Friday, May 18, 2012

Greece - exit, stage left?

Will Greece exit the eurozone?  There is an increasing probability that it may occur, depending on the results of the upcoming election in June.  Rather than consider whether they will leave the eurozone, let's consider what it may look like if they do leave.  In some ways, there's no parallel to a country leaving a major currency union such as the eurozone.  However, some lessons can be drawn from the Argentine default of 2001 and the experiences of several countries during the Asian financial crisis of 1997-98.  What do these 3 sets of countries have in common (Greece, Argentina, developing economies of Asia)?  All had fixed exchange rates which were unsustainable.  Though there are clearly differences in terms of the economic and financial situations, Argentina and the Asian economies were forced to abandon fixed exchange rates, resulting in extreme depreciations of their currency.  The short-term effects were devastating, resulting in severe recessions and high inflation.  The second round effects depended in part on the policy response, perceptions of global investors, and the strength of the global economy.  Argentina defaulted on its debt and was locked out of the global financial market for years (until it negotiated a deal with many of its debtors).  Even today, Argentina pays a high risk premium (high interest rates on its bonds), partly due to its default and partly due to its economic policies.  On a more positive note, the significant depreciation of their currencies (Argentina and Asian economies) helped to restore competitiveness, planting the seeds for an economic recovery.  The strong global economy of the late 1990s helped many of the emerging economies of Asia rebound.  Similarly, the global economic boom helped Argentina recover in the mid-2000s.

What does this mean for Greece?  Besides being heavily indebted, the Greek economy is not globally competitive for a variety of reasons.  To become competitive, unit costs must be reduced significantly and/or its currency must be devalued.  Since it's part of the eurozone, its currency can't decline as much as is necessary.  Thus, unit costs must be slashed either through increased productivity or reduced labor costs.  Since productivity increases take time (and changes in policy), the focus is on reducing labor costs.  When this is combined with the austerity required as part of the bailout packages, it is easy to see why Greece is experiencing a depression (unemplyment over 20%, negative economic growth for the last 4 years, etc.).  If Greece left the Eurozone, there would be considerable pain, but unit costs would not need to be reduced as much (competitiveness would be enhanced in part by a cheaper currency instead of lower costs).

So if replacing the euro with the drachma takes the pressure off of reducing unit costs (less need to eliminate jobs and/or cut wages), why not just do it?  A bank run is already taking place in Greece as depositors fear that the value of their bank accounts may drop significantly if they are redenominated into drachmas instead of euros.  As money leaves Greece and moves to other countries, there's less funds available to finance investment in Greece, reducing both short-term and long-term economic growth.  In addition, exchange rate risk will rise (the drachma will be less stable than the euro), leading global investors to require higher interest rates to invest in Greek debt.  Of course the default itself will also increase the risk premium of Greek debt.  In addition, Argentina and the developing economies of Asia both benefitted from a strong global economy to boost exports.  Few economists expect the global economy to grow rapidly any time soon.  In particular, Greece's largest trading partners (countries in the EU) are expected to struggle for years to come.

Even though this is a long post, it still only scratches the surface of what a Greek exit from the eurozone would entail.  Regardless of whether Greece remains in the eurozone or not, it will need to undertake significant economic reforms to become more competitive and achieve a sustainable recovery.  In future posts, we'll examine the debate between austerity vs. growth as well as other issues related to the European debt crisis.