In recent months, some commentators have argued that Europe’s single currency project is destined to become unstuck. According to this line of reasoning, the fiscal crisis in Greece is unfailingly pushing that country towards an exit from its immutable fixed exchange rate arrangement within the eurozone. Greece, in other words, will suffer the same fate as all undisciplined countries that previously adopted hard pegs, such as Argentina in the early 2000s. Another Greek tragedy, so the argument goes, is waiting to be played out.
This view is based on flawed reasoning. At the heart of Greece’s recent economic problems has been a loss of competitiveness since Greece joined the euro area in 2001. This loss is due to structural weaknesses, including fiscal profligacy in a period of robust growth when fiscal adjustment was called for, and a large government sector, up by 6 percentage points of gross domestic product (to 51 per cent) since Greece joined the eurozone. Rigidities in labour and product markets have contributed to persistently higher wage and price inflation than in the rest of the euro area, undermining competitiveness. Rising fiscal deficits have pushed up borrowing costs, adding to those deficits. The expanded public sector has eroded the export base and exacerbated inefficiency. The net result has been a twin deficit problem – large and unsustainable fiscal and external imbalances.
The problems faced by the Greek economy are extremely serious. However, the key question is whether it will be easier to solve them from inside or outside the eurozone. My answer is that it will be unequivocally easier to solve these problems from within the euro area.
Those who argue that Greece will wind up leaving the eurozone believe it lacks the will to slash the structural fiscal deficit and to implement the cost adjustments and structural reforms needed to restore competitiveness. They argue that a devaluation of a new national currency would be like waving a magic wand, thereby restoring competitiveness. But would it?
During the 1980s, Greece had another twin-deficit problem and its own national currency, the drachma. It waved the magic wand twice, with large devaluations of the drachma in 1983 and in 1985, but in the absence of long-lasting structural adjustment and sustained fiscal contraction. The devaluations were followed by higher wage growth and inflation, with no sustained improvement in competitiveness. Speculative attacks against the drachma were avoided only because of strict controls on capital flows, an option that is no longer feasible or desirable. The twin-deficit problem remained. So much for the magic wand of currency devaluation.
Suppose, however, that Greece were to neglect these lessons and adopt a new national currency. What would an exit from the eurozone imply? Here are some likely consequences.
●Any devaluation of the new currency would increase the cost of imports, raising inflation.
●Monetary policy would lack the credibility established by the European Central Bank. As a result, inflation expectations would rise.
●Expectations of further devaluations would arise, increasing both currency-risk and country-risk premiums.
●The above factors would push up nominal interest rates, leading to higher costs of servicing the public debt and undermining fiscal adjustment, thereby taking resources away from other, productive areas.
●The costs of converting currencies with the remaining members of the eurozone would be re-introduced, inhibiting trade and investment.
●The exchange-rate uncertainty with the euro area would increase the costs of conducting business, further deterring trade and investment.
●Existing euro-denominated debt would become foreign-currency debt. Any devaluation of the new domestic currency against the euro would increase the debt burden.
●Greece would no longer benefit from the economies of scale, including the enlargement of the foreign exchange market, which decreases the volatility of prices in that market, derived from sharing the euro.
The Greek economy currently stands at a crossroads. The fact of the matter is that it will be immensely less costly for Greece to eradicate its problems from within the eurozone. Rather than a Greek tragedy, a more appropriate analogy for the Greek economy stems from Homer’s Odyssey. In that epic, the enchanting sounds of the sirens enticed sailors to jump to their deaths in the sea. Those who suggest Greece might leave the eurozone are like Homer’s sirens. Greece will not be tempted by these short-term options, but will undertake the necessary, bold adjustments. The future of its economy is unwaveringly tied to the mast provided by the euro.
The writer is governor of the Bank of Greece and a member of the ECB Governing Council
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