?  It's not obvious!

Here I'm willing to offer my Keynesian colleagues a friendly wager: Let's look at Greece 6 months after Drachma introduction and swift devaluation. I bet it will be a continuing basket case, and that Greece won't be exporting lots of Porsches back to Germany. If return to the Drachma and devaluation produce a swiftly growing Greece based on a hot export sector, well, I'll at least say I was wrong. No, you don't get to say it's awful but it would have been worse otherwise.


  1. John, but why do we need to wait for Greece to devalue to look at your wager. Isn't this exactly like what happened in Argentina, whose Real GDP per capita has grown since the last devaluation quite a bit, yet Argentina is pretty clearly a basket case by any sort of reasonable measure of structural economics ?

  2. "No, you don't get to say it's awful but it would have been worse otherwise."

    Why not? The statement would be unprovable but could quite possibly be true. It is certainly an opinion which might be legitimately held under those circumstances at that time depending on the evidence at the time.

    No matter what currency it uses, Greece is a mess and is going to go through some gut wrenching changes.

  3. Some people want to know what you think of Mises

  4. "But really, why would Greece not "upholding its commitments" mean it has to "leave the eurozone?" Why is it impossible to turn off the bailout spigot, and let Greece default and stop running deficits, while it stays in the euro?"

    John, this is a good point. Not many people are saying this.

    I also fail to understand how people expect Greece to be able to start a new drachma - as if it was as easy as changing one's hairstyle. It's one thing for a healthy country to introduce a currency by pegging it to an existing currency so as to gain credibility. But Greece isn't healthy. It doesn't have the resources to maintain a credible peg and, with an already-existing credible currency in circulation, the most likely value for a new drachma is 0. Nor can drachmas be forced into circulation by the government, since this is the very government that has so many problems with the much simpler task of collecting taxes. The only outcome here is that Greece stays on the Euro, either de jure or de facto.

  5. In other words, I wager that your wager will never have a chance to be fulfilled, since Greece can't reintroduce the drachma.

  6. I am a regular reader of this blog who is unsophisticated about macroeconomics. To me, your posts on this topic beg this question: Why is the rest of Europe bailing out Greece rather than letting it default?

    From the media reports, one would have thought that this was to stave off the collapse of the Euro Zone that would result from a Greek exit and contagion to Spain and Italy. Perhaps the journalists covering the European debt crisis share my confusion.

    The analogy to the Dollar Zone seems instructive, but if California were expected to default by December, one would not expect Alaska or Texas to make emergency loans to prevent it, would we? States have defaulted in the past, presumably without this type of assistance.

    Sometimes one hears that the bailouts are about French banks (among others) that hold Greek debt, but to a lay observer it seems that allowing Greece to default and then directly recapitalizing the important French banks would be a more efficient use of the money.

    What especially complicates this for me is that I thought there were parameters set on the permissible fiscal policies that Greece is said not to have followed.

    If Greece can just default on its sovereign debt without disrupting the rest of the Euro Zone, I don't see why they cared so much about these fiscal policies in the first place.

    These fiscal policies also don't seem to exist for states in the Dollar Zone, or if they do I am not aware of them. The best I can do is think there is something imperfect in the Dollar Zone to Euro Zone analogy that might not have been discussed in your post.

  7. Why would greece default an stay in the. Euro? Wouldn't it be more attractive to get out?

  8. Deutsche bank lead economist seems to be finally getting the point....though he is talking about Greece staying in the euro in a slightly different for 'Geuro'

    even UBS finally said that default doesn't mean exit!!

    i think they will get it just in time (although a lot more damage will be done by then)

  9. Devaluation can have an effect even in a closed economy. But since the Greek government perpetually borrows money, I suppose you're right to highlight the exports necessary to pay for the money they're borrowing from abroad.

  10. Prof Cochrane,

    I am a little confused by the "model by Mr. Delpla and Mr. von Weizsäcker" in which two grades of debt could be issued. They refer to it as blue debt and red debt.

    Is there a way to fit this concept in your reserves as floating-rate bonds analogy? Can you issue blue and red reserves?

  11. Greece needs the Hamilton Plan:

    1) its own currency

    2) issued in connection with a serious plan to pay off its debts, as issued in it own currency, in 30 to 40 years, including all the (and I mean all) the institutional changes this would require. IOW, Greece needs to attack its problems on all fronts. This a much strong executive, with power to make all the changes needed.

    3) the later would include: (a) devaluation; and (b) tax free or low tax "new economic zones"; (c) extremely extremely liberal bankruptcy laws, so that everyone can shed their private debt but keep their current assets.

    4) a new "Marshall Plan" with the United States to assure short term stability, principally putting people to work tackling its infrastructure problems.

    The US ought to do this for all of Southern and Eastern Europe, out of fairness and Russia

  12. If the Greek government defaults on the debts it has not already defacto defaulted upon (I count a 75% "haircut" on certain debts as a default) who would lend it more Euros to finance its Welfare State and its own employees?

    "The Greeks could pay their taxes" - the silly IMF lady. Greeks already pay very heavy taxes, they can not AFFORD to pay more (clue - the Greek economy is already in terrible trouble).

    So the Greek government would face a choice if it defaulted on its remaining debts (the debts to the E.U. and so on).

    Get rid of its Welfare State - not likely.

    Or - print its own currency, in order to pay the domestic bills (its own government employees and the Welfare State).

    If the Greek government prints its own currency it has BY DEFINITION left the Euro.

  13. John, hasn't the experiment been done recently? In Dec 2001, Argentina left its "currency union" with the US. 2002 was bad; GDP growth rates above 8.5% from 2003 to 2007...


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