Grexit: Drachma and Devaluation spells Disaster, not Deliverance

Mr Bootle, an economist from Capital Economics writes in a tongue-in-cheek letter to Greek Prime Minister Mr Tsipras published in the Daily Telegraph today. His advice: Exit the Euro and issue a new currency, which will then devalue against the Euro.

As all Grexit advocates, he conveniently forgets two things:

Greece’s debt of 320 bn is in Euro, and the Greek banking system heavily reliant on the ECB. The ECB offer 120 bn of liquidity support for the Greek banks, making a total debt of 440 bn. All denominated in Euro. Greece is barely able to pay for its debts now. A (hypothetical) 20% devaluation increases debt Euro denominated debt by 25%. As the income stream is now 20% lower, it will need even more of its income to service the debt. Greece will definitely be insolvent.

So Before Devaluation : Greek liabilities 440 bn, Greek GDP 180 bn
After 20% Devaluation:   Greek liabilities 440 bn, Greek GDP 144 bn (in Euro)

This insolvency of Euro 440bn would be the largest ever recorded in the world. By a fair way, as Lehman Brothers was only about a quarter of the size. Bootle, by completely ignoring the issue of insolvency, in effect advocates a financial Armageddon on the scale of 2008 or bigger.

So Grexit and a new currency will not happen, as also the ECB, the IMF, and possibly even the German Finance Ministry can see that it does not add up. And the threat of it towards Greece all empty bluster.

However, it is still worthwhile to go through the 10 points he raises to see who would in fact benefit from a devaluation, and who would be the losers.

1. You should not be reluctant to leave the euro. Even if you somehow manage to cobble together a deal with the creditors, this would not solve your country’s crisis. They are obsessed with the financial problem, i.e. with getting their money back. But your fellow Greeks’ plight derives from your economy’s catastrophic loss of output. Even if Greece is granted a significant amount of debt forgiveness, this would do next to nothing to bring an economic recovery.

Bootle is right that the shrinking of the Greek economy is at the heart of the Greek problem. But he is wrong that a significant debt forgiveness, say, 120 bn, would not work for Greece. A 120 bn forgiveness, effectively cutting debts to European Institutions by half, would strengthen bring its debt/GDP ratio from 180% to 110%. All of a sudden Greece would have similar debt levels as Italy or Belgium. And it will lead to a more prosperous Greece.

2.  Don’t fall for the parallel currency idea. It may be tempting to believe that there is some middle way that will allow you to stay in the euro while also enjoying the benefits of devaluation, whether by the Greek government issuing IOUs or allowing the banks to issue certificates of deposit which then circulate as currency. These may be temporary palliatives but they do not square the circle. There isn’t a third way. Greece needs to devalue and that requires a national currency.

Bootle advocates that there is no third way but does not say why it would not work. Why would an additional currency have t devalue against the Euro? It could even strengthen.

3. You must constantly keep in mind how devaluation works. It does so by shifting relative prices. This shift drives a change in people’s behaviour. A lower exchange rate would persuade Greek citizens to spend less on imports and more on things produced in Greece. Moreover, it would persuade foreigners to spend more on Greek things, including visiting your many wonderful tourist attractions. Increased spending by both Greeks and foreigners would call forth increased output.

Not much to say about that, that is the text-book explanation why devaluations work.

4. The rub, though, is that the adverse price change comes at once, while the favourable changes in quantities take time to develop. This means that the devaluation will initially inflict some pain as import prices rise without any obvious immediate offset. Yet, before long, ordinary citizens will benefit from the devaluation. So hold your nerve.

Immediately imports will become more expensive, raising inflation. The real income of the population will suffer straight way. It will be cut. That is a huge draw-back for a population which has already suffered from a devastating fall in incomes over the last 5 years.
Also the wealth of all Greeks will suffer, as expressed in Euro terms. All their Euro deposits in Greek banks would be converted into the new currency and equally devalued. What Bootle is proposing is a de facto expropriation of Greek wealth, in Euro terms, by the Greek government which would go down the devaluation route. No wonder the Greeks like to stay with a 70% majority in the Euro.

Who would benefit, it is of course the rich, who had the means and money to open bank accounts outside Greece, and who now could bring these funds back to Greece. They would get more for their money in Greeks goods and services, so effectively rewarding them for their capital flight. That, of course, brings with it some more moral hazard. If the rich Greeks could increase the real value of their wealth, why should the rich Spanish not try the same and also put all their money into foreign bank accounts?

On a macro-economic level, as imports immediately become more expensive, and export receipts fall in money terms, Greece would all of a sudden have a balance of payment deficit again. It immediately would have to borrow abroad, in foreign currency, to close this gap. That would be difficult after a huge insolvency, which a new currency would entail. Even the IMF might not want to lend any more.
Or Greece introduces import/export controls to ensure that it has sufficient exports to pay for its imports and a balanced current account. That would undoubtedly lead to shortages.

5. Nevertheless, you must not try to shield everyone from the initial ill-effects of the devaluation. That could nullify the benefits and land you back at square one. You will be able to bring relief to some hard-pressed citizens later. The dynamics are very important to the re-establishment of confidence.

So, what Bootle is saying here, do not subsidise petrol or other goods which are imported, if it becomes more expensive, the Greeks will have to bear it. A further reduction in real income for Greece after 5 years of hard-ship. Not sound advice for a government elected to reduce hardship.

6. Don’t be worried by the lack of new Drachma notes and coins. Of course, as soon as you know that you are leaving the euro, you should order these to be printed and minted immediately. But they will not be ready for months. Once you have made the declaration of euro exit, however, bank deposits will be re-denominated in Drachma. Most transactions can take place by transferring these deposits by cheque, debit card or credit card. Meanwhile, you should encourage small transactions to take place using whatever people find most effective, including euro notes and coins, IOUs, bank certificates, cigarettes or whatever.

This is just pure comedy. He says that Euro notes and cigarettes shold circulate in the economy as money. So presumably a loaf of bread will cost 1 Euro, or 1.25 New Drachma, or 5 cigarettes, with all shops displaying all three prices at once?

I think the last time such as system operated relatively successfully like that was in post-war Germany, prior to the introduction of the German mark. I say relatively successfully, because the shops were empty, food was rationed, and there was a thriving black market. No reason to think it would be different this time.

To introduce a currency without being able to give out notes and coins, which will have a value, is just madness.

7. You will need to impose capital controls but these need not last long. Once you have your own currency again, your central bank will be able to support your banks without going cap in hand to those austere chaps in Frankfurt. The Bank of Greece will even be able to buy government debt and hence engage in Quantitative Easing. Don’t think, though, that this is a magic wand. You will still need to act carefully and responsibly. Inflation will rise a bit following the Greek exit. It is important, however, that you don’t allow it to rise uncontrollably.

What is needed first is exchange controls, specifically. If the currency were to float freely, it would  immediately be subject to speculation by the foreign exchange markets. In which case a 20% devaluation could not be guaranteed.

So if the Greek government decided that a 20% devaluation was best for its economy, it would be important to make sure that the currency could only be bought and sold at the Greek Central Bank, the Bank of Greece, at the rate of Drachme 1.25 for each Euro. It would not be freely floating.

To ensure that not too much of the new currency would be exchanged to Euro, and leave the country, fearing further devaluation, capital controls will be introduced, allowing each Greek perhaps to change 300 Euro a day to change into Euro, and not more.

It follows some generic unspecified advice on how Greece should continue to follow the advice of its creditors, run a balanced budget, even with the new currency and not cuddle up to Russia, but stay with its friends UK and US. I will spare you the details. Then the last point.

10. Leaving the euro is not a disaster. If you follow my advice then, before too long, you will be able to tell the Bank of Greece to stop the Drachma from appreciating on the exchanges. What’s more, the investment bankers will be knocking on your door trying to lend you money. (Admittedly, if you don’t follow this advice, you and your countrymen could land up in an even worse mess!) You should think of Grexit as giving you the opportunity to make things better. D-Day approaches: D for Default, Devaluation and the Drachma. As you know, in our recent European history, D also stands for Deliverance. It can do so again for you. Within a year or two the gains may be so extensive that you (and they) will wonder why you didn’t make the move earlier.
Yours sincerely, Roger Bootle

The Drachma appreciating in exchanges? Again, there should not be any exchanges where the Drachma should be traded. It should only traded at the Bank of Greece. That would not be a bad strategy to follow, as those exchange controls helped China to become one of the power-houses of the global economy.

There could initially be import/export controls to ensure a balanced current account, as no foreign currency loans can be secured for a country which just has defaulted. Further, there would need to be foreign exchange capital controls to avoid money being sent abroad again, which would also have an effect on the current account.

“Admittedly, if you don’t follow this advice, you and your countrymen could land up in an even worse mess!”- Bootle thinks continuing to go along the route of Troika advised austerity is disastrous, he is right there. Yet Bootle advocates devaluation, which he himself says will make things worse before they get better. So not really sound advice for a country which has been struggling to get out of recession for the last five years. More pain for gain in two years’ time. The Greeks have heard that from the IMF for 5 years, and each time it turned out to be a lie.

What will the Greek government get out of the devaluation? Bootle says that ” investment bankers will be knocking on your door trying to lend you money”. Bootle is advocating investment bankers as the route to riches, (rather than the highway to hell, presumably), with more loans. Does Greece need more money? Not really, they have a virtually balanced budget in Greece. They have however 26% unemployment. And Bootle says things get worse before they get better.

As import led companies in Greece shed jobs faster (the BMW dealerships will now definitely close) and export industries will only grow slowly to offer more jobs. Try to sell that to the Greek people,Mr. Bootle, who have had one of the longest and deepest recessions ever in the world.

Finally, a general point. Devaluations are advised by the IMF and other experts usually when countries suffer a balance of payment problem. A devaluation induced export recovery might be a good idea in those cases, as more exports and less imports will eventually close the balance of payment gap. But Greece is not at that point, it has a balanced current account. So there is no reason to follow that advice.

And, of course, there is the minor inconvenience of a Euro 440 bn insolvency that is blanked out here, but which would follow a devaluation. Devaluation and Disaster, a D which he forgot to mention, go hand in hand.

So is Bootle completely wrong here?

Well, the Grexit idea and new currency is a non starter. But in one thing he is right, Greece, as Bootle pointed out in the beginning, has a demand problem. Although Bootle advocates an export led recovery through devaluation, it is really domestic demand which has suffered. Greece already had record tourist numbers last year, its main export earnings, why pile on more exports?

So that is the other Ds in his long list of alliterations which he does not mention. Domestic Demand. Surely, there must be other ways to boost internal demand in Greece other than through a devaluation which leads to a catastrophic insolvency. I will write about that in another post.


2 thoughts on “Grexit: Drachma and Devaluation spells Disaster, not Deliverance

  1. Grexit does three things:

    1. It lets Greece devalue and be more price competitive on exports. Greece doesn’t have industrial exports that would benefit from this. It has tourism, food, and ores, which are not supply-side elastic so this point is moot. Greece would earn about as many Euros as it does now after devaluation, probably less.

    2. It makes domestic goods significantly cheaper compared to imports, forcing consumers to shift their consumption basket from imports to domestic. The introduction of the Euro in 2001 had the opposite effect. Leaving the Euro makes Greeks import-poor but domestic-rich. It also makes earning Euros a privilege compared to earning drachma.

    This is a big deal because it fixes Greece’s trade deficit problem. Given that Greeks prefer imports, it’s welfare destroying. But given widespread poverty, making tomatoes more affordable and iPhones less so may be welfare enhancing, for now. Letting Euro earnings diverge from drachma earnings is brutal, but also gives the right incentives.

    3. It allows the state to inject money into a liquidity starved economy and guarantee economic security: Pensions will be paid, even if by printing money. Given huge unemployment, idle resources, massive amounts of black debt (unpaid invoices) and a deflationary expectation, adding money of any kind will lead to a massive increase in domestic output and welfare. Money is so tight that there’s a long way to go before crossing over into inflation.

    External observers annoyingly treat Greece as if it were an industrial economy with inefficiently overpaid or rigid labour. Greece has no industry and an unusually small fraction of the economy is in corporations of any kind. Greece is a nation of professionals and small owner-managed businesses trading overwhelmingly with each other. They are in fact very competitive. But they can only make a Euro from another Greek. These people outnumber exporters, so Euros tend to leave the country.

    The solution to Greece’s problems is to shift its economy from the non-tradable (but import consuming) sector to the tradable export sector. A devalued drachma is the quick, protectionist medicine. It stems the inflow of imports and outflow of Euros, trying as best it can to substitute alternative domestic goods.

    The longer-term fix is to remove the price distortion of the Euro, where the Euro wages of the domestic and export sector are comparable. Letting the export sector pay much better (assuming what you want eventually is to consume imports) would give Greek people strong incentives to become hoteliers instead of lawyers, tech exporters instead of teachers.

    Greece will then find the balance it wants between protectionism and international competitiveness. It may not be at parity, in other words Greece may organically choose to forego some imports in order to maintain island postmen and ancient Greek teachers. In fact the revealed preference is almost certainly not at parity. If it was, the Euro would have worked.


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