Eurozone (EZ) countries formally approved on Wednesday 14th of March a second, €130-billion, bailout for Greece that will keep the Greek government funded until 2014. This “historic agreement” came amidst many voices from academics and policy think tanks arguing that Greece may be better off by exiting EZ and regaining control of its (new) national currency. In fact, the debt crisis in EZ has given rise to a debate over the advantages and disadvantages of a monetary union membership, especially for countries such as Greece, Portugal and others.
This debate is not new. In the years leading to the institution of the European Monetary Union (EMU) there had been a heated debate on the pros and cons of a country entering a monetary union. This debate will almost certainly resurface in the run-up to the forthcoming elections in Greece.
The basic economic arguments in favour of entering EMU are:
Adopting the Euro will make it easier for businesses and consumers to compare relative price levels across member countries. That is, being part of EMU would increase price transparency. This will facilitate intra-union trade and increase the competitive pressures across member countries and markets. As this will lead to lower prices, entering EMU will potentially have gains in terms of consumer welfare.
A related argument comes from the fact that joining the Euro will reduce exchange rate uncertainty, and lead to lower transactions costs for companies and tourists. Membership of Euro can thus have a further boost in consumer welfare, directly through lower costs, or indirectly through higher corporate profits and hence paid dividends and corporate tax revenues. Reduced exchange rate uncertainty and transaction costs will also lead to increased trade flows. This will further stimulate competition in markets for goods and financial services.
The potential gains from lower transaction costs were estimated in 1990 by the European Commission at around 0.1-1 percent of EU GDP, with the actual savings varying with the size of the countries.
Estimations of the gains in terms of increased trade flows vary. However, even conservative estimates point to significant trade gains. For instance, research in 2001 by T.Persson and co-authors, which that corrects downwards earlier work by A.Rose and (joint work with) J.A.Frankel, find 60% trade gains in the long run from joining EZ. Under a 2002 estimation by Frankel and Rose that 1 percent increase in total trade (as a share of GDP) raises per capita income by 1⁄3 of 1 percent, we thus have that adoption of Euro could potentially raise GDP in the long run by 20 percent. The UK government estimated also in 2003 that if UK were to join EMU, and certain flexibility and sustainability requirements were met, it “could enjoy a significant boost in trade with the euro area of up to 50 percent over 30 years and that UK national income could rise over a 30-year period by between 5 and 9 percent.” Even after restricting attention to short-run gains and of materialised gains by EZ members so far, Euro adoption could raise GDP by 2 percent over 20 years.
The increase in competitiveness by joining the Euro will also increase businesses’ incentives to innovate and invest in R&D. Higher investment will enhance productivity. Higher competitive pressures due to increased trade flows could also help to promote supply-side reforms in member countries and encourage specialisation, which will further increase productivity.
By removing currency barriers to trade, a country potentially faces improved access to foreign funding. Thus, EMU could also facilitate investment flows within the EZ.
Membership of a single currency area increases also the competition for inward investment both from within and outside the EZ. Such competitive pressures will further increase the scope for supply-side reforms and, in particular, for enhancing the flexibility of labour markets. The reason is that flexible labour markets are highly effective in attracting foreign direct investment. In a study by the UK Department of Trade and Industry of primary data, generated from a questionnaire distributed to 1800 trans-national companies, all of whom possess existing production facilities in the UK economy, it was found that “labour market flexibility identified as representing moderate or high degree of importance by 60 per cent of respondents.”
An Increase in inward investment and the enlargement of markets will also imply an increase in the productivity of labour. Thus, EMU membership will also lead to higher wages and employment, and hence to long-term benefits for households.
Taking this broader (and harder to quantify) range of benefits into account, recent studies that focus on Central European countries, specifically on Hungary and Poland, find that adopting the Euro could add 0.3–0.9 percentage points to average GDP growth for 20 years.
In a monetary union, inflation is the responsibility of an over-arching central bank - the European Central Bank (ECB) for the case of EMU. Because of this, monetary policy may not always follow narrow national interests. In this way inflation is insulated from national politics and electoral cycles. This delegation of monetary policy will thus enhance price stability and maintain interest rates at low levels, and hence further boost investment. These effects have been more than obvious for countries such as Greece and Italy. For instance, the nominal interest rate on 10-year Greek government bonds dropped from around 20 per cent in 1994 (when it was announced by the government that Greece will aim at entering EZ in 2001) to less than 3.5 per cent in early 2005. Inflation, which averaged almost ten per cent in the decade prior to EMU entry, was only 3.4 per cent on average over the period 2001 through 2008.
However, economic reality is often much more complicated and unpredictable. For instance, politics play a central role on the kind, if any, of reforms that a nation adopts. Interest groups such as labour unions may be strong enough to block reforms that run against their interests. Existing institutions and bureaucracy could also hinder the administration of policies, and prove to be an important obstacle for inward investments. Consumers and national governments may abuse the availability of loans at low interest rates. Banks, in the face of competitive pressures, may adopt practices that involve excessive risks. Recessions occur, and can hit countries differently depending on the flexibility of existing institutions and the sector-specifics of economic downturns. These are not arguments against EMU membership per se. Rather, they are reasons why materialisation of benefits can delay, and why countries might need to delay entering EZ until their economy has been adjusted and prepared for entry. They are also reasons for increasing fiscal cooperation within EMU, and harmonising tax and pension systems.
For many experts, a combination of the above factors has been the main contributor for the debt crisis in EZ. What is interesting, however, is that this crisis has also brought up some (new) arguments for why exiting a monetary union can be very problematic, especially in times of economic distress. We outline these arguments with reference to a Greek exit, though many of them apply also for other EMU member countries such as Ireland, Italy, Spain and Portugal.
To start with, exiting EMU would have an irrecoverable damage on the credibility of the eurozone. A pre-requisite for the achievement of currency certainty we have discussed above is that markets perceive the exchange rates between member countries as permanently fixed. Having a country exiting the EZ would mean in effect that exchange rates within EMU are not permanent, with profound consequences for price transparency, levels of exchange rate uncertainty and transaction costs, and thereby for trade flows and competitiveness across EZ.
Another major damage of Greece exiting EMU would be to the credibility of the bailout process. Markets would start questioning the ability/resolve of eurozone politicians to manage the Portuguese, Irish, not to mention the Spanish and Italian crises. The bailouts of Portugal (€78bn in May 2011) and Ireland (€85bn in November 2010) were designed to assist both countries until they could borrow in the markets again, just as with Greece. Investors may thus question whether the same solution will work for the other bailout recipients. The borrowing cost of these countries will skyrocket to the levels Greece has been experiencing for the last two years, making a default by these countries a foregone conclusion.
If Greece reintroduces the drachma, everyone in EZ could be affected. Any unilateral exit from EMU would prompt panic in other EMU countries that are in trouble. Citizens in countries such as Ireland could easily assume that their governments might follow suit, with negative consequences for consumers’ confidence in keeping their money domestically.
A new drachma would devalue to such an extent (more than 50% according to some experts) that the Greek debt liability (around€260bn after the recent “haircut” of 105bn Euros) would explode, given that Greek debt is denominated in Euros. In all certainty, this will lead to a default on Greece’s public debt, which will cost the Greek banks around €30bn (taking into account the recent “haircut” of 50% on average).
The chain reaction will be profound. The ECB will have lost around 150 billion Euros (because of money owed by the Greek banks and the Greek bonds that ECB has purchased since May 2010). EZ member countries will have to recapitalise the ECB. There will also be a very high risk of a domino effect onto Eurozone’s banks, as they own a big share of the Greek debt as well as of (private) debt issued by others who have lent to the Greek government. According to figures from the Bank for International Settlements, when you add in other forms of Greek debt, such as lending to private banks, pre-haircut exposure of private banks amounts to $14.6bn for the UK, $34bn for Germany and $56.7bn for France. Even after taking into account of a “haircut” of 60% on average, it is clear that a domino effect will give rise to additional debt problems in EMU and additional pressures for propping up private banks across EZ. Economic activity will plummet across EMU and by implication the European Union (EU). Countries across EU will face an unprecedented recession, with countries such as Germany and UK hit the hardest due to their high volumes of trade (around 40% of trade) with (other) EZ countries.
In addition, the remaining currency union will be left with a Euro whose value will skyrocket, propelled by the collapsing exiting economies and an ensuing currency war. This will lead to a massive drop in the exports of Germany and its remaining partners, and a further dip in economic activity.
To make things worse, a Greek exit could increase free-riding behaviour within EMU, as other countries might perceive that it is possible to run excessively expansionary policies and subsequently exit the currency union to devalue their debt.
The above effects on EU and EMU countries of Greece exiting EMU in the current economic environment lie, in fact, behind the two bailouts of total value of €240bn offered to Greece to date. They also lie behind voices within Greece that urge for a return to drachma, hoping that such a threat will force Germany and other “like-minded” countries that push for strict austerity measures to accept bigger losses for their banks and taxpayers, and support alternative measures such as the introduction of a Eurobond.
Preventing similar “hold-up” problems in the future by EZ member countries can explain the hard stance many fiscally disciplined EMU members have adopted against Greece. However, another reason for this could also be that a threat of Greece exiting EMU may be “empty” because of the catastrophic consequences such decision will also have for Greece.
Following an exit from EMU, there would be a significant increase in exchange rate uncertainty vis-à-vis the eurozone, which would imply a loss of inward investment funds and hence a significant decrease in wages and employment. Reintroducing the drachma would also have negative implications for price transparency. Competition and productivity-enhancing investment would thus suffer. Long run inflation rate would once again be under the control of domestic politicians (as it was prior to joining the Euro) and hence prone to electoral incentives. Indicative of this is that the Greek inflation rate was over 20% in late 1980’s, following overly expansionary monetary (and fiscal) policies prior to national elections.
Capital controls would have to be introduced to prevent the movement of Euros outside Greece in the run up to re-introducing the drachma currency. This would call into question the country's EU membership itself and the loss of all the socio-politico-economic benefits that come with such membership. Benefits that are well accepted even by countries who doubt the desirability of EMU.
Greek politics have been marked by a drive to bring the country closer to Western Europe than Eastern Mediterranean. Therefore, exiting the Eurozone and not being at the core of European integration would be seen as a political suicide. Greece would loose its status as a major investor in Balkans and Eastern Europe, and hence as an important actor in this volatile region. For example,12% of foreign direct investment in FYROM in the period 1997-2009 was Greek, while Greek investments in Serbia, Bulgaria and Romania total at around €6bn. Accordingly, factoring in the geo-political characteristics of Greece and their interaction with its neighbours’ EU membership should be enough to send shivers down the spine of Greeks.
As we have already mentioned, exiting EMU would almost certainly be followed by a default, which would also be catastrophic for the Greeks themselves. A default would cut off rescue loans from the EU and IMF to the Greek government, and from the ECB to the Greek banks. The key observation here is that the Greek government has consistently been earning less in tax revenues than spending (even after excluding debt payments). As a result, the Greek government would be unable to pay for basic functions of the state (though Greece's primary deficit has been decreasing lately following the austerity measures of the last two years - currently being at around 2% of GDP). This would bring about more revenue-raising measures, and a further massive blow to domestic activity.
More importantly, the Greek government, having no access to external funds, would have no money to rescue Greek banks. The economic upheaval by a bank run (or rather the prevention of it by banning withdrawals and freezing banking accounts) on exiting EZ would be devastating. The collapse of the banking sector coupled with the shutting down of basic state operations would push the country's economy even deeper into recession. Tax coffins would drain and spending on benefits would plummet bringing even more despair to the less fortunate economic groups in Greece.
To make things worse, Greece's current account deficit, which measures the trade deficit, is currently around 10% of GDP. That is, Greeks spend around 10% more than what they earn from selling their own products abroad, and all this despite the spending cuts in the last two years. This is a symptom of low competitiveness, which as we have hinted earlier is a result of a badly organized domestic bureaucracy, very strong unions and interest groups. In fact, in the period 2001 - 2009, competitiveness declined by around 20-25% (with the lower number corresponding to a measure by consumer prices, and the higher number to a measure by unit labour costs). A current deficit requires an economy as a whole to attract an equivalent amount in financial investments from abroad. Such investments take mainly the form of lending. Crucially, most of the Greek current account deficit consists of imports of basic goods that are not produced domestically and of necessary inputs for domestic production such as fuel, chemicals and machinery. Therefore, having no access to external funds would paralyse the country in the short run.
And this onerous situation would continue for as long as the much needed supply-side reforms do not take place, unless the Greek government allows the (new) drachma to plummet vis-à-vis other currencies in an attempt to regain competitiveness and eliminate its current account deficit. Nevertheless, though this might seem an attractive option, it would be an extremely painful one.
Import prices and inflation will skyrocket. An example of what may happen comes from the 2008 banking and currency crisis in Iceland. The Icelandic krona lost around 40% of its value in one summer. Interest rates reached 15%, and inflation climbed at 14%, very quickly. In fact, many economists do expect a rapid devaluation of the new drachma of at least 50%. Living standards would be hit hard, as Greeks would be rushing to spend their drachmas before their value erodes further due to subsequent devaluations and increases in the inflation rate.
Of course some could argue that these short-run costs will soon be outweighed by the increase in competitiveness, the attraction of foreign investment and the return to positive growth rates. However, modern Greece is mainly a service economy: agriculture accounts for 3.6% of GDP, industry for 18% and services for 78.3% (2011 est.), The main sector that would benefit from an episode of severe devaluation would be the tourism industry that accounts for roughly 20% of GDP. But there are limits to how much the tourism industry can expand and absorb, especially in the face of similar incentives on the part of Portugal and Spain, and fierce competition by other Mediterranean countries. Unless the necessary reorganisation of the Greek state takes place and labour markets become more flexible, it is hard to argue that Greece has any credibility in terms of attracting foreign investment.
I have argued that the economic effects of Greece exiting EMU will be devastating both for Greeks themselves and their European partners. However, paradoxically, it is the nature of these effects that makes a quick solution to the debt crisis in the Eurozone very difficult. One - unfortunate - reason is that a divide between North and South Euro members seems to have emerged with each side trying to avoid bearing the biggest part of the costs that are needed to resolve the crisis. Another reason is the complexity of the situation with various proposed solutions often having counteracting effects on different dimensions of the problem. In any case, I do hope that Europe comes out stronger from this crisis.