Martin Feldstein suggested last week that Greece take a “holiday” from the Eurozone, rejoining with a depreciated nominal exchange rate. This column argues that the idea is not just impractical, it’s dangerous for the Eurozone.
Martin Feldstein never liked the euro idea (Feldstein, 1997) and like many early doubters, he is back in the front line. His latest contribution in the Financial Times makes an apparently interesting suggestion. Greece should take a holiday from the Eurozone – leaving the Eurozone temporarily, issuing a new drachma to adjust its competitiveness, and committing to rejoin at a depreciated conversion rate. This, Feldstein claims, would eliminate its competitiveness handicap.
Feldstein is absolutely right that the real problem of Greece is neither its public debt nor its current deficit. The problem is the wage and price inflation that has knocked its economy so far down the competitiveness league tables. As such, Feldstein’s proposal is refreshing in the midst of the current mindless hype on Greek budgetary problems. But Feldstein’s proposal is not just impractical. It is dangerous, impossible and illogical.
1. It is impractical because it takes months to issue a new currency.
And what would markets do in the mean time? Investors, Greek and non-Greek alike, would run away from every asset that is Greek. Not only would the government be forced to default, but numerous firms as well; foreign investment would immediately dry up. The economy would collapse. (This is a point made forcefully by Barry Eichengreen in his famous Vox column on how leaving the Eurozone would lead to the “mother of all financial crises” (Eichengreen 2007).)
Of course, Feldstein has thought about this and he has a solution. He proposes that “bank balances and obligations would remain in euros”. It is unclear whether he has in mind all obligations or only bank liabilities. If the latter, it would seem to protect bank depositors but what if banks go bust as their assets, presumably converted in drachma, lose value?
To deal with the problem, all assets and liabilities should remain in euros. But then Greece starts down a familiar path – blazed by Latin American nations in the 1980s. Decades of experience have taught us that this is a dangerous situation for a nation. If you have lots of debt in a foreign currency, but the holders of those debts earn in local currency, borrowers can get caught in a scissors. A devaluation of the currency makes the debt look bigger in local currency terms. Many euro-borrowers who earn their living in drachma would default or fall into arrears. As the Greek financial system started to look shaky, the interest rates demanded by euro- lenders would rise, thus increasing the problems for Greek euro-borrowers. As the weight of non-performing loans and suspicion rise, the result would be the very capital flight that the measure is intended to dispel. Indeed, if the Greek government did embrace the idea, their debt service would skyrocket almost immediately – putting an even bigger hole in their budget.
Exactly this sort of thing has happened repeatedly: in Latin American in 1980s, in Asia during the 1997 Asian crisis, Russia, Argentina, etc., etc. Most recently the Baltic nations got into trouble due to a mismatch between the currency of borrowing and the currency of the earnings meant to service and repay the loans.
2. The plan is illogical.
It is perfectly time inconsistent. Symptomatically, Feldstein writes: “combining a single currency with independent national budget policies encourages fiscal profligacy”. This would only be true only if Greece gets a bailout and/or a holiday. Both are forbidden by the Treaty, by design, precisely to provide the right incentives to behave. Greece is now discovering this and providing them with a holiday is not a solution to a lack of discipline. Sticking with the Treaty is the right way to go.
Moreover, the plan assumes that a nominal devaluation of the drachma would lead to real improvement in competitiveness. It is a scheme for cutting the real value of Greek wages. This fact would hardly be a secret. In the months or years it would take to re-introduce the drachma, Greek workers would surely catch on and demand nominal wage increases to offset the shift. In fact this devaluation-wage spiral is one of the reasons that European nations were willing to lock themselves into the hard ERM in the 1990s and eventually the Eurozone (Baldwin and Wyplosz 2009). Governments found out that trying to cut real wages with devaluation was like trying to make a blanket longer by cutting off 10cm from the bottom and sewing it back on the top.
3. The plan is dangerous because Greece is not the only country in this position.
Sadly enough, several other countries will have to re-establish credibility the hard way – through wage and price moderation. Should every country that lets production costs increase be given the option of taking a holiday? If that is the case, no country would be a credible member of the union; wage and price discipline would be likely to breakdown.
If Feldstein wants to destroy the euro, he is on the right track.
•Baldwin, Richard and Charles Wyplosz (2009). The Economics of European Integration, McGraw-Hill.
•Martin Feldstein (1997). “The Political Economy of the European Economic and Monetary Union: Political Sources of an Economic Liability”, Journal of Economic Perspectives 11(4), Fall, p. 3-22
•Feldstein, Martin (2010), “Let Greece take a Eurozone ‘holiday’”, Financial Times, 16 February.
•Eichengreen, Barry (2007). “Eurozone breakup would trigger the mother of all financial crises”, VoxEU.org, 19 November.