International Political Economy

Analyzing the effects of politics on business and markets.

Special Report
THE DEVALUATION OF THE GREEK EURO
February 17, 2010

ROBERT Z. ALIBER

Bailouts and Guarantees won’t work. Greece will leave the euro,
devalue it increase its competitiveness and then rejoin the euro.

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International Political Economy

THE DEVALUATION OF THE GREEK EURO

Robert Z. Aliber

Greece joined the Euro in 2001, several years after its birth. The delay of several
years resulted because Greece’s fiscal deficit in 1999 was too high to satisfy the
Maastricht criteria. Now it appears that Greece satisfied these criteria only
because of some accounting shenanigans, somewhat remindful of the off-balance
sheet activities of Enron and Citibank’s SIVs.

The basic Greek problem is that costs are too high, which has led to a massive
current account deficit, and contributed to the high level of unemployment, and
hence to a low level of fiscal revenues. It doesn’t help that tax evasion is
extensive.

Assume a counterfactual scenario. Assume that Greece has not yet given up the
drachma for the Euro; its parity is 1 Greek drachma = 1 Euro. Everything else is
the same as currently, government indebtedness is 110 percent of GDP, the
unemployment rate is 9.8 percent, industrial production is down 7.6 percent from
a year ago, the current account deficit is 12.4 percent of GDP (whereas the
average for the Euro area is 0.7 percent), and the budget deficit is 13.0 percent
of GDP, more than twice the average for the Euro area.

Assume Greece were to devalue the drachma. How large a devaluation would it
need to achieve a satisfactory external balance position? Probably twenty to
twenty five percent.

If a twenty percent devaluation were necessary to achieve a satisfactory

domestic and external imbalance, then it would take a twenty percent reduction
in wages and salaries to achieve the same improvement in the international
competitive position of the Greek economy.

How likely is it that the Socialist government in Athens can bring off a reduction in
wages and salaries of ten percent? Not likely, Greece got into this mess because
its polity has been fractious, which goes back a long, long way.

If Greece can’t reduce wages and salaries, then it should leave the Euro for a year
or two. But many observers believe that can’t happen because there are no
provisions in Maastricht treaty for a divorce or separation.

That’s nonsense. International monetary treaties are good for fifteen or twenty
years and when market conditions change, countries do what they believe they
need to do. The Czechs and the Slovaks had a peaceful divorce. Slovenia left the
former Yugoslavia Republic peacefully, but then it got ugly. Quebec came close to
a peaceful secession from Canada.

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International Political Economy

The Greek competitiveness problem cannot be solved by loans or loan

guarantees from Berlin or Frankfurt or Brussels. And it won’t be solved by the
Athens equivalent of Chancellor of the Exchequer Churchill in 1926 who thought
a little deflation would have eliminated the serious overvaluation of the pound.

Market forces are now in play, there has been a “run” on the debt of the Greek
government. No one—well hardly anyone except government controlled
entities—will buy the debt of the Greek government. But the Greek government
has to finance a fiscal deficit of nearly fifteen percent; otherwise the public
service workers in Athens and Thessaloniki won’t get paid. For a while, the Greek
government may borrow from the Greek banks.

But wealthy Greeks are too smart to hold most of their liquid wealth in banks in
Greece. The next shoe to drop will be a “run” on the deposits in the banks in
Athens, including the foreign banks with offices in Athens. The owners of these
Euro deposits in Athens will move their money to German, French, and Italian
banks in Frankfurt, Paris, and Rome.

The technical issues associated with a devaluation by Athens are trivial. The
Government closes the banks for several days and instructs them to re-label all
deposits and loans and all other contracts as Euro drachmas. The banks are
reopened and a new currency market develops as individuals buy and sell the
Euro in terms of the Euro drachma. Many goods and assets then will have two
prices, one in terms of the Euro and the other in terms of the Euro drachma.
Initially there will be some turbulence in the currency market but prices will
stabilize after several weeks, and in eight or ten months the Euro drachma will
be pegged to the Euro and then the Euro drachma will be converted into the Euro.

Obviously the politicians in Brussels and Frankfurt, Berlin and Paris are petrified
about the contagion effect. The cost structure in several of the other
Mediterranean countries may be too high and they face the same painful
choices. The financial costs of financing payments deficits while hoping that
costs will decline is fanciful.

Consider the menu available to those in Athens, Brussels, and Frankfurt:

--monthly checks from the Berlin, Paris, et al that will enable the
Greek government to finance its fiscal deficits.
--a decline in costs and prices in Greece that will lead to a reduction
in the current account deficit and an increase in fiscal revenues.
--a devaluation of the Euro drachma.

In the end, all three will come to pass.

Robert Z. Aliber is Professor Emeritus of International Economics and Finance at the

Booth School of Business at The University of Chicago. He is the author of New
International Money Game (March 2010). He can be reached at RZA5638@cs.com.

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