Is Greece really like Argentina? In 2002 Argentina abandoned years of painful efforts to maintain its currency’s hard peg to the US dollar, and shortly thereafter defaulted on its international debt. Greece will find it increasingly tempting to follow the same path, I argued yesterday.
But wait: It’s one thing for Greece to default on its debt, as seems increasingly likely. (Greek debt was downgraded further into junk status by S&P today.) But does it also have to drop the euro? And if so, how would that work?
When Argentina defaulted on its debt (thus freezing it out of international capital markets), it also dropped its uncompetitive fixed exchange rate, which helped tremendously to quickly pull the Argentine economy out of its tailspin in 2002. In Argentina’s case, in fact, its actions were primarily motivated by the desire to drop its peg. The default came afterwards and as a direct result, when dollar denominated debts suddenly became three times larger in local currency terms.
Greece’s situation is slightly different. The primary motivation for dramatic action in Greece’s case would be to reduce its debt service burden. Ideally, it would like to keep using euros even after defaulting on its debt.
But is that a realistic possibility? I’d say probably not. Imagine what will happen if they try to maintain the euro after defaulting. As soon as the Greek government announces that it will not make payments on its bonds, it will lose the ability to borrow money. Assuming no bailout from Germany (a safe assumption right now, I think), that means that the government will have to immediately balance its budget. Drastic cuts in government services, as well as possible tax increases, become inevitable – on the order of 10% of GDP. The economy tanks. At that point the Greek government will face a choice much like Argentina did in late 2001. It can allow the economy to collapse, the unemployment rate to skyrocket, protests to flood through the streets of Athens, and try to hold things together with the only credible economic plan being further years of debilitating deflation. Or, it can create its own currency.
Suppose that the Greek government begins printing pieces of paper – call them scrip, or IOUs, or New Drachmas – in order to pay government employees. In order to give the New Drachmas value, the government could promise to allow people to pay their taxes with them. Voilá, a new money is born, and the government has bought some time for the economy.
Note that this doesn’t mean that the Greek government has to prohibit euros from being used as legal tender; all it has to do is allow a second currency to come into existence. However, the government would probably have to impose capital controls and put a freeze on withdrawals from Greek banks in order to prevent a run on the banking system. (Note that in Argentina’s case, the government also forcibly converted all dollar bank account balances into the local currency.) The New Drachma would depreciate rapidly and substantially against the euro. There would undoubtedly be significant inflation in New Drachma terms, depending in part on how much of the government budget deficit was being plugged by the printing of New Drachmas. Greek citizens would effectively become poorer, virtually overnight.
But then the payoff would begin to be realized. Greece suddenly looks cheap to the rest of Europe, and by contrast the rest of Europe looks very expensive to Greeks. And as a result, the Greek economy would be in a position to take off.
So the choice that Greek policy-makers will face after default is this: (1) endure a spectacular economic crash, and then subsequently try to hold on through years of depression, deflation, and gradual impoverishment until high unemployment rates drive Greek wages down by enough to make the Greek economy competitive again; or (2) endure a spectacular economic crash, immediately make everyone in Greece poorer by introducing a local currency, but in so doing set the stage for a rapid resumption of economic growth.
I can’t predict what choice they will make – international political considerations will have to be weighed against domestic concerns. But I can tell you that the arguments in favor of creating a local Greek currency will seem pretty compelling to many.