Sunday, October 2, 2011

Thinking aloud...

Greece and 16 other European countries decided over a decade ago to run their countries only with a foreign currency. The Euro is a foreign currency for Greece in the same manner as it is a foreign currency for, say, Austria.

What is a foreign currency? A foreign currency is a currency which a sovereign state cannot print on its own. By giving up their local currencies, 17 European sovereign states gave up their right to print their own currency.

Let me think aloud for a moment. What if Greece, for example, introduced - in addition to the Euro and not in its stead - the Drachme as a new local currency? What would be possible impacts?

The Euro remains in place and everyone who owns or owes Euros does not lose or win anything. Those who have Euros and want to continue to do their business in Euro are free to do so. Essentially, Greece would have 2 legal currencies: the Euro and the new Drachme. However, the government would from now on pay its domestic bills (salaries, pensions and all the other government expenses) in the new Drachme at the original Euro/Drachme exhange rate of 341 Drachme for 1 Euro. The new Drachme is a currency which the government can print on its own. Since printing money has something to do with inflation, the new Drachme will depreciate against the Euro if the government prints more Drachme than it has available in Euros at the exchange rate of 341 to 1.

If the government now has to pay a pension of, say, 1.000 Euro, it doesn't pay in Euro but with 341.000 new Drachme instead. If the government wants to increase salaries and pensions, it can print new Drachme. When the government is spending more in Drachme than it has in Euro at 341 to 1, it is de facto printing Drachme without any counter-value. The latter, of course, will have something to do with inflation and the new Drachme will become worth less than the equivalent of 1 Euro at the exchange rate of 341 to 1.

The recipients of government expenses (state employees, recipients of pensions, etc.) now only have Drachme to spend (unless they want to use Euros from under their mattresses or from their bank savings). When they now want to pay their bill at the shopkeeper's, the shopkeeper will want to take his price in Euro, multiply it by 341 and ask for that amount in Drachme. If the government does not print more Drachme than the equivalent of 341 Drachme for 1 Euro, things will continue as though there had never been a new local currency.

In all likelihood, the government will have to print more Drachme than it has Euros available at the exchange rate of 341 to 1, and the Drachme will become worth less against the Euro. While the Drachme amounts which recipients of government expenditures receive may go up in nominal terms, they are likely to buy less and less Euros at the exchange rate of 341 to 1. Government expenditures will become less in terms of Euros; recipients of government expenditures will receive less in terms of Euros; what they now spend is less in terms of Euros than before; and the shopkeeper will receive less in terms of Euros than before. Throughout the economy, wages and prices will decline in terms of Euros.

Imports will become more expensive in terms of the new local currency and exports will become more competitive.

A new Euro/Drachme exchange rate will develop on its own. A foreigner who would never have considered buying an apartment in Greece at the exchange rate of 341 to 1, might now consider to do that when he gets perhaps twice that amount in Drachme. A German importer who ceased buying agricultural products from Greece when they became too expensive in terms of Euro might now want to start importing again if their price in terms of Euro drops significantly.

Cross-border transactions (between Greece and other countries) will continue to take place in Euro. If the government no longer receives its revenues (taxes) in Euros but in the new local currency instead, where will it get the Euros from which it needs to honor its Euro-obligations abroad? Well, it would have to buy these Euro in the new Euro/Drachme foreign exchange market. The more domestic inflation there is, the more nominal Drachme the government will need to buy the Euros in the new foreign exchange market.

The above proposal is purposely headlined with "thinking aloud". Common sense suggests that there must be a catch somewhere. But these are certainly times where it cannot hurt to think aloud!


  1. In theory, even considering the massive legal ramifications, this should be executable. After all, this appears to be just the inverse of the Euro introduction process, where, for the first two months in 2011, both the old and the new currency were considered legal tender. Notable differences would be: the exchange rates between the old and new currencies remained fixed during the transition period, and account balances as well as legal obligations were force-converted.

    But: However interesting the idea of having two legal currencies might be, unless the government pays salaries, pensions, etc. in both, the other will be a foreign currency. Greece would have no connection to the ECB (what for? Neither could influence the other). Greece could just as well deem the Swiss Franc (or any other currency for that matter) as a second legal tender.

    The keyword above is 'transition'. Practically speaking, it should be clear now that in the medium-term, the proposal above is effectively equivalent to Greece exiting the Euro. That would certainly help Greece out of its current dilemma (as you outline), but it would be an exit nonetheless and as such unacceptable to the stronger members of the union (at least according to their current position).

  2. Greece would remain a member of Euroland. This is a conditio sine qua non because otherwise Greece might as well leave Euroland.

    The trick is that the government must pay its domestic obligations ONLY in Drachma, albeit at the original Euro/Drachma conversion rate. That way, inflation occurs only in Drachma. The government could collect its revenues (taxes) in Euro or in Drachma, at the option of the payer. But who would want to pay in Euro if he can pay in Drachma? That way, the government's payments inflate less rapidly than its revenues; there is more of a Drachma shortfall for the government; the government needs to print more money and the Drachma will definitely decline against the Euro, albeit not as rapidly as it normally would.

    There would not have to be a transition period. During the original Drachma/Euro conversion, a transition period was necessary because the transition was to a fixed currency.

    Greece would continue its connection to the ECB because cross-border transactions will continue to take place in Euro. In secected situations, the ECB could be a lender of Euros of last resort.

  3. Some counterpoints:

    1) A permanent duality would be completely against the principles of the currency union (which, as its name indicates, is unification). Either you're in (if you satisfy the criteria), or you're out. You have a choice, but you can't have it both ways.

    2) A system in which the ECB does not have absolute control over monetary policy is clearly in violation of the aforementioned principles.

    3) There is no need for a connection to the ECB for cross-border transactions and so forth. There are plenty of other non-Euro member states in the EU (most notably the United Kingdom) which get along quite well. Being a member of the EU is key, being a member of the currency union is not (again, as demonstrated by the few member states who were eligible but opted not to join).

    4) Even though the idea of fixing the original Euro/Drachma rate, sounds clever, coupled with the expected inflation it is, amongst other things, effectively a slashing of salaries, pensions, etc. But, in contrast to the 'regular' austerity measures, the exact outcome is unknown. No such law will ever pass a parliament (who in her right mind would ever agree to a deal where she has not the foggiest idea what she'll get out of it?)

  4. Careful. I am answering this with kind of negative logic.

    The only catch would be Gresham's Law

    But that would also not work.

    Two bad currencies, where both the Euro and the Drachma can be printed at will, makes this option workable.

    Europe’s main problem is an overvalued Euro.

    Euro devaluation would make the Euro unacceptable to countries which are using Euro as reserve currency.

    Tough choices ahead.

  5. Introducing Drachmas while retaining Euros will do little if anything to alleviate the crushing burden of debt which Greece is facing.

    Instead a new Drachma can be introduced at the rate of one Drachma to one Euro. It ill not take long before the new Drachma will be worth something like 25 to 50 Eurocents, if not less. Thus the banks and other creditors will get an automatic "haircut" and be paid in non-convertible money. They will have to find a way to repatriate the payments.

    A new Drachma will not only get the debt burden off Greece's back, it will enable the state to meet its onerous obligations and for the economy to recover, as "exports", like tourism, will become attractive, while imports will become expensive. Leaving the EU will enable Greece to reintroduce customs and and import duties.

    In short, the solution to Greece's problems is to turn the clock back to the year 1955, in which the now discredited Spyros Markezinis devalued the Drachma from 15 to 30 to the Dollar. This started a period of growth and parity with the Dollar was basically maintained until Greece joined the EC.

  6. I approach the problem from a different point which is (bluntly): I don't give a damn about the debt aspects in the first instance because that debt is there and is going to be there whether we like it or not. We can do a lot of financial engineering à la Sub-Prime but we know that the underlying poor housing loans didn't get any better because of the financial engineering.

    My nearly one-track-mind question is: how can the borrower (not only the Greek state; the entire Greek economy) become strong because only a strong economy can service its debt.

    I agree that a return to a new Drachma would dramatically improve the workings of the Greek economy in a hurry. I think an oderly Euro-exit could have been made a couple of years ago and it probably can be made in a couple of years when things have quieted down a bit. My worry is not the economic chaos which would happen in case of a Euro-exit right now (even a disorderly one). It's going to be chaos for a while in Greece one way or another. My worry is the political risk. To put it bluntly: I think a Euro-exit at the present time of hardship for many Greeks would have a high chance of leading into anarchy; and I really mean anarchy!

  7. Dear kleingut,

    I agree that the size of the debt is unimportant if Greece goes bankrupt (which is a very likely prospect). Whether Greece goes bankrupt with a huge debt or an even bigger debt will make no difference to this country. It will make a difference to the banks which hold Greek debt, and to the countries which have to bail out the banks.

  8. The link below refers to an article by Udo Neuhäusser where he suggests the implementation of a New Drachme as a parallel currency. While my above thoughts fall into the category "thinking alound", Neuhäusser's proposal is professional and complete.