Government and Institutions

Greece – the conundrum of currency and institutions (Part 3)

…continued from Part 2.


Would a Return to a National Currency without Institutions Work?

Some economists like Stiglitz claim that Greece should give up on the eurozone and exit the common currency. But even if Greece did abandon the euro and was able to reintroduce a heavily devalued version of the drachma to regain competitiveness, the country would still not have solid institutions to allow for a level playing economic field that would lead to long-term economic growth. It would still have a huge shadow economy and free riding, only they could become even larger.

Most importantly, the economic actors would still have little incentive to invest in the long-term, and little trust in the rules of the economy and the state. The new currency and its subsequent devaluations would be adding more uncertainty. The immediate upheaval that would follow the exit would make this distrust for the state even worse requiring even longer time to heal.

There are growing voices around the world both in politics and business that call for action on what one can control rather than consuming time and energy to tackle external events that countries and businesses cannot influence directly. Greece will need to put its house in order and create a modern state and solid institutions in order for the country to get back to a prosperous trajectory and the currency is not the single biggest dependency for it.

The Path to Building Stable and Solid Institutions

Nobel laureate Douglass North claimed that “only when it is in the interest of those with sufficient bargaining power to alter the formal rules will there be major change in the institutional framework”.

The analysis so far has shown that special interest minorities, put together, are deciding elections and the political direction in Greece. This hinders the modernization of the state and is exactly what needs to change for Greece to come out of this crisis.

However, rebuilding and modernising institutions is a lengthy process that by definition will challenge the status quo and hurt the interests of specific groups. Therefore, the process needs to start first with a strong message of inclusive change. This message will have to be about providing short-term incentives to the broader electorate along with a promise of modernisation through institutions that will benefit everyone in the mid- to long-term. The right short-term incentives will mobilise voters outside special interest groups to go back to the ballot box and reduce abstention that allowed organised minorities decide the election outcomes. For Greece to change it needs to give incentives to majorities and get them to vote for it.

To incentivise and mobilise the majority, policies need to be designed and communicated that increase the private and social rates of return[1]. Judging from international experience and history the most effective way to increase private and social returns in the short term is a well-designed tax incentives framework (tax cuts, investment tax breaks etc). Such framework would directly reduce the cost of doing business and increase the disposable income of households that will kick-start in the economy. Lower taxation will also increase incentives to invest and hire new people out of unemployment which will directly add to government revenues and the GDP.

A coherent tax incentives strategy will help create a sense of recovery and gradually restore trust in the prospects of the economy. This will give space to the government to start the long term process of rebuilding and modernising institutions and make the people receptive to them.

But how do you reduce taxes and increase rates of return in an economy that is in recession and under strict supervision by its lenders to produce consistent budget surpluses? The answer to this question will be attempted to be addressed in a subsequent essay.


[1] The private rate of return is the sum of net receipts which the economic unit receives from undertaking an activity. The social rate of return is the total net benefit (positive or negative) that society gains from the same activity – it is the private rate of return plus the net effect of the activity upon everyone else in the society.

2 thoughts on “Greece – the conundrum of currency and institutions (Part 3)”

  1. Posted 30/01/2017 at 10:33 | Permalink

    You view the question of Greece’s membership of the euro largely in terms of the country’s need for institutional and moral reform: “Greece will need to put its house in order and create a modern state and solid institutions in order for the country to get back to a prosperous trajectory and the currency is not the single biggest dependency for it.”

    In my opinion, you are mistaken to do so.

    The question of Greece’s euro membership needs to be considered in its own terms. So too does the question of institutional reform in Greece. To conflate the two issues makes little sense. Indeed it begs the question why did Greece’s institutional shortcomings – obvious for decades – only become so pressing after it joined the euro? Answer: because it should never have joined the euro. Euro membership for Greece was wrong on its own, economic, terms and gravely aggravated the country’s institutional shortcomings.

    As far back as 1972, British Treasury official Derek Mitchell wrote a private note for his political masters on the implications of monetary union. Mitchell warned that “Full EMU would deprive member countries of many of the policy instruments needed to influence their economic performances and (particularly in the case of the exchange rate) to rectify imbalances between them. . . . In an EMU, equilibrium could only then be restored by inflation in the ‘high performance’ countries and stagnation in the ‘low performance’ countries, unless central provision is made for the imbalances to be offset by massive and speedy resource transfers.”

    The scenario that Mitchell depicted – of inflation in high performance countries and stagnation in low performance countries – is exactly what we face today. German residential property prices are soaring and unemployment there is at a 20-year low but Greece must endure economic depression.

    Greece needs to reform its institutions whether it remains in the euro or not. But it also needs to leave the euro, whether it reforms its institutions or not. The two questions are substantially separate and distinct.

  2. Posted 06/02/2017 at 17:02 | Permalink

    Thanks for your comprehensive reply – I appreciate your feedback and views.
    Indeed there is an argument for Greece to go out of the Euro and try to restore competitiveness through currency devaluation. A few arguments to consider based on latest experience would be:
    • Globalization has scattered supply chains all over the world much more than in the past. Therefore, in many cases to build different products producers need to import a number of materials/components from abroad. Currency devaluation makes those imports more expensive thus reducing the potential net positive impact of currency fall on margins and prices. Case in point, this morning (06/02) the British Chamber of Commerce published a survey which shows that the fall of the pound led to profitability margin compression for nearly as many businesses as those that experienced margin expansion. You could argue that if you devalue the local currency as much as e.g. 2/3s, margins and prices would have room for a healthy competitive adjustment, however the dynamics that would kick-in in that case, eg inflation, foreign debt servicing etc can be much more destructive in the mid-term than the competitiveness benefit (especially in countries with problematic institutions like Greece).
    • The point that Greece should have not joined the Euro in the first place is indeed a hard one to argue against. Bloomberg just a few days ago compiled an analysis with data from the European Union statistics office for the past 18 years (1998-2016). One of the key findings was that Italy’s GDP per capita over that period has shrank 0.4% in real terms. So Italy’s economy during the life of the Euro has broadly shrank – even Greece did better than that. Is it that Italy should not have joined the Euro in the first place too or maybe consider going out now? Similar arguments can be made for example on Spain’s structural unemployment, France’s GDP growth stagnation and so on. On the other hand, European countries have been growing and benefiting consistently from the single market up until the Euro area crisis.

    I am not familiar with Derek Mitchell’s perspective on the quote you mentioned. If he meant to predict that the current monetary union will eventually end up with “inflation in the ‘high performance’ countries and stagnation in the ‘low performance’ countries” by and large he got it right (although just Germany has shown signs of inflation trending towards the 2% ECB target only lately). But could you reach an equilibrium through this in practice? I think recent experience has shown that weaker debtor countries have plummeted in deep recessions instead of remaining stagnant which has led many people to question the European project overall.

    A monetary union without a fiscal and banking union has many flaws by construct. So, if the European model needs to be tweaked to work by definition, the question becomes not which of the countries should have not entered or which should consider to leave, but rather how we can create the conditions for the current Union to work for all countries and its people.

    Considering the above, I focused on the pre-requisites for Greece to get back to sustainable growth while remaining within the European Union. If you have in mind a comprehensive blueprint of the steps a European country can follow to successfully issue its own currency and at the same time dis-integrate from Europe and its institutions, I would be very interesting to explore it.

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