Would the Return to the Drachma Be a Real Greek Tragedy?

Greece has been the center of attention when discussing the Euro crisis. A recently-constructed bailout package put the minds of Europeans at ease, but the recent elections in Greece have made financial markets worldwide feel uneasy. The first round of Greek elections resulted in a stalemate, which is why there will be a second round of elections in June. Leftist candidate Alexis Tsipras, the projected winner for the upcoming elections who will lead the anti-austerity Syriza bloc, is making waves and criticizing European leadership because the previously negotiated bailout conditions include austerity measures as part of the the European Central Bank's conditionality on loaning money to Greece. Tsipras does not want austerity to be a condition because he believes it will be the beginning of the end of the Eurozone, not to mention its wide unpopularity in Greece. There have been many speculations of Greece's exit from the Eurozone. Some would consider an exit to cause chaos in Greece, while others consider it the bitter medicine of returning to the drachma that Greece needs to take in order that its economy can have long-term sustainability. The question here is whether Greece should stick with the Eurozone or not.

For those who support Greece's exit, the issue comes down to fiscal discipline, something which the Greeks severely lack. As of 2011, Greek government debt was 165.3% of the GDP, a lot of which is attributable to cushy government jobs and having to finance insolvent benefit packages, most notably with their pension plans. [If you want to put the data in terms of euro, I provide the chart below created by the Mercatus Center, although if you want to look at the data for yourself, you can go to Eurostat and play around with the data.] Combine the high levels of expenditure with Greece's low levels of economic freedom and its high levels of tax evasion and corruption, and you have one huge fiscal mess in which spending cuts are inevitable.

Nations such as Greece should have never joined the Eurozone. The Eurozone unto itself is a non-optimal  monetary union. The chart below, which is from a working paper from my professor on the Euro crisis, shows the interest rates from the bond market for the past twenty years. Before the creation of the monetary union, the interest rates are more disparate. Once the union was formed, the interest rates converged at the German interest rate because there was an implicit guarantee that the other nations would be covered. The European banking crisis shook that assertion, which is why the interest rates became spread out once more. Nations with such economic disparities do not make for a successful monetary union. What can you expect when you unite twenty-seven heterogeneous nations that have much less in common than initially perceived? An overvalued currency that causes prices within the Eurozone to be higher than what the Greeks can afford to charge.  

As such, returning to the drachma has been offered as a possibility. It will cause an immediate devaluation of the currency, which in the short-term will unquestionably hurt the standard of living for the Greeks. However, the devaluation will cause the drachma be more competitive in the markets. The competitiveness will make Greek goods and services more attractive in the markets, which is supposed to provide medium-to-long-term growth.

The extent to which this move would succeed would be based on two factors. The first is its response to institutional reform. Exiting the Eurozone would lead to default, which would most probably mean no further assistance from the European Union or the IMF, especially since Greece's only form of financial stability was its European Monetary Union (EMU) status. Greece would either need help from other international financiers or rely on its own public policies to get itself out of its debt-deflationary spiral. If this fails, Greece would face the reality of becoming a closed economy, which could in worst-case scenario lead to becoming a failed state. The second issue is the extent of financial contagion. What happened in Thailand in 1996 spilled over to other countries and caused the East Asian crisis of 1997. Brazil, on the other hand, kept its 1998 financial crisis within its own borders. Sometimes, it's not what is actually going on, but the perception of what could happen, which erodes market confidence and breeds uncertainty. Whether financial contagion would occur in this situation is difficult to tell. If it does, it would be problematic since EMU bonds are important to international banking. Even if the Eurozone could prevent Greece's exit to affect the Euro's strength, it would still deliver a coup to its credibility.

In summation, it is very difficult to discern whether Greece can survive in the Eurozone or whether it should just exit. In either scenario, the Greek situation will unquestionably have to get much worse before it has any chance of getting better. Greece cannot stay competitive in the Eurozone, and it should be no surprise that the Germans do not want to reward the Greeks for profligacy when Germany is dealing with its own debt-to-GDP ratio of about 80%. Plus, a bailout only enables fiscal indiscipline, much like the coddling that led up to the Argentinian crisis of 2001. An exit out of the Eurozone is Greece's best chance of ever seeing any hope of recovery, but it is debatable whether they have the institutions and the willpower to do what it takes to ameliorate the situation in the long-run. Whatever the outcome, I'm just glad I don't have to make those decisions.