Exit of Greece from the euro is nonsense

2011-10-05

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Those who call for an exit of Greece from the euro have not thought of the implications or they are laboring under false assumptions. Either way the costs greatly outnumber the benefits.

There are many who advocate that Greece should exit the euro in order to escape from the downward spiral it now finds itself in. I have recently written two articles on the matter illustrating why such a position is false, but I intend to elaborate more on the matter since rumors have again intensified now that it was made public that the country will fail to meet its budget targets for this year and the next. [the previous articles are 1) Default and euro exit will destroy Greece and 2) Currency union and Greek Euro Exit]

I shall start my article by laying down the most simple parameters and progressively add more and more to paint the broader picture. First let us assume that tomorrow Greece leaves the euro and reconstitutes its national currency, the drachma. Let us also assume that there will be no impact on the rest of the euro or on Greece (those will be included as I forward my thought). For start we focus on the new currency. So what does it mean for Greece to have the drachma again tomorrow? The fact is that a national currency allows the country to depreciate the value of its currency so as to make its exports cheaper. In that sense, Greek exports, because they will be cheaper to the outer world, will be more competitive – they will sell better. But what about the imports of Greece? What will happen to their price? The imports will simply go in the exact opposite direction by becoming much more expensive. Thus in order to find out whether an exit from the euro would make sense, we need to see how much Greece imports and how much it exports, so as to compare the costs with the benefits. The fact is that Greece imports approximately 5 times the value it exports. The Greek economy looks like a reversed pyramid with exports at the narrow bottom and imports at the much broader top (see image).

The Greek trade balance

What does that reversed pyramid mean in practical terms? It means that Greece imports five times more than it exports, so overall the gain in competitiveness from a depreciation of the currency will be far less than the cost. This will have a massive impact on the Greek economy as everything will become much more expensive. Let us consider a few examples to make this crystal clear. Imagine a businessperson who owns a shop that sells clothes or shoes. Greece does not produce any of the two at least nothing of good quality, which means that the businessperson is importing the products she sells. So if the clothes she imports become all of a sudden much more expensive she will face a tough dilemma: either to increase prices in order to include part of the additional cost, or to go bankrupt. Increasing prices in an economy that is already in a recession (do not forget that – Greece is in a deep recession) is largely self-defeating as even less products will be sold. Which means that again the businessperson faces the threat of closing operations. Something similar applies for supermarkets, for shops that sell accessories for cars or bikes, for coffee shops and for basically almost everything, including farmers.

I want to expand a bit more on agriculture since many think that this particular sector can survive just because Greece was once a rich agricultural country (now it is more services-oriented). There basically are two types of jobs related to agriculture. The first is the cultivation of agricultural products (tomatoes, potatoes, grain, fruits etc.) and the second is the transformation of such products into other forms (such as wine, beer, olive oil and any other product that requires processing). The first type of business depends on a given machinery and fertilizers and other relevant goods/tools that are necessary for cultivation and collection of the crops. Greece does not produce machines, or it produces very little and of dubious quality. Same for other related goods or tools. In addition to that Greece does not produce oil (fuel) that is necessary for agricultural production. So the ordinary farmer is immediately facing increased costs for nearly everything. Now the second category, think of a wine-maker. The machinery, the bottles and anything else are not produced locally, so again the story is the same. I could expand in detail in every single sector of the economy to apply the same reasoning, but I think my point has been made clear so far.

Now let us add to the above one more parameter: employment. The Greek state does not have enough funds to support government spending in order to stimulate the economy nor to change the trade balance (that reversed pyramid) by investing in local production. Moreover it does not have the capacity to employ people. As we now see those who lose their jobs in the public sector amount to some thousands and this figure will continue to increase. This implies that many people are unemployed and they need to find a job and only the private sector is available to employ them. But to remind you of the above paragraphs the private sector is already facing higher costs in its products and will thus be more than hesitant to employ people, since that would further increase the costs. What does that imply? That unemployment will increase and will keep increasing. This has two effects. The first is that the unemployed will ask for support from the state, which means more pressure on public finances, and second they will have less money in their pockets to spend. The former suggests that the government will have to increase taxes in order to raise revenue to cover unemployment benefits (so again more cost on the economy). While the latter implies that they will not be able to buy the goods from the private sector both because they have less money and because the goods have become more expensive. This is understandably a much worse downward spiral than what Greece is already in. The only sector that will be able to absorb part of the unemployed is the tourist sector, which will however be seriously affected by the general conditions in the economy and after all a sector alone cannot possibly get the country out of trouble.

In all of the above add the extra cost on fuel which will immediately make life more expensive in general and you get the bleak picture. What I wrote so far is based on the assumption that the drachma devalues to a reasonable level which will most probably not be the case, as the most likely scenario is for the drachma to devalue in the many-fold to levels that resemble the 1950’s. If the drachma loses too much value with respect to other currencies, then all of the above become much worse.

Now let us add some more elements to the above story. What will happen the moment the Greek Prime Minister announces an exit from the euro and the re-introduction of a much depreciated national currency? Two things, first the debt of the country which is denominated in euro will increase dramatically because of the depreciation of the drachma, which makes it unthinkable to pay it back – this leads to default. Second the moment the announcement is made, people will rush to banks and ATM’s to draw their savings in euro so as not to lose from the depreciation. Hence within a few hours the ATM’s will run out of cash, while all banks will be packed with people waiting to get their money back. But as we know, banks do not have all the savings in their vaults. They only keep a portion of them and the rest they give it away in loans – that is how they make money. Thus banks will be unable to give the savings back to the people. The resulting panic can lead to all sorts of unpredictable events but it certainly implies that banks will be forced to remain closed until they have drachmas to give. A transition from one currency to another requires considerable time to materialize, which practically suggests that banks will have to remain closed for some time, directly affecting all economic activity. For a country in recession a cease of economic activity even for an hour, is disastrous as the losses would be immense. But for arguments sake let us say that the transition was prepared in secret and it happens overnight without anybody knowing.

Let us also assume that all Greek banks are prevented from collapsing by a European mechanism, probably the EFSF since they too will be victims to the depreciation of the drachma (I cannot even think of the Greek state coming to their support, since it is broke). Banks make money through people’s savings that they lend to other people and gain interest. But as we saw earlier many will be unemployed and many businesses will have reduced revenues/profits because people will be unable to buy their products and because their costs will increase. So the aggregate savings will also decrease. Thus banks will also be in trouble. This suggests that whatever savings people make will rest in the banks since they will be more than hesitant to lend it out to a stagnant economy. In short banks will act like black holes by hoarding all money that goes their way. Also they will remain an open wound for the EFSF who will have to support them for as long as necessary.

The only way Greece could exit the euro, would be if the rest of Europe was willing to support the country in any way possible (so why exit in the first place?). But can Europe really come to the support of Greece if the country leaves the euro? What will be the ramifications of a Greek euro exit on the rest of the euro countries? The story is quite long but I will keep it within a few lines. The sort of financial panic I mentioned above where people rush to get their money from the banks will also occur in Ireland and Portugal since the people there will start worrying about a similar fate for their countries. That means that a self-fulfilling process that leads to a euro exit is triggered from the inside. Moreover markets will be betting on which country will follow the path of Greece, which suggests that no matter how well Ireland and Portugal perform with their bailout programmes, they will most probably succumb to the pressures. In addition think of the pressures on Italian and Spanish bonds (Italy was further downgraded by Moody’s on October 4). They will skyrocket. In short these two countries will be caught in the eye of the storm which will lead them to the need for bailouts. But those two countries are too big to bail so Germany and the other surplus countries will prefer to bail their selves out instead leading to the collapse of the euro.

In the above paragraph I did not add the direct impact a Greek default (which would accompany a euro exit) would have on the European banking system, which already verges on insolvency as the revelations about Dexia are only the tip of the iceberg. This will simply multiply the pressures but the result is the same, collapse of the euro. If the euro collapses then no European will be able to support Greece after it exits the euro, which brings us back to the situation I described above about the Greek interior. A collapse of the euro would further worsen the current deep recession. Therefore everybody becomes worse-off and I think there is no need to drive this to its logical conclusion about the chaos in the global economy.

I left out a number of parameters that would reinforce the negative dynamics, for the sake of illustrating my point that an exit of Greece from the euro is nonsense and is parallel to a collective suicide. I understand those who are eager to provide solutions to the problems of Greece and Europe in general. I am not questioning their intentions. I am just saying that they either have not thought well of the impact that would have or they are laboring under false assumptions. Everyone must accept either she likes it or not that the future of Greece is tied to the euro and so is the future of the euro tied to Greece and to all its members.

We must all realize that there are no magic solutions to the malignancies of the Greek economy on one hand and the structural flaws of the euro on the other. An exit from the euro would only make things worse in just about everything and thus is not a solution to the problems. It is nonsense.