When leaving is really hard

Greece’s credit rating is now the worst in the world. Any non-Euro country borrowing in its domestic currency would have been able to deal, in part, with their financial crisis through depreciation / devaluation of the currency.

The burden of debt would be reduced (although many investors might see this as implicit default) and the competitiveness of local wages would be boosted through the depreciation. Increasing the money supply might stoke a little inflation, but given the economic doldrums the country is facing, it’s easy to see that there are few inflationary pressures on wages and rather an increase in labour utilisation would be likely.

A reduced-import, increased-export boom would help bring the economy back from the brink.

Of course, Greece can’t do this since they can’t print Euros and are stuck with the same currency that Germany has. And stuck with the same currency that Germany and France, in a totally different current economic position,  basically have control of given their contribution to the European economy,

In many ways, the answer is for Greece (and several other peripheral countries that are struggling) to leave the Euro. Leave forever or temporarily might be question for debate.

But can Greece “leave the Euro”? Think for a minute what that means practically. In 2002 when Greece moved from the Drachma to the Euro, a stable exchange rate was determined (in the case of the drachma, over a two month period). For a limited period, the two currencies co-existed. Bank balances were converted overnight, but coins and notes remained in circulation for a period. Joining the Euro required certain stability measures to be met, including low inflation, manageable debt and interest rates similar to that of the rest of Europe.

Greek 10 year government bond yields are now at 17%. Not exactly low and stable.

If it were announced that Greece would leave the Euro, what exchange rate would be used? Which coins and notes would be converted? Can you imagine the run on the relevant banks where individuals would want to take their Euros and keep them as Euros? (After all, don’t forget that the aim here would be to depreciate the currency! Would you want to be converted into a currency you knew was going to be depreciated?)

So at the merest hint that conversion and depreciation are being considered, we’d have the biggest run on a banking system since the Great Depression.

Greece cannot leave the Euro in an orderly manner. Therefore they will need to default more explicitly and will still likely have an extended period of economic hardship.

Consider the imaginary world where the Euro doesn’t exist, but all participant countries have agreed to pegged exchange rates and promise to maintain those exchange rates. Apart from the practical difficulties for trade compared to the adoption of the Euro, this isn’t a particularly different scenario. Countries cannot depreciate their currencies (by definition this breaks the peg) and similarly can’t increase the money supply beyond co-ordinated levels (as this will naturally put pressure on the peg, pushing speculators to short this currency and purchase others, ultimately resulting in a required devaluation as happened with Soros and the Pound Sterling). The situation with the Euro is not particularly different.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.