Monetary Dilemmas

Monetary Dilemmas

It is well known that the economy is a breathing, living organism. Much like a glacier, it shifts and moves around; the changes may seem sluggish or even non – existent to the common eye but nonetheless they do exist. However, just as a glacier can experience sudden break ups which cause devastating avalanches, the economy can and does experience crises the consequences of which may persist well over a generation. The above parallelism helps us understand that the economy functions on a dynamic equilibrium. Any shifts from this path, either due to random events or due to artificial interference are unsustainable and the economy will revert back to its dynamic path. The larger the divergence from the dynamic equilibrium, the more violent the correction will be. The longer an economy stays on artificially static, unsustainable equilibria (for example maintaining unsustainable public consumption through borrowing) the more violent and painful the realignment will be. In other words, the higher the inertia and the stickiness an economy has the longer it takes for it to correct.

In Greece there has been a heated debate about the benefits of staying in the Euro zone versus returning to a national currency. I’m afraid that this is a non existent dilemma; the long term result will be the same whether Greece adopts the drachma or not. It is a well established fact, both theoretically and empirically, that monetary supply generally does not influence the long term equilibrium of the economy (monetary neutrality). Money has only a short term impact on the economy and then its influence zeroes out. The only way through which money may impact upon the long term equilibrium is through credit expansion. If the credit is used to increase the capital accumulation within an economy thus increasing its output, then we can say that money had a positive effect. If credit is used to increase consumption and worse of all imported consumption, then there will be a short term positive effect but in the long run there will be serious negative repercussions.

Economic and financial analysts claim that if Greece was to return to the drachma the new currency would have to be devalued by at least 50% in order to be competitive. Assuming that everything works like clockwork and the economy rebounds in two years after the adoption of the new currency, this switch will mean a severe reduction of the GDP. If this is the long term equilibrium for Greece (i.e. a 30% reduction of the GDP) then there is no difference if we reach this point by using the Drachma or by using the Euro. There are of course differences in the implementation, but the long term result will be the same. Proponents of the drachma state that once the new currency is adopted the economy will become competitive again by making Greek exports and Greek tourism much more attractive. The argument goes on to say that if this is combined with a drastic reduction of the foreign debt, soon the economy will be back on its feet with the added benefit that the country will be able to once more exercise independent monetary policy more suited towards its specific needs.

Let us examine these assumptions one by one. It is certain that with the adoption of the Drachma the Greek trade imbalance will be drastically reduced overnight; people will simply lack the purchasing power to acquire foreign consumer goods. The assumption is made that Greek production will be increased in order to substitute these foreign goods. This substitution, combined with a boost in the tourism and export industries will quickly turn around the economy and return it to growth. There are serious flaws in these assumptions which I will proceed to lay out promptly. There is no doubt that the trade imbalance will be drastically reduced. This will have the positive effect of immediately addressing the trade imbalance but will also cause a short term deepening of the recession due to the dismantling of the internal economic circulation that the imported goods create (all economic activity associated with imported goods will be severely curtailed). There are serious doubts whether local production will be able to substitute imported goods due to two factors: first of all many of the elements incorporated in the production of goods in Greece are exogenous and irreplaceable from local sources (for example imported hydrocarbons). Second, it is assumed that cheap labor will make Greek goods more attractive in the export markets. However, Greece is a mature economy and does not and cannot compete with emerging economies in labor intensive products no matter how much it lowers labor costs. Furthermore, it has been shown that the cost of labor is not a detrimental factor in the Greek production cycle. It is the excessive bureaucracy, cumbersome government, poorly drafted and often contradictive laws, unstable and irrational tax system and corruption which make investments and production unattractive in Greece. All these factors will not be eliminated with the introduction of a new currency and it is highly possible that transaction costs will be increased and not reduced in such an eventuality. The Greek economy suffers from serious structural flaws which will not magically vanish no matter what currency is used. Attempting to reach the long term equilibrium with the Euro will involve a slow and painful process of deflation which has but one big advantage; there is less uncertainty and volatility in the economy and this can allow the easier adoption of the necessary reforms.

The introduction of the Euro in Greece led, overnight, to much easier access to cheap credit. What happened is in my opinion, a case of double moral hazard. First, the financial markets implicitly assumed that Greece’s borrowing in Euros was guaranteed by the economic might of Germany and France, an assumption entirely unfounded. The European Central Bank’s mandate explicitly forbade the direct purchasing of public debt from member states. The member states were assumed to be following a common set of fiscal rules which provided for economic stability. Thus the market based its risk assessment on an assumption which was unfounded. The introduction of the Euro as it was could not have changed Greek credibility overnight and this was well known by the markets. Therefore the financial institutions failed in their primary function which is adequate risk management and chose instead to invest in Greece, ignoring previous credit history and economic fundamentals. On the other hand, Greece irresponsibly borrowed money in order to sustain an irrational level of domestic consumption and an inefficient public sector. Nobody forced Greece to such levels of lending; it was the democratically elected leaders of Greece which willingly pursued such a reckless course. Therefore the blame can be split somewhere in the middle, or to put it otherwise, it always takes two to tango.

Germany, which nowadays is involved in serious finger pointing towards Greece, is not without its own faults in this case. It has been a well known fact that the Euro is a currency which is tailored to suit German economic needs. It was a known fact that in order to survive in the Euro zone a country had to adopt German economic behavior. This involves tight fiscal policies, tight price and wage controls and a religious devotion towards productivity increase and exports. Germany knowingly turned a blind eye towards the excessive economic behavior of the south because this behavior increased German exports and productivity at the expense of the south. Let us not forget that 40% of German exports are headed towards other members of the Euro zone. Germany tried in effect to hold both melons under the same arm and failed. Fiscal conformity was needed for the stability of the common currency as there was no other way to keep the Euro stable should the need arise (lack of an effective risk sharing and convergence mechanism). But boosting German exports was deemed as even more desirable and in the end this was the policy that prevailed.

Germany, fully in accordance with its national interest, flooded the Greek market with German goods, German companies were awarded major construction and other contracts and German arms dealers sold major weapon systems to the country. This was done with the full knowledge that these goods and services were purchased with unsustainable public borrowing. Now that the Greek economy has foundered, Greece is no longer of any use to Germany and is more likely seen as a nuisance. However, Germany does not wish to seriously damage its clients; this is always bad business. Therefore, since Greece is an unsalvageable case, Germany will squeeze the lemon one last time before it discards it. Greece will serve as a black sheep, a scapegoat and a paradigm to the rest of the south so that they stay in line and do as they’re told. Since the Greek market is of negligible importance to German exports, Greece will be put to the stake as an example of what befalls those who cross German national interest. The rest of the south will receive gentler handling because business is always business and German exports require markets.

The above displayed behavior in no way absolves Greece of its own wrong doing. Greece is a country which dwells in an anarchic, competitive system of states where the self help principle is the golden rule. Other states will try to maximize their benefit at your own expense and will see your downfall if that suits their needs. It is up to Greece to pursue all the necessary policies in order to accrue more power, be it economic, military or other. Explaining the how, the when and the who offers no excuses for Greece’s failure to act towards its own survival. There is no such thing as fate, Messiahs and Divine Intervention when it comes to states. It is the actions or inactions of the state which in the end of the day make things happen.