Going back to the drachma

There is a strong case that the only solution to Greece’s economic problems is to leave the euro. At current wage levels, Greek workers are unproductive, giving foreigners few reasons to buy their exports and giving Greeks every reason to import from outside their own country. There are two clear ways to restore competitiveness: drive down wages or depreciate the currency. The first diminishes demand in an already depressed economy and worsens unemployment, while the second allows the domestic economy to muddle through while sparking export growth. Argentina, Thailand and Iceland were able to emerge from financial crises on the back of a strong export sector enabled by a deflating currency.

Jane Jacobs (for my money the greatest thinker of the 20th century) made the point in her brilliant Cities and the Wealth of Nations more than 20 years ago. She asked us to imagine if Detroit had its own currency. As auto workers’ wages rose, and as demand for General Motors cars declined, the value of the Detroit dollar would fall, meaning that Detroit-made cars would be cheaper everywhere from California to Guangdong. If Detroit had its own currency, it would not be half-deserted today. But, since its currency was tied to the stronger economies of New York and Texas, the US dollar could not fall enough to save Detroit.

Currency depreciation is the relatively painless way to stimulate exports, restore competitiveness, and encourage economic growth. But were Greece to restore the drachma, all hell would break loose. For one thing, all Greeks assets denominated in Euros would lose half their value. The day after drachmatisation, the Greek middle class would wake up to find their bank balances worth a fraction of their value the day before. This, of course, is the inevitable (and just about bearable) result of currency depreciation. The real problem is that since savers are not stupid, more and more depositors will pull their euros from Greek (or Portuguese or Italian) banks and shift them to Frankfurt or Zurich. It is that bank run on PIIGS financial institutions that would devastate the European and global economies.

A Greek withdrawal from the euro would spread a contagion through all of southern Europe, as depositors in Italy, Portugal and Spain would fear that their country could be next. The banking systems of Europe’s periphery would most likely collapse. As depositors yank their money out, already fragile banks forced to sell assets into a crumbling market would become insolvent, ATMs would stop spitting out cash, credit would freeze and economic activity throughout the eurozone would disintegrate. German workers now scoffing at the profligate PIIGS would lose their jobs and the current recession will seem mere preamble.

The Germans would like the southern nations to pay the entire cost of adjustment by cutting wages, slashing demand and accepting an increase in unemployment.  But the Greeks can see the upside of leaving the euro, even if it will devastate their bank balances. It is starting to look as though leaving the euro really would be the better of several bad options for the debtor nations. The northern eurozone countries don’t recognize it yet, but today the debtors have more cards than the creditors. Watch out.