Sunday, June 17, 2012
How Greece Exits
Today's elections in Greece could very well force the nation's exit from the Eurozone. Yet amid the worry, there has been strikingly little discussion of how, exactly, drachmaization would be achieved. This post thinks out loud the actual means which I see as necessary. (Let's save for another post the policies which the rest of the Eurozone countries will need to make it through.)
Drachmaization is a logistical nightmare, raising a variety of pressing economic, political, and technical questions:
First and foremost, how so you convert a nation of 11.3 million people and an economy of 55.5 billion euro to a different currency?
How do you do this given national unrest? Without causing bank runs? Given the obvious necessity of huge devaluation? In the context of hyperinflation?
How do you balance the objectives of public finance and economic stabilization?
Here are my tentative answers to these questions. Please leave a comment, or write your own blog post, if you see better alternatives.
When Greece joined the Eurozone, the entry process involved a conversion period in which savings deposits were available in both euros and drachma, when cash was distributed to businesses and banks, when drachma could be returned to banks in exchange for euros but not the other way, until full euroization was achieved. But Greece will not have the luxury of time needed for such a gradual, orderly process.
The Greek government should first establish capital controls to prevent a massive capital outflow, which would destroy its banking system. The Wall Street Journal suspects border controls may also be necessary. The harder part, though, is replacing the entire physical currency stock within the country immediately after the Greek government declares the establishment of a new drachma.
The government would need to print and distribute the new drachmas to banks as quickly as possible. During a hasty transitional period, the government could temporarily allow the legal use of euro by establishing an official exchange rate and forcibly converting all foreign and domestic deposit accounts into new drachma. The problem with this is that a period of two currencies cause hoarding of the euro, per Gresham's Law, as the "bad money" drives out the "good."
To prevent bank runs, some sort of "bank holiday" program will be likely necessary, minimizing the euro withdrawals to what is absolutely necessary for economic activity. Furthermore, the government should let banks restrict payments voluntarily beyond what the government requires. As the new drachma becomes available, government could reduce the legal availability of euro currency until all withdrawals had to be made in new drachma. The government should also pledge publicly to all depositors that their savings are safe even if the bank temporarily runs out of physical currency. The temporary lack of reserves should not spell bank failure.
To get the new drachma and circulation and to phase out the euro, the government could offer a favorable initial exchange rate for depositing cash as an incentive -- say, by establishing an initial one-to-one official convertibility rate, pledging to maintain that for a month, and then scheduling progressive official devaluations for which euro could be returned at banks for new drachma. The Bank of Greece would then exchange new drachma for euros with commercial banks at the official rate, using the euro to pay off some of the early-maturity debts partially in euro, partially in new drachma.
Devaluing the new drachma, after deposits have been converted over, is also certain -- The New York Times reports a consensus estimate of 50 to 70 percent. The objective is not temporary stimulus, but rather to reduce real wages and restore competitiveness, given that downward rigidity in nominal wages has obstructed the internal devaluation process of prices adjusting to clear markets.
Amid drachmaization, the relationship between the Greek government and its central bank will be precarious. Indeed, central bank independence will be severely compromised, if not eliminated. I could easily imagine a period of total subordination of the Bank of Greece to the fiscal needs of the Greek state -- the central bank would fully monetize the budget deficit and inflate away.
On the other hand is the competing objective of economic re-stabilization and regaining competitiveness. As I've discussed before on this blog, Greece faces a 22.6 percent nominal GDP gap, as well as a 21 percent unemployment rate. It is most certainly in the country's long-term interest to keep the Bank of Greece, to the greatest extent possible, independent. Perhaps some compromise can be arranged in which the Bank of Greece will purchase government debt and devalue the currency in foreign exchange markets until unemployment returns to some tolerable threshold and NGDP returns to its level path, at which point the Bank of Greece expects the economy to have improved sufficiently for tax revenues to be up and for the government to have cut spending, such that the fiscal position is sufficiently improved.
The Greek government may still need financial repression for quite some time to finance its debts. Once the new drachma is established and Greece returns to economic stability -- that is, if history is any indication, several years off -- the capital controls and financial repression program could be dismantled, the Bank of Greece could return to full independence, and Greece would be back to square one.