To Euro!

The article below, written by Yannis Ioannides and Chris Pissarides, is part of the ongoing discussion on this blog about the costs and benefits for Greece to continue being part of the Eurozone. The authors argue that Greece has a strong interest to stay in the Euro.

A shorter version of this article in Greek was published by Kathimerini, November 27, 2011.

The full article of Yannis Ioannides and Chris Pissarides

There have been calls recently for Greece’s (and probably some other countries’) exit from the euro. High profile among these is one by Nouriel Rοubini, and one from our friend Costas Azariadis. If Greece were outside the euro, the argument goes, it would have a powerful tool in its ineffective arsenal, the exchange rate. A massive devaluation of its currency would quickly restore competitiveness without having to go through painful wage cuts and the many other sacrifices that are required. We beg to disagree.

Our main disagreement is with the vision that such writings have of Europe’s single currency. The Eurozone is not a club that countries may enter or leave according to the economic parameters of the day. If that were the intention of the founding fathers, there would be no euro but a European Bretton-Woods type system of fixed exchange rates, with the old Deutschmark as its anchor.  European governments went into the trouble of creating a single currency with a new central bank, and not a system of fixed exchange rates, because they wanted to remove speculation about exchange rate adjustments once and for all. The Eurozone is part and parcel of the process of European integration. Although the extent of fiscal coordination necessary to make the common currency  function properly was underestimated, it remains a critical part  of the movement for closer European integration.

Britain remained outside the euro and it is likely to continue outside, but its prime minister understands well this role of the Eurozone. That is why he attached so much importance to the recent Brussels summit on the debt crisis and emphasized so strongly that it is necessary for the Eurozone to find a quick and lasting solution to its debt problems. He never suggested that perhaps countries would consider leaving it. It is also why, when agreement was reached with Sarkozy and Merkel as protagonists, the British Tory press was so concerned about Britain being “left behind” in a united Europe led by the core of the Eurozone. And it is not only the government that thinks so. Tony Blair, in an interview on the BBC on November 13, emphasized that it would be disastrous for Europe if any country left the euro.

Critics of the euro seem to forget that the euro was originally conceived as a pillar of closer economic union, and it is even more so today, more than ten years after its birth. If Greece were to exit the Eurozone the big question is not whether the new drachma will depreciate by 50 or 70 per cent, but whether Greece will ever succeed in becoming a modern European country with fully paid-up membership rights in a united Europe. We fear that a runaway Greece will command little respect by its European partners, will be cited as an example of a massive failure in Europe by Europe’s enemies, and will not be regarded as a port of entry into core Europe by prospective international investors, in the way that countries like Ireland and Cyprus are today. Is that what we want for Greece, for the benefit of some temporary relief from austerity measures that are painful but  long overdue?

We believe that even if the narrow economic argument for leaving the Eurozone were watertight, there would still be strong reasons not to leave the Eurozone. The long-term prosperity of the Greek economy depends on it. But the narrow economic argument is not watertight.

To be sure, Costas Azariadis has considered the costs of some of the drawbacks of not remaining in the euro. But he seems to be unduly confident that suspension of interest payments would confer net benefits on Greece. We think that such a policy move would be disastrous, both for Greece and for the world economy.

To start with, this would amount to default, with capital “D.” It will then become necessary to recapitalize European and other banks much more than now. How do we know that this will be cheaper than bailing out Greece? The exit option might even become more expensive than a current bailing out strategy. The shocks from default to the European, and indeed the world, economies are hard to assess at the present juncture, but they could be enormous. It is not at all clear that the Eurozone can withstand the shock, considering the rapidity with which capital markets and speculators can attack other vulnerable economies. In a nutshell, it could well be the end of the Eurozone, arguably for the wrong reasons.

Costas Azariadis claims that “Argentina has recovered from its default of 10 years ago, and prospered.” We think that this is an exaggeration but more importantly, conditions in Argentina were very different from the conditions faced by Greece today. First, Argentina went through turmoil for several years after default. Is Greece prepared to do it, without European help? Second, Argentina distanced itself from the IMF and relations are still very cold. It still has a poor reputation in international capital markets and cannot borrow easily. Third, Argentina exited a currency board with the United States, a country that was a trading partner but not one that was part of an economic union. The United States did not care very much whether Argentina had or did not have a currency board with its dollar; Europe cares about Greece and the Eurozone. Fourth, a key to Argentina’s re-emergence was that Argentina is a producer and exporter of natural resources. She was very lucky in that the price of these resources went up a lot soon after it defaulted, giving it a welcome bonus for which it made no sacrifices. Greece’s only natural resource is its sunshine, and it is doubtful that the price of it will rise much.

A return by Greece to the drachma is not a panacea. Azariadis suggests the new drachma may be introduced at 600 to the euro. But it would surely float, and no one can guess where its value would be in one, two or three months from now, let alone in three years. Greece will not have the resources to defend it, and the drachma’s new value would be determined by the combined effect of its value as an asset and as the price of Greek exports, both of which are affected by expectations about the future. The pre-euro experience is not a guide of where the new drachma would settle, and how much it would fluctuate before it settles somewhere. Uncertainty would kill international transactions for some time. It is hard to believe that the euro will not stay as the store of value and the unit of account for a long time, exactly as the dollar, and the golden sovereign, were before that especially for large transactions.

Under a pessimistic scenario of a greatly depreciated drachma, an offer by Greece to its creditors of 35 cents to the dollar (as Argentina did), would still leave the debt at about where things are now (in real terms). None of these thoughts is a substitute for a quantitative analysis, but our assessments worry us.

If Greece were to leave the euro, any local  pressure for reform would disappear at once. Moreover, subsequent labor and other unrest would intensify because people would feel poorer and this can create havoc in the tourism sector. Greece imports much of its food from the EU (but also lemons from Argentina and garlic from China), and all these would become more expensive. And even with a vastly favorable exchange rate, the fundamentals of why there is little productive investment in Greece would not change.  Worse yet, there may be no incentive for them to change.

Given how unpredictable Greek politics are, we might not have the luxury of being able to study in depth the full impact of Greece’s abandoning the euro. Greece may be forced to, or even choose to, exit the common currency at some point down the line. But, to us “no to euro” looks like a very risky option at the moment. There is no doubt, the euro is an expensive currency for Greece, and indeed for the entire Eurozone.  As a start, a looser policy by the European Central Bank that would cause some inflation in the Eurozone and some depreciation of the euro, would be a much better policy that would benefit all the beleaguered countries of the Union and not just Greece.


About C_Pissarides

London School of Economics
This entry was posted in Banking and finance, Europe, Macroeconomics, Public finance. Bookmark the permalink.

10 Responses to To Euro!

  1. Spyros Cavounidis says:

    It is commonplace to note that, to stay in the eurozone, Greece has to make tremendous efforts and the greek people tremendous sacrifices. But that would be either way-whether in the eurozone or not.
    Beyond economics,though, we have to look at the question as another-major- episode in the history of modern Greece, namely its placement (by choice or by default) in the West (Europe) or the Middle East. Somebody may call it the “dominant contradiction” The “solution” of this “contradiction” has economic but also political and most of all cultural implications.
    Suggesting the “return to the drachma” cannot be argued solely in terms of the economy-and even economically it is obviously very doubtful that the merits of the drachma outweigh those of the euro. The opposite seems much more probable. But arguing for the drachma implicitly means arguing for a middle eastern Greece. Hopefully the greek people do not aspire to that.

    • Yannis Ioannides says:

      Thank you for your comment, Spyro!
      Regarding your first argument, please note that not only the effort that the Greek people have to make but also the real value of the debt would also be roughly the same, if Greece were to default and renegotiate with its creditors at roughly similar terms to those of Argentina’s (which we invoke only for the sake of the argument).

      I see your point that “arguing for the drachma implicitly means arguing for a middle eastern Greece.” There is of course “deep” Middle East, but there also exist Middle Eastern examples worthy of emulation. Turkey and Israel offer some remarkable lessons of economic and technological progress.

      I too hope that “the Greek people do not aspire” to a Middle Eastern choice. But it also needs to be explained to the Greek people that deep institutional reforms are necessary in either case, in or out of the euro. Costas Azariadis, Christopher Pissarides and I have been arguing in favor of such reforms. Our writings may be found elsewhere on the blog.

      Thank you again for your comment,

      Yannis Ioannides

  2. Costas Azariadis says:

    On October 6, 2010 Chris, Yannis and me of posted an article on this blog predicting that the first round of austerity measures and structural reforms would not succeed without powerful pro-growth policies. We suggested 17 proposals to get the Greek economy going.
    After three rounds of reforms, 14 of our proposals have been ignored; 3 were partially adopted(#5,11 and 13); none has been implemented. The economic situation in Greece is much worse than one year ago: the cumulative fall in GDP since 2008 is 12.5% (we predicted the potential decline would go as high as 25%); the unemployment rate is above 18% , vs. 7.7% in 2008, and heading north; and the Athens Stockmarket index is at 665, vs 2,800 in October 2008, and heading south. The big cities show every imaginable sign of an economic and social implosion.
    Our words were prophetic. There has been no growth push. The evidence before us shows that austerity has failed miserably and that its failure has doomed all attempts at structural reform. With Greece inside the euro, interest payments exhaust bailout funds; progress in balancing the government budget is glacial and so are improvements in competitiveness. Most importantly, there is a lot of human suffering with no hope for the future, no visible light at the end of the tunnel.
    Is there a choice out of this predicament that does not involve a return to the drachma? Is there a quick way to stop the freefall in GDP, the spike in unemployment
    and the looming social earthquake? Is there a quick way to convince Greek voters that
    the deep economic and social reforms explained in our “17 Proposals” are a MUST if
    they do not want their consumption to regress thirty years?
    I think the answer to all these questions is no. The drachma will give Greece the time and opportunity-not a guarantee-to put its affairs in order, starting with a new constitution.
    Two more things to keep in mind. One, the country grew fast under the drachma in 1953-1980. And two, membership in the eurozone does not appear to have improved the quality of governance in Greece or Italy. Apparently, institutions are important and slow to change. Greece must find a way to change them fast, but prolonged belt tightening is not the right way to start.

  3. Hans van der Schaaf says:

    First of all: Greece as Greece was and is today should never had become member of the eurozone.
    But the Greek politicians did and still do not (want to) understand that.

    The question now is whether Greece is able AND WANTS to become an eurozone member in all its relevant aspects ? Specially concerning (Protestant; see Weber) attitudes, lifestyle and ethics ? And does it really want to implement all those
    aspects ? Questions you need to organize a referendum on I think.

    Greece made a stupid choice to become an eurozone member. The result is this crisis concerning its future. Economics are of course important for this future. But they are not the key issue. Nor is its currency. The key issue is what the Greek people do want now: How do they want to reboot ? Because they need to.

    And of course it will be Worse 1 or Worse 2 the coming next 10 years. But what Worse is the Greek people able to manage ? And how can they do that ? And what kind of future does it bring them ?

    When these questions are not addressed, questions concerning the kind of currency are questions of second order. And by that without relevant answers .

    • Panos Vlahopoulos says:

      The EURO is only a stage of a project called “European integration”. If you don’t like this project (and “you” stands for all the “Greece-should-have-never-been-accepted-in-theEurozone guys) say it loud and clear. If you think Europe should be a Protestant Union, again, say it loud and clear. Otherwise try to accept that Greeks know what’s best for them.

    • Yannis Ioannides says:

      Dear Mr. van der Schaaf:

      I agree with you that questions about institutions are more important than questions about the choice of the currency. But I would rather not stick to stereotypes that modern economic science has refuted, regarding in particular Protestantism or Weber etc.

      Greece has the political institutions and tools to bring about institutional reforms, among which some constitutional reforms are also needed. Again, the question of a referendum is too blunt a tool, in the absence of elaborate debates about what kinds of new institutions the Greek people wish to adopt.

      But, the Greek and broader eurozone debt crisis has also revealed the existence of serious design problems at the very core of the eurozone, that unilateral solution of the Greek crisis will not make go away.

      Thank you very much for your comment!

      Yannis Ioannides

  4. Thanasis Stengos says:

    I tend to agree with Yannis Ioaniddes and Chris Pissarides that Greece’s exit from teh euro zone would be creating a lot more problems that solving them. I think Costas Azariadis in his piece identified many of the problems associated with the exit, even though he went on to argue that these problems would be overcome by the positives Borrowing from Costas Azariadis last sentence:

    “The real danger of default is not that it causes friction between trading partners, domestic banks and depositors, or even international borrowers and lenders. Default is just a stopgap policy that gives borrowers time to put their affairs in order. That means spending less, working more, and planning ahead. If Greece really wants to prosper, default will buy perhaps two years in which the country must reform itself from top to bottom, from one end to another. The real risk is that the temporary relief from exiting the eurozone will be wasted in a vain effort to maintain the status quo. This is a risk that Greece must take.”

    It is however very doubtful from what recent Greek economic history has taught us that Greek politicians and Greek economic agentss will perceive this change as only a stop-gap period of adjusment. It is more likely that they will look at it as a premanent state of affairs where inflation, business as usual with an expanding state and ignoring the supply side of the economy entirely in favour of “progressive” demand side measures will prevail. I think despite the pain of being in the euro zone right now for Greeks the only way forward is to go through the pain and the prospect of having the EU overview the necessary painful steps leaves me more confident that finally there will be light at the end of the tunnel.

    It is for this exact reason that Ioannides and Pissarides are right in advocating that Greece remains in the Euro zone and transforms this crisis into an opportunity for reform.

  5. George says:

    ”If Greece were to leave the euro, any local pressure for reform would disappear at once.”

    Unless this is an axiom, i can’t really follow your argument.
    Do you really assume that the whole Greek society and the whole Greek political spectrum is fully satisfied with situation and does not want reforms??

    Argentina has recovered and i think Pr.Azariadis is right.

    I tend to agree that an exit from euro zone can have unpredicted consequences , but what about not leaving euro? Can somebody ensure Greeks that all the consequences are well predicted?
    And if so, why nobody could predict the whole mess 10 years ago? or even 5 years ago? or at least 3 years ago?

    What i am trying to say is that euro is not a dogma.
    I really believe that euro zone is not an ”optimum currency zone”(with the classical meaning) and Greece should not enter euro zone in the past, or at least not do so until Greek economy is integrated with the rest of European Union and have achieved all the necessary fiscal goals. But this did not happen and almost everyone thought that the ”European pressure” for reforms would be sufficient to normalize Greek economy and impose a fiscal discipline. Well, this did not happen again. WHY this should happen now? I think Greek society is at a trigger point(or should i say breaking point) and the continuation of wrong recipes(IMF and ECB failures added to Greek government’s ones) would cause unpredicted chaos

    • Yannis Ioannides says:

      Dear George:

      thank you for your comment!

      The ongoing crisis has revealed serious design flaws with the eurozone, which as our piece emphasizes is an important part of the European integration project. The design flaws require, as you say, working on the fiscal union, which inescapably is a political matter.

      Initiation of a productive debate within the European publics would go a long way toward bringing us closer to a resolution of the crisis.

      I agree with you that “Greek society is at a trigger point … or breaking point and the continuation of wrong recipes (IMF and ECB failures added to Greek government’s ones)” are causing serious problems. But the crisis is also an opportunity for deep structural reforms. As Costas Azariadis, Christopher Pissarides and I have argued — see our writings elsewhere on the blog —Greece will not be able to deal with the crisis by means of short run measures only. Deep reforms are needed.

      Yannis Ioannides

  6. Greece would be stupid not to hold on to the Euro. Just think what wiping out a large portion of the value of domestic financial assets (around 200 BN€ bank deposits; pensions funds; etc.) would mean to a population in the midst of austerity pains? Perhaps anarchy?

    Greece should hold on to the Euro but simulate a situation as though she had returned to the Drachma: special taxes on imports accompanied by new Free Trade Zones for new domestic production as import substitution; new Foreign Investment Law guaranteed by the EU to attract foreign investment into those FTZ; and capital controls to stop capital flight.

    Just as simple as that! A violation of EU-freedoms of free movement of goods/capital? Yes, but treaties are there to be amended in emergency situations, if only temporarily.

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