Wednesday, May 23, 2012

Leaving the Euro

I find all the reporting of the Greek (and following Spanish, Italian, etc.) debt crisis unbelievably frustrating.

Why does everyone equate Greece defaulting on its debt with Greece leaving or being kicked out of the euro? The two steps are completely separate. If Illinois defaults on its bonds, it does not have to leave the dollar zone -- and it would be an obvious disaster for it to do so. 

It is precisely the doublespeak confusion of sovereign default with breaking up a currency union which is causing a lot of the run.

It's pretty clear that if Greece leaves the Euro and reintroduces the Drachma, that event will come with capital controls, swift devaluation, effective expropriation of savings, and a disastrous and chaotic rewriting of all private contracts (do I have to pay this bill in Euros or Drachmas? Every contract ends up in court. Greek court.) 

Quiz: If your politicians are even talking about this sort of thing (together with "austerity" which is heavy on higher capital taxation) what do you do? Answer: take your money out of the banks, now.  Take everything that is not bolted down and leave.

Just talking about leaving the Euro is How To Start a Bank Run 101.

The right step is the opposite: firmly announce and commit as much as possible that Greece (and Italy, Spain, etc.) will not leave the euro.

Precommitment is hard, but a good first step is to make it clear you know the action you're trying to commit not to do will hurt you.  Communicating a commitment not to have dessert is hard. Communicating a commitment not to shoot yourself in the foot should be easier. Start by not saying  that shooting yourself in the foot will taste good.

Politicians need to repeat over and over again that they understand a default does not mean euro exit -- that the two steps are completely separate decisions; that a currency union with sovereign default is perfectly possible.

Them they need to articulate just what a disaster leaving the Euro will be. They need to say they will tolerate sovereign default, bank failures, and drastic cuts in government payments rather than breakup.

Yes, cuts. The question for Greece is not whether it will cut payments. Stimulus is off the table, unless the Germans feel like paying for it, which they don't. The question for Greece is whether, having promised 10 euros, it will pay 10 devalued drachmas or 5 actual euros. The supposed benefit of euro exit and swift devaluation is the belief that  people will  be fooled that the 10 Drachmas are not a "cut" like the 5 euros would be. Good luck with that.

Think what would happen if, in order for Illinois or California to solve their debt,  pension and benefits debacles, they decided to leave the dollar zone, institute capital controls, redenominate all bank accounts and private contracts in their borders, and devalue. Plus big wealth taxes. Now they can tell their pensioners, "see, we didn't cut your benefits after all." Would the pensioners be fooled? Would this set of steps make them more competitive? And if Illinois or California politicians started talking about this sort of thing, how fast would the bank run start?

A Greek departure would also be disastrous for the rest of Euroland. Yes, Greece is small. But  people with bank accounts in Spain or Italy would see clearly that their leaders do not understand sovereign default can coexist with a currency union. The run starts. Sorry, intensifies.  Greece is a huge precedent.  


  1. The argument for leaving the Euro is that Greece can adjust the quantity of money in Greece according to the demand for money in Greece, so that nominal incomes in Greece can return to, and then continue on their previous trend.

    If prices and wages current in Greece are just right, so that the current level of real expenditure just matches the productive capacity of the Greek economy, then returning to the previous trend of nominal expenditure will have no positive effect on employment or real income in Greece. Presumably you have some theory as to why the drop in nominal expenditure in Greece in 2008 and 2009 just happened to match a catastrophic drop in productive capacity. You should explain this theory.

    Even if that is what happened (and I think it absurd,) then with its own money, internal Greek creditors, including pensioners, will share proportionally in the loss.

    I agree that shifting from the Euro to the new Drachma has no impact on foreign creditors. The Greeks still owe the Euros, and they can default or not.

    For example, many Poles borrowed Euros and while the recession in Poland was mild and the recovery rapid, Poles that owe Euros have a larger real burden of debt because their currency lost value relative to the Euro.

    If, on the other hand, prices and wages are too high in Greece, then if Greece had its own currency, then it could expand the quantity of money, nominal expenditure on output, and generate a larger real output, income, and employment. This larger real income would make it possible to better pay debts, pensioners, and so on.

    With Greece being a small open economy with a fixed exchange rate, it could cut wages, and the prices of nontraded goods and have the same effect.

    To me, you facilly assumed instant and continuous market clearing, so that real expenditure is always equal to productive capacity. You assumed a real business cycle disaster in Greece, with productive capacity suddenly dropping. Perhaps. But you should mention this highly controversial views.

    Then, with those assumptions, it is all about debt.

    1. Bill, you say: "If, on the other hand, prices and wages are too high in Greece, then if Greece had its own currency, then it could expand the quantity of money, nominal expenditure on output, and generate a larger real output, income, and employment. This larger real income would make it possible to better pay debts, pensioners, and so on."

      The problem is that Greece, while having the Drachma, was not an example and paradigm of good monetary policy. Greece is populated with demagogue politicians, that used Drachmas and its inflation to sell false prosperity. This is the reason why countries fix their domestic currencies to harder currencies. This is the reason why Ecuador, even under a left wing demagogue like Rafael Correa, has not given up the dollar as its currency. Politicians like Tsipras in Greece are not very encouraging with regards of being able to manage their monetary affairs. Tsipras would treat the Central Bank of Greece as the printer of money to prosperity, and sell a very facile prosperity gospel to the Greek voters.
      The way I see it, Greece is a country with Third World productivity and investment, but wants the welfare state of Germany. If you print your own money, Drachmas, you can pretend that you can finance this thing. But, when you do not, it becomes patently obvious that your dreams are unsustainable. This is the beauty of a fixed exchange rate system, or better, a system where you do not print your own money: you cannot shove your productivity problems under the inflation rug. You cannot pretend to be richer that you really are.

    2. Greece, like every other country, should target Greek nominal GDP on a stable growth path.

      To the degree the supply side problems you describe intensify, they do lead to a higher price level and so inflation under such a regime. That is the least bad result, and those who don't like the inflation should be directed at the productivity reducing (and cost increasing) policies.

      Fixing exchange rates is an undesirable approach, unless, of course, Greek workers are able and willing to move to Germany and German plants to open up in Greece.

  2. Could you please make some refrences in regards to the constitution article 10 no ex post facto laws. I remember that Milton friedman started to talk about honoring contracts in capitalism and freedom but he didn't go anywhere with it. I think it is because he was afraid that the judges would have him offed since they are dependent on the use of a ever expanding money supply which undermines contracts which is the main reason for the judge office in our government. I want to see some professor with the courage to address this most corrupt system. Please be our hero and bark loudly at some judges.

  3. Thanks for illuminating this subject. I agree that the two events are separate. But the Greeks seem unwilling to vote for a government that would take the actions needed to stay in the euro zone. If the Greeks default on their euro debt, they will get no new infusion of capital, because they will have broken all trust with their neighbors. Their only way out would be real structural reform. Such reform would include reducing the wages of workers, payments to pensioners and hiving off state businesses. There is no political will to do so. The leftists actually think they can threaten/blackmail the Germans into giving them an endless supply of euros. That's not going to happen. Result, Greece leaves the euro; not because of the debt default, but the refusal to deal with its root causes.

  4. The problem is not only the government deficit, it is also the enormous trade deficit that at the moment is just payed by printing money. You can't expect the other Euro countries to delived the goods for free. Another aspect is the capital export from Greece that can't really be regulated by staying within the Euro. Due to the bad government structure in Greece much of the money designated for help is just going to swiss bank accounts.

  5. Hi John,
    Can you explain in more detail how Greece might finance its deficit and support the Greek banks if it chooses to default, yet stays in the Eurozone?

  6. its frustrating but pls keep trying Prof...

    your earlier article on this issue corrected atleast my thining on this issue

    more power to you!

  7. There is the reporting, which is frustrating indeed, and there is the politics, which is what is to be expected from it: institutionalised irresponsibility, not only on behalf of politicians, but on behalf of voters as well. The best means of precommitment would probably be to take away the political power to do harm (giving up the chance of benefiting from it). A tall order, if ever there was one.

  8. The Greeks want to leave the Euro for the simple reason that they cannot run up a high rate of inflation to manage their ever growing public sector if they are tied to the Euro.

  9. "If Illinois defaults on its bonds, it does not have to leave the dollar zone -- and it would be an obvious disaster for it to do so. "

    Exactly. Good post, agreed with much of it. I think the press and politicians have been framing the issue as if default and exit were twinned, whereas that is simply not the case.

  10. But neither Illinois nor California had their own currency ~10 years ago. Instead, both have >200 years of national and currency unity with the rest of the states.

    I don't see the link as being between default and leaving the Euro...the link to default is with the new government in Greece not agreeing with the terms of the austerity agreement. In that case, there is nothing to do but leave the Euro and go back to their own currency. I think the end result will be the same in both cases, but if they go back to their own currency the politicians will be better able to lie to the Greek people.


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