Is Greece trapped in the eurozone?

Political instability in Greece and a further worsening of the banking crisis in Spain recently sparked a new wave of the European debt crisis. The possibility of Greece leaving the eurozone is now openly discussed in political circles. Banks and enterprises have prepared emergency plans for the so-called ‘Grexit’. This article analyses the problem and implications arising from the adoption of a new Greek currency. Surprisingly, these could lead Greece back to the euro.

A Greek exit would mean exchanging the current euros for a new national currency, say the drachma. The new currency would immediately depreciate against the euro (this is wanted to adjust Greek price competitiveness). Due to the depreciation, the Greek government would be insolvent as the value of liabilities denominated in euros would explode, measured in drachma. Moreover, the depreciation would increase the prices of imported goods, such as crude oil and liquid gas. The Greek central bank might not have the credibility to curb inflation. Therefore, the drachma is highly likely to become a weak currency compared with the euro.

This implies that Greeks will convert their savings from a relatively strong currency into a weak drachma. Yet it is doubtful who would voluntarily accept the weak currency of an insolvent state and who would trust such issued fiat money. But both are preconditions for the success of a currency. Past currency reforms were, however, characterised by exchanging a weak for a supposedly stronger currency, often after periods of high inflation. The new currency was introduced to curb inflation and to stabilise the struggling economy. Whether such consequences will follow in the case of Greece is open to question.

A study from 2004 also provides evidence that break-ups of currency unions were often related to high inflation differentials between union members. Countries who left a currency union thus benefited more by introducing their own currency than staying in the union. Indeed, euro area inflation rates diverged, too, in the past decade. While Greek inflation between 1999 and 2008 averaged 3.3%, the German value was only 1.7%. Interestingly, growth differentials, as we experience in the euro area today, were no strong indicator for the break-up of a currency union.

Since a new currency threatens to impair the Greek people and enterprises then it is not surprising that there is already substantial capital flight out of Greece. For instance, the deposits of private non-banks (private depositors and enterprises) with Greek banks have declined by 25% from the peak in 2010. These total about 75 billion euros or 1/3 of Greek GDP. Additionally, the inter-banking market has dried out for Greek banks, which are forced to rely on the refinancing operations of the ECB.

This is reflected by the high TARGET2 liabilities of about 100 billion euros of the Greek central bank vis-á-vis other European central banks, in particular the German Bundesbank. The capital fight is basically financed by public capital. Data show that private capital is flowing out of Greece, while public capital is flowing in. That also explains the persistence of the Greek current account deficit, which implies a net capital inflow into Greece. The capital flight will certainly accelerate the more probable a euro exit becomes. Bank runs would be a consequence. On the day of the currency reform, many Greeks would have the bulk of their deposits with a bank outside Greece or bundles of euro banknotes at home.

Could a new Drachma be successful? Not if Greeks prefer to use their euros instead of weak drachmas. This might be particularly true for deposits and invoicing with major trading partners in Europe. One scenario could be that the euro remains as unofficial parallel currency in addition to the drachma. It would be almost impossible to prevent such a currency substitution without deploying the kind of draconian measures used in the Argentinian crisis. These could violate EU regulations and would promote a black-market economy. Thus Greece might be de facto ‘euroised’ (similar to Latin American countries that were dollarised). Greece would have its own currency, but it would be dominated by the euro.

In the case of a de facto ‘euroisation’, an autonomous Greek monetary policy would become ineffective and would need to follow the ECB to prevent large exchange rate volatility with the euro. Fiscal policy would also negatively be affected. Moreover, Greek society would split into one part that has access to euros and the poor. To overcome those and other disadvantages of a de facto euroisation, Greece could give up the drachma and vote for a de jure euroisation – the unilateral acceptance of euros as only currency, as practised, for example, in Montenegro. Following this further currency reform, Greece would have returned to the euro, but without voting rights in the ECB council, without seigniorage profits and without direct refinancing access of Greek banks with the ECB and other benefits.

In summary, even if there are economic benefits from Greece leaving the euro, a new national fiat money currency might be doomed to failure. That is because economic forces cannot be ignored even for the euro exit. A new drachma might lack acceptance and credibility. This could lead Greece back into the euro but under less beneficial conditions. And the need for reforms will not vanish. In this context it may be argued that Greece is effectively trapped within the eurozone – as all crisis countries are.

This article reflects the author’s personal opinions and not those of his employer.