Return of the Drachma?

by Stubborn Mule on 8 May 2011 · 17 comments

It has been reported that Greece is considering leaving the euro and re-establishing its own currency*.

More than a year ago, I argued that being part of the euro seriously exacerbated Greece’s economic woes, and for the reasons given there, I do think that re-establishing sovereignty over its currency is in Greece’s interests in the long run. Nevertheless, it would be a painful process exiting the monetary union.

To begin with, there are all sorts of practical complexities. The switch to the euro was an enormous project, years in the planning and to switch back would require major logistical and systems changes for banks and businesses across the country. Mind you, the work involved may act as a stimulus to employment! The other challenge, is that Greece still has significant quantities of public and private debt denominated in euro. Inevitably, there would be defaults and restructuring of this debt. That, combined with the fact that the new currency would be launched by a country known around the world to be in dire economic straits, would result in ongoing weakness of the new currency. While a weak currency would have some advantages, making Greece’s exports far more competitive than they have any hope of being while the country retains the euro, imports would become very expensive and there would be significant inflationary pressure. The problems Iceland has faced since its default provide a useful comparison, although Greece does have the advantage of a broader domestic production base.

So, while an exit from the euro would be an unpleasant experience, it is probably just the medicine that patient requires.

* Thanks to @magpie for drawing this article to my attention.

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{ 17 comments… read them below or add one }

1 MC May 8, 2011 at 10:03 pm

Three points:
1/ devaluation is defacto monetary stimulus. Huge hit of all that extra NGDP would help especially if the devaluation is larger than expected
2/ related to 1/: inflation might be just what thus debt laden country needs. Although without micro reform this is useless long term
3/ Tyler Cowen thinks this is an unstable game at a nation state level.
http://marginalrevolution.com/marginalrevolution/2011/05/some-simple-game-theory.html

2 Stephan May 9, 2011 at 1:56 am

I disagree.

The €zone as we’ve set it up does not work. Dissolving the €zone going back to where we were before will only create a big mess. So let’s just simply dump the word “single” from the €zone charta. The Greek government can issue its own currency in addition to have €s as legal tender. The government of Greek issues the Drachma 2.0, accepts tax payments only in Drachma and government expenditure only happens in Drachma. The new Drachma is free-floating versus the €. The new currency Drachma follows the logic and rules of MMT. Thus no need for the Greek government to worry about the bond market. And for all inflation paranoid citizens there’s still the safe heaven €.

But we must deal with Greek € denominated debt. The Greek government can offer all bond holders a conversion deal into Drachma bonds. Which certainly means a haircut. Bond holders not happy with the deal can be compensated by its government which instead of being in a permanent bail out loop simply accepts to be repaid by the Greek government in Drachma. I personally would nationalize all banks which fail upon a Greek haircut just because of incompetence and being broken anyway. But well, this is a political judgement.

3 Zebra May 9, 2011 at 8:29 am

Apparently cutting the interest rate doesn’t constitute a restructuring according to the ECB. Recently it was suggested that to avoid a restructuring they could cut the coupon and lengthen the maturity. That’s not a restructuring? I assume conversion from Euro to Drachma would be a restructuring but who can be sure. Seems the ECB will do anything to avoid the “R” word. When you get this kind of newspeak you know they are in big trouble and the politics has taken over from the economics.

It was suggested in the press that Greece breaking away from the euro would lead to a devaluation of the drachma. How can you devalue a currency which doesn’t currently exist?

My guess is this is just the Greek govt creating a stand-off with the ECB.

4 Magpie May 9, 2011 at 10:38 am

While Zebra’s guess seems likely (the Greek Govmnt is just bluffing, that is), I believe the larger European economies have plenty and obvious reasons to be worried (the Der Spiegel article made it quite clear, at least in what regards the German banks).

What doesn’t seem obvious is that the Greek debt had to remain denominated in euros:

“The other challenge, is that Greece still has significant quantities of public and private debt denominated in euro.”

Why should that be the case? Faced with a likely default and restructuring (if the Greek Govmnt launched its own currency), wouldn’t, say, German (Dutch, French, English, Spanish) creditors be willing to take a haircut via devaluation?

Finally, Stephan’s idea (dual currency), however heterodox, seems interesting and worthy of consideration. A warning to Stephan: I’m no MMT buff, so I don’t know if the question I’m about to make isn’t simply nonsense.

Anyway, the question that seems obvious to me is the following: what would be the difference between a dual-currency Greece owing euros and the US$-indebted Latin American countries in the 80s-90s?

5 Zebra May 9, 2011 at 12:51 pm

Magpie – surely the problem of Greece owing Euros following redrachmatisation is they haven’t solved their problem – in fact they may have made it worse if the ratio of GDP (coverted to Euro from Drachma) to Debt (in Euros) increases. Plus they will be susceptible to ongoing exhange rate volatility. They could just restructure at a lower coupon but longer maturity.

I presume the reason Brady bonds were denominated in USD is that no-one would buy them if the weren’t (or at least required a much higher coupon to compensate them for the increased risk due to FX volatility). It also removed the possibility of the LatAm issuers discounting their debt by exchange rate manipulation, which is basically what Greece are proposing.

Perhaps they should consult Ocean Finance who offer a similar service for households with unmanageable debt problems. And the actors all look very pleasant and are happy to discuss the football while they process your details.

6 Magpie May 9, 2011 at 10:24 pm

“It also removed the possibility of the LatAm issuers discounting their debt by exchange rate manipulation, which is basically what Greece are proposing”.

No, I don’t think this is what the Greek Govnmnt is proposing. What I think they want is to restructure their debt (lower interest, longer payment). And in this, I believe, they are justified: without any new concessions, they will go bust and everybody loses.

The threat of withdrawing from the Eurozone is simply to gain leverage over the ECB, which is acting essentially as a representative of the big European banks.

What I think is that maybe a compromise could involve a change of the debt from being denominated in euros, to being denominated in a devalued Drachma. With this the banks have a haircut, but possibly a smaller one. The Greeks get some relief and the other European Govnments don’t need to run to bail out the banks.

BTW: You don’t have any links to Ocean Finance, I assume? :-)

7 Zebra May 10, 2011 at 8:44 am

@magpie – with all due respect doesn’t your penultimate para contradict your second para?

Also with regards to “devalued Drachma” – the only way this makes sense (since the Drachma doesn’t currently exist) is if the Greek govt picks a nominal exchange rate to denominate the debt from Euros (de-euroziation) to Drachma (redrachmatisation). This isn’t actually an exchange rate though, there is no drachma at this point, it is really a haircut in disguise. Following redrachmatisation the currency settles at a level below this (not an exchange rate) level at which point the debt, if converted back to Euros, has been discounted. At best the conversion level represents the initial offer on day 1 of the new currency which doesn’t get hit. If the first bid is at 70% of the opening offer I’d argue it never represented an actual historical exchange rate.

Since the decision to allow the Greek govt to convert to drachma must be made with the agreement of the debt holders (or else we are in a repudiation situation and hence default) they may as well just agree to a haircut in Euros.

8 Magpie May 10, 2011 at 10:30 am

“@magpie – with all due respect doesn’t your penultimate para contradict your second para?”

Not really. I’m just trying to examine the possibility of a negotiated way out of the current situation.

I agree with the rest of the comment.

What this situation illustrates is something economists in general, and particularly mainstream economists, prefer to ignore: a lot of economics has to do with zero-sum situations (or, as Uncles Chuck and Fred would have said, “antagonism” and “conflict”). I win what you lose.

9 Magpie May 10, 2011 at 9:29 pm

@zebra and everybody

Merkel Allies Signal Germany Backing Off Push for Greek Debt Restructuring
http://www.bloomberg.com/news/2011-05-09/merkel-allies-signal-germany-backs-off-greek-restructuring-push.html

10 pfh007 May 11, 2011 at 3:10 pm

It would be very surprising if Greece decided to leave the Euro and even more surprising if they were kicked out.

I doubt anyone has the stomach for it even though the prospect of very cheap holidays on Greek Islands has some appeal.

The Europeans have learned a valuable lesson about managing the Eurozone and in particular the risks of allowing banks to lend money to incompetent administrations without question.

No doubt in future Brussels’ will keep a closer eye on the debts being run up by its members.

What we have at the moment is the slow political process of transferring the mistakes of bankers, politicians and bureaucrats onto the european taxpayer. It is messy and involves a lot of huffing and puffing but ultimately it will happen. There will be some formula reached that conceals the reality that the Greeks, Portguese, Spanish and Irish will only pay back some of the money owed. The language of austerity is important to assure the rest of europe that the PIGS did not get off the hook too easily.

The break through moment may be some further crisis point at which the taxpayers are warned that unless they cough up there is real chance that the European history of conflict will be repeated. The deal will then be done – a haircut but enough hair left for a mild hair shirt for the debtors.

They should put this period of reckless banking down to experience. After all the bankers are deeply apologetic and promise never to do it again.

11 Alex May 15, 2011 at 3:18 am

Can someone discuss what will happen to mortgages held by Greek citizens that are denominated in foreign currencies such as Swiss Francs?
In case of a return to the drachma will there be a restructuring or a demand to full payment? Since these mortgages are usually not fixed I assume the banks will raise the interest rates to a degree that it will be impossible to be repaid resulting in defaults and loss of properties via foreclosures.

12 pfh007 May 22, 2011 at 8:52 am

Recent news from Europe, including the arresting of DSK and increasing levels of political tension in Greece and Spain, the hard line being taken by Brussells, suggests that there is a real risk that the Europeans will not find a politically acceptable solution to their debt crisis.

http://www.theaustralian.com.au/business/news/rifts-widen-over-europes-debt-crisis-as-greek-borrowing-costs-soar/story-e6frg90o-1226060084011

Certainly there are rational and sensible ‘solutions’ to the current situation but they are complicated and contradict the understanding of many European citizens (particularly Northerners) about how the Eurozone was going to work. Selling them may be beyond the capacity of the structure of European politics or the current crop of European politicians.

To make matters worse the capacity of the European political and monetary system to respond to the ‘unexpected’ appears to reducing week by week.

In a few years we might find ourselves marveling how a relatively insignificant event set in chain a course of events that changed European history.

Here is one that will bring High School memories flooding back.

http://en.wikipedia.org/wiki/Gavrilo_Princip

13 Stubborn Mule May 22, 2011 at 2:49 pm

Ultimately Greece’s current situation is untenable. Whatever language is wrapped around the eventual outcome (“restructure”, “haircut”, etc), Greece will have to default on their debt one way or another. While I have argued here and elsewhere that Greece would be better off with their own currency, changing back to their own currency now would stave off other problems in the future: it would not solve their current problem. If the only debt the Greek government had was denominated in their own currency, they could always elect to avoid default. But the fact is, they have euro debt and they do not have enough euros. Lending them more and more euros only delays the eventual reckoning. They should get the inevitable over and done with, default and get started on getting themselves on a better footing.

As for Alex’s question, if Greece did revert to their own currency, then everyone with euro debt (or debt in any foreign currency) would likely find themselves in a pretty tough corner. The chances are that the eventual exchange rate would be such that the earning power of Greek citizens would make their euro debts look very large and difficult to service.

14 Pfh007 May 26, 2011 at 12:57 pm

An interesting read on the grim options facing Greece

http://macrobusiness.com.au/2011/05/solon-ghost-greek-default-scenarios/

15 pfh007 May 26, 2011 at 3:59 pm
16 mrvm November 2, 2011 at 6:00 am

We have a considerable mortgage in Greece for a property that we are still paying off, BUT are not actually living in Greece.

Our earnings therefore are in another foreign currency.

My questions are: 1. what happens to our mortgage if Greece defaults and returns to the Drachma? Will the loan amount go up in real terms and how will this affect our repaying capacity?
2. Will the value of our property drop?

17 Stubborn Mule November 2, 2011 at 7:24 pm

@mrvm: assuming your mortgage is in Euro, you will still owe the full amount in Euro, whether or not Greece defaults and/or returns to the Drachma. Even if the Greek government defaults on its debt, that does not mean that private sector borrowers’ debts are expunged. As to your ability to repay the mortgage, if your mortgage is denominated it in Euro, it really depends on what happens to the exchange rate between the Euro and the currency of the country in which you work and earn your money. Regardless of what happens, things are not looking particularly good for the Greek economy, so I would say that there is a good chance that your property will fall in value if it has not done so already, but I am certainly no expert on the Greek property market, so that is really just speculation on my part.

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