Should Greece Abandon the Euro?

I agree with Becker that it would make sense for Greece (from the standpoint of Greek self-interest) to replace the euro with its own currency, but my reason is slightly different; it is that it is the politically more practicable solution to Greece's economic woes. I also suggest a caveat based on the costs to Greece of transitioning from the euro to a homegrown currency: Greece would be better off in the long run with its own currency, but it may not be able to avoid or tolerate the short-run costs.

From a narrowly economic standpoint, disregarding politics, abandoning the euro would have consequences for the Greek economy comparable to the consequences of adopting a further set of "austerity" measures, as urged by the Germans. Such measures might include laying off a large number of public sector workers, cutting public pensions, curtailing the powers of unions, cracking down on tax evasion and corruption more generally, and eliminating restrictions on competition, such as licensing requirements for new businesses and for professionals such as lawyers and accountants. The problem with enacting such austerity measures is that they are politically infeasible in the circumstances in which Greece finds itself. This is partly due to Greeks' hatred of Germans (rooted in the brutal German conquest and occupation of Greece during World War II, and also in the disdain for Greeks that Germans feel and make little effort to disguise), but more to distrust by the Greek people of the Greek government and to the understandable resistance of the beneficiaries of Greece's economically unsound policies (public sector workers, public pensioners, professionals protected from competition, and so forth) to give up any of their benefits.

The beauty of replacing the euro with a Greek currency is that this single, politically feasible—if not downright popular—legislative measure is likely to bring about indirectly economic results similar to those that explicit austerity measures would be likely to bring about. Euros held by Greeks, including Greek banks, would be exchanged for the new currency (the drachma—the name of the Greek currency before Greece substituted the euro), which because of Greece's parlous economic state, and the benefits of devaluation, would be worth substantially less than the euro. One result would be that Greek exports would be substantially cheaper, and this would increase demand for them, which would stimulate an increase in their supply, leading to increased employment in the export sector of the Greek economy. The prices of imports would be higher, and this in turn would encourage substitution of domestically produced goods for imported goods; domestic production would thus increase to serve domestic as well as foreign markets, further increasing employment.

Such mechanisms make devaluation an almost surefire way of bringing an economy out of a depression by lifting emplooyment. Successful recent devaluers include Russia, South Korea, Indonesia, and Argentina. In addition, increased demand for workers in productive industries would lead to higher wages, which would draw workers from the bloated public sector, thus reducing the size of that sector (one of the goals of austerity measures). Increased demand for Greek products would also place pressure on government to relax restrictions on competition (another goal). There would also be pressure for a more rational system of taxation and public benefits. A thriving private sector, in short, would exert pressure for greater economic efficiency, just as the austerity measures that are political poison would do.

Still another consequence of abandoning the euro and of the ensuing devaluation would be a reduction in Greece's huge public debt. Much of that debt has been financed by the European Central Bank, and one of the main aims of the austerity measures it to avoid Greece's defaulting on that debt. With the change in currencies and ensuing devaluation, creditors would be paid in drachmas worth much less than the euros in which the debt to those creditors was denominated. The pressure for politically destabilizing short-run austerity measures would be relaxed; instead those austerity measures would unfold gradually as a consequence of an increasingly productive and prosperous private sector, a trend that would reduce the demand for government services along with incentives for tax evasion and corruption.

Default would of course reduce the ability of the Greek government to borrow at tolerable interest rates, but that would exert a further indirect pressure for efficiency and for a reduction in the bloated (and therefore expensive) public sector.

The main objections to Greece's abandoning the euro are twofold:

First, because of the possible domino effect of that abandonment, and of the ensuing default, on other financially precarious euro nations such as Spain and Italy, Greece may be able, by threatening to leave the euro rather than actually leaving it, to obtain further substantial financial aid from the European Union, though this seems unlikely and would in any event be only a short-term solution to Greece's economic problems. Yet the threat route seems to be the one the Greek government is on at the moment.

Second and more ominous, the transitional costs involved in switching currencies could be immense, creating its own political risks. Most of the benefits of devaluation, namely the benefits in increased exports and in substitution of domestic for imported goods, and resulting pressure for overall increases in efficiency, will not be felt immediately. But the transitional costs will be.

Suppose Greece were to announce that in three months it would be freezing transfers of capital to other countries and requiring that all euros in Greece be exchanged for drachmas at a specified rate of exchange. The reason for the three-month waiting period would be that it takes time to create (in this case, re-create) a currency, print the new currency, and price all goods and services in the new currency. (In 2003 it took the United States three months to create a new Iraqi currency.) But given such advance notice, Greek individuals and companies would forthwith transfer to other countries all the euros they could spare from immediate consumption or other expenditures, thus draining enormous wealth from the country before the switchover data prevented further capital flight. What the Greek government needs somehow to do is prepare for the changeover in currencies in secret, so that euro holders are unable to transfer their euros abroad. It is not clear that this is feasible. Devaluing an existing currency is much simpler than changing currencies, especially changing out of a foreign currency, such as the euro. Greece cannot devalue the euro.

And even if the currency changeover proceeded smoothly, the immediate effect on the prices of imported goods (immediately much higher), and on savings (immediately worth much less—the obverse of the effect of devaluation in reducing debt), would be economically destabilizing, with potentially serious political as well as economic consequences in an already depressed economy.

If the transitional costs can be reduced to a tolerable level, however, abandoning the euro seems the best bet for a Greek economic recovery. But it's a big "if," and the alternatives are not appealing.