Lost Competitiveness for Greece and Spain - Is There a Way Out?

Using ECB data the chart below shows the substantial loss of competitiveness for Greece and Spain since 2000. With flexible exchange rates against Germany there is no doubt that the countries would have allowed their national currencies to depreciate against the mark. That would have allowed an improvement in the external balance.

With the euro straightjacket, however, the only way to restore competitiveness and give hope for future economic growth is to reduce unit labour costs by following austerity programs and implementing supply side changes that could promote investment and the return of confidence. Of course, the unpopularity of such programs is directly proportional to their severity, making their advocacy by politicians difficult. And the actual implementation can be even trickier...

Does this mean that abandoning the currency union is the only way out? Recent history teaches us that 'artificial' pegs (i.e. pegs that involve significantly dissimilar economies) are indeed prone to disintegration. Think of the UK's exit from the ERM mechanism in 1992 and the Argentinian abolition of the peg with the US dollar in 2002 - is there another spectacular peg disaster in store for 2012? 

The problem is that de-pegging in a disorderly way is bedevilled by dangers. High inflation, the collapse of the banking system, violent income redistribution, deep recession and social disorder are some of the possible scenarios for the day after. So, whenever there is a choice policymakers normally prefer the (costly) status quo than the (potentially disastrous) alternative.

So what should Greece and Spain do? 

I think more or less what they are already doing. Fighting tooth and nail to stay in the eurozone (EZ). If the Germans are serious about the viability of the euro experiment (and I think they are) they will eventually have to consider a more accommodative monetary policy (leading to a higher inflation that would erode the real value of existing debt), some form of eurobonds to allow countries in difficulty to borrow at lower rates and potentially more debt write-downs for the criminally indebted nations. The EZ banking system will need to be reinforced as well.

As long as Greece and Spain implement the necessary structural changes (the Greeks have been given a handy MoU with detailed instructions by their creditors), such changes would eventually allow these countries to grow again. No doubt, this is politically explosive stuff in Germany and that's why time is needed to prepare the public for the price they need to pay. (For the Greeks that time is now.) Unfortunately, the markets are pressing hard and a clear roadmap to an "ever deeper union", fiscal and political, will need to be presented sooner rather than later. 

Too much is at stake and everyone should do their bit. The rich EZ "North" should help the poorer "South", and the South should undertake painful but necessary economic adjustments. It is in the interests of everyone involved -and the rest of the world.

You can read more about the harmonised competitiveness indicators at the ECB's website.

Why Exiting the Euro is a Bad Idea for Greece

A number of world leaders, including the UK PM, have made it clear that the forthcoming election in Greece on the 17th of June will decide whether the country stays in the Eurozone (EZ) or returns to the old national currency, the drachma. Some greek politicians, however, would have you believe that the country can disentangle itself from the terms of the bailout and remain in the EZ at the same time. They argue that the potential cost of a greek exit to the world's economy is so high that Greece's creditors (the IMF, EU and ECB) would be willing to do anything to avoid it.

This is a miscalculation. The markets have already discounted the greek departure to a certain extent. A return to the drachma is not as unthinkable as it was a year ago and it is naive to think that behind closed doors EZ policymakers have not devised damage limitation strategies. Given that a unilateral greek withdrawal from the terms of the bailout would eventually -and quite quickly- lead to a voluntary return to the drachma, it would be honest for the politicians that support such unilateral action to admit that what they, in effect, advocate is the abolition of the euro.

So what can we expect to happen if the electorate votes an anti-bailout government in? Here is a likely (but not the only) scenario for the short run:

• The newly elected government declares that it wishes to renegotiate the terms of the bailout 
• Greece's creditors either give little way or none at all
• The government pulls out of the bailout agreement, misses the next loan instalment and defaults in its debt repayments
• Greek banks find themselves unable to borrow from the ECB, which no longer accepts greek debt as collateral, and there is a bank run
• Restrictions are placed on deposit withdrawals 
• The government nationalises the banks and starts printing money to recapitalise them
• A new exchange rate is set for the EURDRS (euro-drachma)
• Imported goods become (much) more expensive and greek tradable products and services gain competitiveness
• The greek government places rationing on the purchase of petrol and medicines
• The primary budget deficit cannot be financed through borrowing so the government resorts to inflationary finance (money printing)
• High inflation erodes stable incomes of pensioners and employees 
• Greece's output collapses and unemployment increases further

In the longer term, it is likely that net exports will improve due to the more favourable exchange rate but the outlook for consumption and investment is more uncertain.

• High inflation and interest rates will not help
• Necessary supply-side reforms will not have taken place and this will further hinder investment
• Public spending will be limited by the inability of the government to access the debt markets

A return to the drachma will not destroy Greece. But it will make it poorer.