Should Greece Abandon the Euro?

Sources:
CNN:Is Greece Going to Default and Leave the Euro?
Economist: When Will the Greeks be Made to Suffer?
FT: Greece Should Default and Abandon the Euro

Despite the vast amount of bailout funds it has received and the extensive austerity measures the country has adopted, there is no end in sight for Greece’s economic crisis. As of October 2011, Greece has received €110 billion in bailout loans from the International Monetary Fund (IMF) and the European Union (EU) to help it get through the crisis and prevent any negative effects from spreading to other European countries. On October 2, 2011, the Greek government announced that its 2011 budget deficit is expected to be 8.5% of gross domestic product (GDP), which is significantly larger than the target of 7.6% the EU and IMF set as a condition for receiving bailout funds. Likewise, IMF estimates show that the Greek economy will contract by 2.5% of GDP in 2012, instead of the hoped for growth of 0.6%.

According to world-renowned economist Nouriel Roubini, Greece has three options. The first option is for the euro to significantly weaken against the dollar. A weaker euro would make Greek goods cheaper, which should increase the demand for Greek goods from countries outside the Eurozone, and thereby increase export revenues that Greece could use to pay its debts. This is not a viable option since for the euro to depreciate there must be, among other things, a sharp appreciation of the dollar, which is unlikely as long as the U.S. economy remains weak.

The second option is for Greece to go through a process of “internal devaluation” to lower prices and wages. During an “internal devaluation” the government would increase the value-added tax (VAT, a European form of sales tax) and reduce public sector wages to put downward pressure on other wages and inflation. A VAT increase will significantly lower demand for goods by raising prices. Lower demand often leads to lower wages as employers cannot afford to keep paying employees the same wages with falling profits. Lower labor costs will effectively make Greece’s products more competitive in the world market.

Greece would need to do an “internal devaluation” because, as a member of the European Monetary Union, Greece does not have the power to use normal monetary policy tools (i.e., it cannot buy and sell its currency on the market or change interest rates to adjust its value through supply and demand principles) to lower the value of its currency. However, lowering the cost of goods by lowering internal demand would have the same effect—i.e., it would increase exports by making it cheaper for foreigners to buy the now cheaper domestic goods. Greece would then use the increased export revenue to pay its debts. However, the “internal devaluation” process is not Greece’s best option as it would likely push Greece into a deep recession with very high unemployment and lower wages.

Greece’s fastest and least painful option, according to Roubini, is to pull out of the Eurozone, return to a national currency, and devalue it. This process would allow Greece to have power over its monetary policy once again, which it could use to keep its currency cheap to become a more competitive exporter without the drastic consequences on employment levels. Greece would also need to restructure its debt, which would require significant write-downs (creditors agreeing to accept less than the full balance due on a debt) on Greek bonds.

Greece would face significant risks if it were to abandon the euro. For instance, Greece would go through a period of limited access to financial markets as creditors will be reluctant to lend Greece for fear of a second Greek default. The country also would not be able to count on loans from the EU and its banking system would no longer have access to the European Central Bank’s liquidity (cash), both of which have been vital to keeping Greek afloat so far. Lastly, the Greek government would have to implement controls on the transfer of capital as individuals and firms would otherwise take their deposits (cash) out of the country to avoid the effects of the devaluation of the domestic currency. If Greek banks were to fail because of this so-called “capital flight,” credit would not be available and the economy would grind to a halt.

The effects of Greece leaving the Eurozone would extend beyond Greece’s borders. Banks in the EU would have to take losses arising from the devaluation of the Greek currency and debt restructuring. If Greece leaves the euro, the debts it owes to banks would have to be re-denominated into its domestic currency. If after this process the country significantly devalues the new currency (which is extremely likely), then the debts owed to the banks (already denominated in the domestic currency) would be worth less—a loss the banks would have to bare. Roubini believes this cost would be manageable if the exit is properly planned and the banks have enough capital to cover any losses.

Considering the potential costs and benefits of leaving the Eurozone, should Greece abandon the euro and return to a national currency?