Why the drachma is no answer

The large majority of the Greek population is still in favor of the country being in the eurozone rather than outside it, but their will is likely to be tested in coming quarters as the ranks of the unemployed and underemployed swell and the disposable income of the rest gets squeezed by more taxes and pay cuts. The stakes are high and therefore the costs of Greece exiting the euro versus the costs of sticking to the rules of the economic adjustment program should be highlighted.

Based on the latest revised data by the Hellenic Statistical Authority, the economy shrank by 5.5 percent in the third quarter compared to a year earlier on the back of another sharp drop in private consumption spending and fixed asset formation. So, the economy looks set to contract by 5.5 percent or more this year with the unemployment rate stuck at high levels, perhaps close to 18-19 percent of the working population on average.

If the estimates of the latest International Monetary Fund report on Greece are right, the economy will experience its fifth straight year of recession in 2012, making the current economic slump the worst since World War II.

As the pain becomes more visible and widespread across social strata, and the costs of the adjustment plan get bigger, it is inevitable that a cost-benefit analysis of the two main alternatives mainly accepting a prolonged recession or even deflation and staying in the eurozone or exiting the euro will have to take place.

It is true that lessons from other countries that experienced successful fiscal consolidation accompanied by sizeable reductions in their public debt-to-GDP ratio in the past, point to the need for large primary budget surpluses. Denmark?s reduction of public debt ratio from 80.1 percent in 1993 to 22 percent in 2008, relied heavily on primary surpluses. The same is true for Belgium between 1993 and 2007, Sweden from 1996 through 2008 and the Netherlands from 1993 through 2007.

Greece should not be an exception. However, the ongoing fiscal consolidation has proved harder to attain. We have long held that this is largely due to two major faults of the existing economic adjustment program.

First, it relied a lot on taxes instead of spending cuts and downsizing the public sector to achieve fiscal consolidation and reduce the government debt-to-GDP ratio over time. By doing so, it weakened the private sector, the economy?s economic engine, prolonging the recession and undermining the fiscal effort. Second, it did not push for privatizations early on to attain greater economic efficiencies, boost market sentiment and help improve business expectations and other structural reforms such as removing barriers to entry in certain professions.

This is very important because it is not just about fiscal consolidation but also about enhancing the competitiveness of the Greek economy.

At this point, the program is associated more with the visible costs rather than any theoretical future benefits which many in the population cannot see.

Some propose that the trade-off between costs and benefits would have been much better if the country had its own national currency. This idea is based on the assumption that the devaluation of the national currency would have helped restore competitiveness and get the economy out of its slump faster.

In doing so, they overlook Greece?s historical experience with the drachma in the past. The country devalued its currency in the 1980s and even in 1998 to prepare for euro entry but any benefits from the initial nominal devaluation were not that great and did not last long since the real devaluation was much smaller. This is so because the devaluation gave rise to inflation which fed in turn into wages, creating a spiral which eliminated a lot of the benefits of the devaluation in the following two years.

This is the reason the Greek economy was never really competitive even under the drachma regime. Instead, the previous regime helped induce speculative attacks on the national currency and balance of payment crises.

In this case, should Greece decide to exit the euro, any benefits would come after a great deal of costs were incurred. Since the Bank of Greece would have had a limited number of resources to defend the new currency, one should expect it to dive versus the other major currencies, creating havoc in domestic economic activity and depressing Greek asset prices, i.e. real estate, to a great extent.

One could also visualize a situation under such circumstances whereby Greece, being in a weak economic position, would face demands by other countries over issues such as its name dispute with the Former Yugoslav Republic of Macedonia and the ongoing reunification talks in Cyprus. So, it is not just economic but also geopolitical issues one has to take into account when arguing for or against the country?s exit from the euro.

There is no doubt that the current economic adjustment program will have to be adjusted to penalize the main source of Greece?s economic woes – namely the public sector – and this will entail more costs in terms of lost economic output. However, this cost will be much smaller compared to the social and economic costs an exit from the eurozone will mean to Greece.

The Greek economy will have to become more competitive and produce more than it spends down the road. This was not the case when the drachma was the national currency and there is no reason to believe it will be different in the future.