What if Greece Reintroduces the Drachma?
In preparation of today’s EU summit that will try to solve the Greek debt crisis, the BBC had an interesting blog yesterday about the implications for one of the structural flaws of having a single currency for multiple countries—a government can no longer print its own money. Even in Europe, this has been a time honored solution to economic problems. After all, the most famous hyperinflation spiral ever was Weimar Germany in the early 1920s, where printing money got out of hand. Greece and Italy have also used this approach before and it is no coincidence that the Greek drachma and Italian lira’s final exchange rates with the euro were 340 and 1,936 respectfully, while Germany’s was 1.96.
As the BBC explained, Greek’s are depositing less money in Greek banks, which are then being forced to go to the European Central Bank for funds. The result is that the ECB now owns a lot of Greek debt and if this debt were to lose value, “ECB losses will ultimately have to be borne by its shareholders – the European governments.” Due to this exposure (both direct and indirect) that other European voters have to Greek debt, let’s assume that the Eurozone reaches the point where other European governments decide not to continue buying Greek debt, either through bailouts or the ECB. What would happen next?
First and foremost, Greece would default. As the old adage about economists goes, let’s make another assumption—that it is somewhat orderly. Suppose that Greece and the EU are able to convince bond holders to take a “haircut” of 30 percent (i.e. the value of Greek government bonds now worth 30 percent less). While this decision will have ramifications for Europe and the world as well, the Greek private sector will still take a hit. According to The Economist, Greek banks own about €70 billion ($100 billion) in Greek government debt themselves. These banks would also feel the pinch of a default, as this debt is now 30 percent less valuable, meaning that their own capital has also decreased 30 percent. As a result, in order to prevent the Greek banking sector from melting down, someone (most likely the ECB) would have to recapitalize Greek banks by providing them with funds to cover this write-down. Otherwise, Greek banks will be a lot less able to continue lending to other firms.
Now for the next assumption—Greece is forced to reintroduce the drachma. I would term this event the “nuclear” option, as it would have dramatic consequences for any Greek that has any economic activity outside of Greece. A new drachma could not be as valuable as the euro, or it would defeat the whole purpose of creating a new currency. Assume that originally €1 = 1 drachma (which will be symbolized by “D”), but the drachma quickly falls to €1 = 2D. Now assume that a Greek citizen bought a house using a loan denominated in euros from a foreign bank. Before the drachma, this Greek paid €500 a month for the loan. With the introduction and then depreciation of the drachma, the Greek still pays €500 a month, but it now costs this poor Greek 1,000D a month (€500 x 2D/€1). This price increase will be even worse if salaries do not catch up with the depreciation. For this example, the Greek made €2,000 a month pre crisis, but now makes 2,000D (€1,000) a month. Obviously, this would be a disaster for the average Greek, even if the drachma does not fall as much as this example.
So why would Greece go down this road? Currency depreciation is an easy way to make an economy more competitive, as Greek firms could now sell their products outside of Greek for less (for an explanation, check out “The Euro Financial Crisis’ Affect on International Trade”). Unfortunately for Greece, it is a relatively closed economy, as imports and exports account for 21 percent of GDP. However, a drachma devaluation would also help tourism, which is worth about 15 percent of GDP. Just imagine that a hotel room cost €100 a night, but now costs 100D a night (or €50 at the €1 = 2D exchange rate) after the devaluation. NPR reported yesterday morning that tourism to Greece is actually up, but many challenges remain in order for the tourism sector to drag Greece back to economic growth.
As a result, some sectors might actually benefit from the reintroduction of the drachma, but many more Greeks would be hurt by the resulting depreciation. One only has to look at the Argentinean debt restructuring in 2001 to see what happens when a country goes down this road.
Interested in learning how the euro has reached this point and what it means for the Midwest? The EU Center at Indiana University now has a webinar on “The European Debt Crisis & Its Implications for the US,” which can be viewed for free at http://www.indiana.edu/~eucenter/media.shtml.