Wednesday, November 02, 2011

Was Greece Joining the Eurozone a Mistake?

Nicolas Sarkozy knows how to spice things up – his comment that it was a “mistake” to let Greece into the Eurozone has ignited much commentary, mostly in support for his statement. And yet that’s a silly thing to say – and it is also an unhelpful thing to say because it focuses attention on the euro as the chief problem, when it is not. 

First things first: today’s crisis would not be alleviated if Greece exited the Eurozone. Europe’s problem is that banks hold Greek debt – whether that debt is denominated in euros, drachmas, gold or goats makes no difference. Think about the United States bailing out Mexico in 1994 – the problem is exposure, not the currency in which that exposure is denominated. Second, throwing Greece out of the Eurozone would trigger a massive banking crisis elsewhere. Spanish, Irish, Italian, and Portuguese depositors would wonder whether their euros will overnight turn into pesetas, pounds, liras or escudos. They will move their money abroad. Their banks will face imminent collapse. Third, would a devalued currency help Greek exports? Yes. But it would do by merely offering a lower price, when instead, Greece needs better products not bad products at a lower price. And fourth, there is of course a political dimension - the period to prepare for entry into the Eurozone, for instance, was also the period when public finances were at their healthiest. 

So much for the present – what about history? To what extent is the current crisis to blame on the euro? In one way, it is hard to blame the euro. The debt problem emerged from the fact that the European periphery was able to borrow at interest rates that were too low relative to their fiscal health. The euro is to blame in a round-about way - although bailouts for fellow Eurozone members were prohibited by the Monetary Union, the markets treated all European debt equally – Greece and Spain were the same as France and Germany. The convergence in bond yields was the result of that treatment. 

This was a view that the market is regretting these days – and yet, the market may not be altogether wrong. Germany is indeed stepping in to guarantee some of that debt – and in a slightly better scenario, investors in Greek debt would have seen no haircut at all courtesy of the German taxpayer. So the problem came not from the adoption of the common currency but the widespread assumption (legally wrong but, in retrospect, politically right) that European countries would step in to support each other’s debt. And much of the crisis now emerges from the uncertainty about exactly how much debt Germany and other countries will really shoulder. Again, nothing to do with currencies. 

So much for debt – what about the broader question? The guiding principle here is an economic theory about “optimal currency areas,” which lays out characteristics that entities must share in order to form an “optimal currency union.” The two key ideas are: (a) countries in a monetary union may end up with monetary policies that are too expansionary or restrictive, either fueling a bubble (if money is too cheap) or slowing down growth (if money is too dear); and (b) with a fixed exchange rate, countries lose currency appreciation or depreciation as a way to correct imbalances. 

There is, in fact, evidence for both propositions. Greece’s inflation rate was above the Eurozone average, and so the interest rate set for the Eurozone was too low for Greece. So people and companies over-borrowed. And there is no also no doubt that with no ability to devalue its currency, Greek exports suffered. Neither of these two statements can be denied. But these points take you only so far; they don’t answer the crucial questions: did membership in the Eurozone push the country to crisis? And second, what would have life looked like outside the Eurozone? 

Cheap money fuels borrowing and Greece’s above average inflation fueled borrowing. But Greece’s debt problem is public, not private – and while cheap money can raise private borrowing, public borrowing is determined by the appetite that markets have to lend to a sovereign. And there the problem was not membership in the euro but, as I said above, the presumption that this membership entitled Greece (and others) to interest rates that were almost identical to Germany. 

At the same time, Greece benefited from the euro with lower inflation and exchange rate stability. More generally, the argument against the currency union betrays the economics profession’s love with monetary policy, trusting that that no matter what the problem monetary policy can solve it. Guess what? It can’t and it hasn't. For example, monetary policy was flawed in the early 2000s in the United States. So yes, Greece gave up the right to conduct monetary policy but there is no guarantee that it would have exercised that right much better than what the ECB did – it would likely have ended up with more inflation and little else. 

A second way to look at this question is to distinguish between inflation as a monetary or a micro-economic phenomenon. Monetarists such as Milton Friedman say that, “inflation is always and everywhere a monetary phenomenon.” The problem is with “always” in that sentence since inflation also has micro-economic roots from the lack of competition in product markets and services and in wage-setting practices. In the case of Greece, in particular, inflation was very much rooted in entrenched and quasi-monopolistic structures as well as in strong unions that allowed for wages to be set without due regard to productivity. 

Why does this matter? Because it takes us to the adjustment issue – with a fixed exchange rate, overvaluation is “internal” which means prices start getting out of sync with underlying productivity trends. But allowing the price to fall is, in a way, the wrong way to correct this problem – you are saying that you are changing too much for something and you should lower the price. By competing on price, you end up not competing on other things such as quality. It also does nothing to correct these micro-economic distortions such as monopoly or improper wage-setting practices – by merely altering the price, you preserve these practices. 

So if you put all these things together, you get the following: (a) excessive borrowing driven by a perception about sovereign risk that was linked but not necessarily connected to membership in the Eurozone; (b) monetary policy under a Greek government is unlikely to have been that much better; and (c) successive devaluations would have done little to correct the underlying problems that produced higher inflation and lack of competitiveness. Plus solving the crisis has little to do with Greek membership in the Eurozone and everything to do with who holds Greek debt. That’s why the question of whether Greece should have entered the Eurozone and whether it should stay in it is more of a distraction.


  1. Nikos, I admire you for your sharp and sophisticated analysis! Thank you for that.

    Since my own knowledge in financial economics is limited, I would like to ask you: Can you also say that Greece could have benefited from the euro because it could have exchanged old expensive bonds with new cheaper bonds after joining the Euro, which could have decreased its overall debt? Isn't that a chance the common currency gave Greece but what its governments didn't take?

    Thanks in advance for your help!

  2. Joining the Euro had implications which went beyond having the same currency. It was in a way a "seal of approval" on a country's finances. A credible approval, which was demonstrated by the convergence of bond yields.

    When Mr. Sarkozy sees a possible mistake in accepting Greece in the Euro-Zone he actually questions whether the Greek were "worthy" of such a seal.

    Now we know that they were not. They would not have been "worthy" with a drachma, but this is now irrelevant. And it is not the question.

    It is possibly interesting because it raises the question of who actually IS worthy. Spain? Italy? Maybe, maybe not. If the Greek could fall from grace, so can - potentially - anybody.

    Which leaves two ways to deal with the problem. Have a big enough fund to guarantee everybody or... go for more integration in the EURO zone.

    The Greek just got a free lunch of which they had just a bit too much.

  3. In the transitional year of the drachma to euro I visited Greece on business. In
    September (still drachma) I was able to buy a 1 liter bottle of Avian water for 200 drachmas. In January the same bottle was 2 Euros or 700 drachmas. Thats a 250% increase in 3 months. The reverse happened in Germany where the Mark was stronger than the Euro. I saw it..did no one else?

  4. If Greece had never joined the Eurozone it is virtually certain the Greek debt crisis would never have happened. The GGB risk would have been priced correctly, interest rates demanded would have been much higher and the debt build up would not have occurred, along with the presence of the GCB to prevent "runs" on Greek bonds.

    The key point though is that with the Drachma Greece would have been free to create an economy of its choice, inflation, growth etc would have depended on the actions of Greek institutions and Greek democracy.

    Obviously Greece going back to the Drachma would be extremely difficult. There is no reason why Greece could not maintain its own currency, set the correct monetary / fiscal policy and enjoy the same stability the euro afforded.

    You are assuming Greece cannot manage its economy properly and that it must give up its sovereignty to Brussels and Frankfurt to achieve anything. Very depressing indeed.

    Greece's crisis is 99% to do with Greeces membership of the Euro, don't kid yourself.

  5. The problem with returning to the Drachma is that after everyones pensions and savings get hit by around a 50% haircut, the Greeks will find that they still have a massive income over expenditure problem. The Greek civil service still would not bring enough Drachma in, in taxes to pay the Drachmas required to pay the civil servants and pensioners, and to run the country.

    So they print more money, inflation goes rampant and the country ends up like Albania in the 1970's, 80's, 90's.

    Default and with no foreign exchange coming into the country other than through tourism, and lets face it, who would want to go to Greece where they have insufficient fuel, electricity, water and the infrastructure is completely shot.

    Turkeys do vote for Christmas as we will soon see.

  6. Thanks, as always Niko.
    I do have a question regarding the new bank haircut, ie the newest great big thing to rescue Greece. How is it supposed to help if it brings Greece back to a national debt of 120 percent. That being roughly the amount we had when the EU first needed to 'help' us. So, how is this new measure supposed to help at all if it just brings us back to first base of catastrophe?

  7. To Anon who mentioned the inflation in the price of a bottle of water. The Drachma converted at 344 to 1 Euro. I recall where I go a lot on holiday the bus fare was 250 Drachma: that fare became 1 Euro. Exactly the same thing happened with all manner of things, but of course this rampant inflation never showed in the inflation figures. It is all very well Sarko & Merkel lecturing everyone that the rules must be obeyed, but neither Paris nor Berlin were quite so keen to follow the rules when it suited them. I hope the Greek people will say No to the bailout.

  8. Very fine analysis but totally misplaced. You Sir, along with other Greek commentators, continue to discuss the Greek crisis as if Greece can be analyzed in terms of orthodox economic theory. In my view, it cannot. It is a gangster state and every single person living there is a lawbreaker on a daily basis. Normal rules do not apply. What you are saying sounds like this: 'The Gambino family could cut its costs dramatically by outsourcing its murder operations'. How does that sound? It sounds just like your analysis!
    Traditionally, the military coup d'etat was the corrective measure available to put the Greeks back on track. That has now been blocked off because of EU membership and also because the military is as corrupt as any other sector of Greek society. Therefore - as I mentioned in a previous post - the only viable options are: emigration, return to the countryside as peasant farmers or suicide. All three are currently being taken up by Greeks en masse.
    Of course, if the economic theorizing - normally reserved for proper states and decent people - makes you happy, please go ahead.

  9. There are a few issues.

    According to the WorldBank data Greece has been running a total debt load of over 100% of GDP since the Drachma Days.

    And Greece has always been running fairly large budget deficit. Off the top of my head I cannot remember them running a surplus.

    Given that these types of data was available to Euro-zone policy makers when Greece joined the Euro...Sarkozy's statement is an insult to the Euro-Zone policy makers.

    Also there are lenders to every borrower. It would not have taken a genius to figure out that given how Greece ran and runs its country they were bound to get into financial difficulties down the road and lending to them at German rates and shorting CDSs on its debt to gain a few million euros in bonus was not a good policy to take for a prudent banker.

    Also you seem to also buy into the financial armageddon theory via a Greek default spreading to similar situations to the other PIGS.

    This I cannot really say because there are no accurate data..but the exposure to the pigs is probably leveraged at least several times over in terms of face value.

    So it might be possible that a spreading of crisis might wipe out the capital base of several banks.

    Instead of forcefully using good tax payers money to bail out the PIGS the authorities should set aside that money to safeguard deposits held at financial institutions should these institutions get into a liquidity crunch(current day term for "a run on the bank") operating within there jurisdiction.

    The problem has nothing to do with currency denominations. Devaluation and money printing is a illicit form of confiscation from the savers.

  10. Niko:

    You need to stop dealing with topics that are out of your depth.

    G-d knows we don't need a bunch of amateurs dealing with national issues.

    Write something about why Nabucco will never happen or why the Azeris will award to ITGI the license to carry gas to the European markets by year end.

  11. Thanks, Nikos. Your comment is a curved ball for monetarist dogma. The problem had everything to do with currency denominations in the Mediterranean basin.

    In the Portuguese case, we were already under heavy pressure (from an overvalued currency) BEFORE joining the Euro. I should recall that EU currencies were pegged to each other. Before the euro, we had something like the dolarization of Argentina: it was, in effect, a "deutsche-mark'ization" of Portugal. Mainstream political parties sold that to the middle class, like Carlos Menem did in Argentina. They offered easy credit (with German interest rates) and little inflation, but otherwise forgot to tell us the hidden cost of those goodies in an economy whose competitiveness was much closer to the South American cone than Germany.

    In Portugal, we entered the Euro Zone at a rate 200 escudos to 1€ that overvalued the escudo. Also, when the dollar started to slip and a free trade agreement contemplating the textile industry was signed between the EU, China and other countries, the Portuguese industry suffered tremendously. After the over-valuation of the euro, the industry of auto components suffered accordingly. In truth, with only 30% of public debt to GDP in 1999, we could have easily defended ourselves from that with a slow devaluation of the escudo. Now, with recession and austerity measures, the public debt to GDP ratio is fast approaching 100%, and in a couple of years we will be in the same situation as Greece.

    Worst still than Greece, private debt here (and in Spain, too) is a huge problem. Our banks have little liquidity, I suspect they are much more busy cooking its books right now than the Greek state ever were. And so they will probably fail before the state is forced to default.

    As for Germany and France, their Versailles policy (as in 1918) only means they can't care less about the well-being of the Mediterranean countries. Their only concern is self-preservation, and that requires a soft transition for their own middle-classes.

  12. Dean Plassaras, why don't you just do us all a favour and stop reading this blog? You have made it clear that you don't concur with Nikos thoughts. And you've made it painfully clear that you belong to a very obnoxious and typically American arrogant know-it-all species who have never learnt to discuss a topic rationally and behave like a spoilt 13 year old devoid of any respect.
    Clearly, you're not in a position to insult and deride Niko.
    You have done nothing, so far, to enrich the debate on current Greek issues here.
    All you have managed to show us, is that you have no clue of Europe, that you (unlike serios economists) have a liking for really easy answers, and that you like to point fingers in the most ridiculous ways.
    I'm sure Nikos, as well as most readers and commentators here are very welcoming to differing opinions, as long as there can be a debate where people take each other seriously and treat each other with a modicum of mutual respect.
    You don't want to do this, so why don't you just stick to blogs that like you see the new Nazi threat coming to the world, and stop annoying us with your eternal wisdom?

  13. Suppose Greece is kicked out of the Euro Zone. I think this is illegal, it is a violation of the treaties, and as such Greece would be entitled to reparations. But, anyway, suppose the creditor nations can pull that one off, over the slumber of the European courts.

    Then the reintroduced drachma devalues to 1/4 of its previous value, as in Argentina. Greece, however, will remain a member of the EU; it surely can't be kicked out of the Union. Every treaty would have to be scraped for that to happen. As an impoverish country, Greece would be entitled to structural funds and other forms of aid. More importantly, the EU cannot stand still while the drachma devalues sharply, knowing that the country has no means to combat the situation.

    In fact, the treaties require that the EU and the ECB should take measures to stop any such sharp devalution, since that would be a "de facto" blow on the Common Market. Note that other vulnerable countries of the EU will be tempted to "retaliate" with a devaluation of their own currencies. Although a formal European Union could continue to exist, this would mean a "de facto" reduction of the territory of the EU to its core nations.

  14. Sorry Nikos but I dont agree with you. You know very well how Greece got into the eurozone. Firstly the EU is a dysfunctional "Union" You have 17 countries in the eurozone and 10 outside WHY? Secondly when the euro came into affect in Greece prices tripled and wages remained the same. Thirdly Greece has an uncompetitive economy. Let me remind you that 50 world renowned economist worldwide have called on greece to leave the eurozone. They must know something.

    1. I think you are missing a very important aspect that makes all the difference. If Greece did not join the EMU, imports would not become cheaper and the sovereign would not be able to borrow cheap credit. Consequently current account deficits and fiscal deficits would not explode as they did. In addition the sovereign would "borrow" in its own currency, thus it would not be exposed to external debt which by the way makes all the difference in the world as you cannot inflate your way out of it. Oh and Greece's debt problem was not just public, it was private too. Remember all those bank bailouts the state has been engaged in since 2008? So yes in terms of pure accounting it is public debt, but in reality Greek public debt is also about some big chunks of private debt/losses that have been socialized.

  15. Niko,I think you are missing a very important aspect that makes a huge difference when discussing this issue. If Greece did not join the EMU, imports would not have become cheaper and the sovereign would not be able to borrow cheap credit. Consequently trade deficits and fiscal deficits would not explode as they did. In addition the sovereign would "borrow" in its own currency, thus it would not be exposed to foreign debt which by the way makes all the difference in the world as you cannot inflate your way out of it. Moreover Greek competitiveness would not have plunged by any means to the extent it vis a vis its trading partners.

    Oh and Greece's debt problem was not just public, it was private too as a result of the credit and property bubbles that took place following the ECB's loose monetary policy in order to accommodate Germany which at the time was in a recession (the sick man of Europe).

    Remember all those bank bailouts the state has been engaged in since 2008? So yes in terms of pure accounting it is public debt, but in reality Greek public debt is also about some big chunks of private debt/losses that have been socialized.

    Back to my point, I think that the answer to the question in your header is really a no brainer. Greece joining the EMU was a huge mistake which resulted in a macro tragedy. The way the EMU is structured (that is in a zero sum game fashion) made it even worse for Greeks. That does not mean off course that pulling an Argentina is advisable.

    1. The issue is you're discussing the trajectory of the crisis -- it would have come sooner if Greece was not part of the EZ. Agreed. But very little of the underlying problems that plague Greece ("competitiveness" for example) are Eurozone problems, unless you could merely successive devaluations as a "proper path to competitiveness" which contradicts Greece's own history of devaluations doing nothing for competitiveness. There is a cost-benefit analysis of joining the currency and I think you ascribe all costs (even those that don't belong) to the EZ without any of the benefits, which is why we differ.

    2. It is not just an issue of whether the crisis would have come sooner. There is also an issue pertaining to the intensity of the crisis as well as the room for manoeuvre available.

      Agreed Greece has been suffering from lack of competitiveness for decades, however there is a leap of faith in suggesting that a crisis of the magnitude Greece is going through right now would have been inevitable both within and outside the EMU. For example, as a matter of fact Greece's lack of competitiveness was only exacerbated under the EMU in various ways (eg credit expansion --> inflation). The same goes for other countries in the periphery too.

      My take is that both Greece's debt as well as its current account deficits would not have exploded outside the EMU and I think it is very difficult to argue otherwise.

      Would Greece have been in crisis earlier? Maybe, although one could argue that it might have benefited (in terms of competitiveness) if it stayed outside the EMU vis a vis Italy, Spain, Portugal, Cyprus. Would Greece have been in crisis following the Lehman collapse? Yes, however the depth and the duration of the crisis would have been an entirely different story under its own currency.

      Sure there is a cost benefit analysis to be conducted, however I really cannot understand how the benefits outweigh the costs here.


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