Saturday, March 30, 2013

Prof. Paul Krugman - a Greek script for Cyprus?

Prof. Krugman recommends in his blog that Cyprus should pursue the script which he had originally recommended for Greece, namely: allow a banking crisis, follow-up on it with sharp limits on bank wirthdrawals and then - with the panic argument against Euro-exit reduced - reintroduce a domestic currency.

Prof. Krugman concludes with the question: what exactly is the point of Cyprus' staying on the Euro?

I cannot judge Cyprus but I do recall that my original recommendation for Greece was quite similar to Prof. Krugman's. One small/giant difference: I recommended that Greece should hold on to the Euro. Why? Because my answer to the question of 'what exacly is the point of Greece's staying on the Euro' is - hold on before you continue reading because my answer might shock you when looking at the economic/political mess which the Euro allegedly caused in Greece - well, my answer why Greece should stay on the Euro is that the Euro means living standard for Greeks!

From the Greek standpoint and against the background of Greece's experiences with the Drachma, the Euro is a strong currency. The Greek Euro has the same international purchasing power as the German Euro. Admittedly, that is part of the reason why the Greek economy got into so much trouble because Greeks intensified importing instead of buying Greek products (thereby damaging the domestic economic value generation). But still: with the Drachma, Greeks could have never imported so much (that is: imported living standard) as it did with the Euro. Give up the Euro and you give up living standard.

My recommendation for Greece was a bit different. I argued that 'if a Euro-exit is the worst of all evils (which it would be) and if Greece cannot make it with the present Euro-structure (which it most likely cannot), then Greece must hold on to the Euro and simulate a situation – at least temporarily – as though she had returned to the Drachma'

As (temporary) measures I had recommended: special taxes on imports in order to make imports altogether 30-40% more expensive (on a staggered scale, however: 0% for priority imports; 100% for luxury imports); selective Free Trade Zones where internationally competitive business conditions are allowed so that new domestic production for import substitution (and for export!) can be started; and capital controls. I also suggested that, during the interim, a deposit freeze with only minimal withdrawals for personal use might be necessary. 

My proposal was detailed in this article which I had first published in Austria in the spring of 2010 and later re-published in this blog a couple of times. Not knowing the Cypriot economy, I cannot judge whether this script would work for Cyprus but I maintain to this day that it would still be the best script for Greece.


  1. Please!

    The euro doesn't mean living standard. What the euro means, or rather meant (since it's not happening anymore), is that for a decade Greeks could borrow like there was no tomorrow and the currency didn't fall.

    Nothing more, nothing less.

    True, for a while that did mean increased income, although as usual with Greece, VERY unevenly distributed (basic-wage earners got next to nothing). But look where we are now, basic wages are at pre-euro levels. Yes, pre-euro.

    A currency is just a tool in order to create activity, preferably activity that benefits society as a whole. In my opinion, the fact that a German euro is equal to a Greek euro, has severely distorted the mechanisms which fairly distribute the damage that is borne out of the decisions of economic participants.

    Don't forget that while Greek producers have to compete with producers from abroad, this doesn't apply to services (i.e. a Greek hairdresser doesn't have to compete with a German hairdresser). This is another distortion which the euro amplifies.

    The drachma will save Greeks from themselves, it's as simple as that.

    1. I didn't say that the Euro brought living standard financed with equity. You are right. Most of it was financed, in the final analysis, with foreign debt flowing into the country. But that doesn't alter the fact that there was living standard which wouldn't have been there without the Euro.

      You have to be mindful that there was a transformation process: money which entered the country as debt of the state was transformed, through salaries, pensions and other state expenditures, into private equity. A public sector manager who earned, say, 10.000 Euro/month didn't have to care whether the state had to borrow in order to pay that salary. Once he collected the salary, the money was his.

      My brother-in-law started his own earth-moving business in the 1970s. In the beginning it was essentially he and his machines. His lifestyle had to be modest. As the money borrowed by the state trickled down to the village of my brother-in-law, the village could begin to shower him with orders. In the 1990s, he opened up a small building supply business. Aggregate demand, as you like to point out, exploded (driven ultimately by the flow of foreign debt) and so did his business. And with the Euro, he could buy all of his machinery & equipment at Euro-prices (instead of Drachma-prices) without tariffs. Thus, thanks to the foreign debt flow but also to the Euro, he could build up quite a bit of wealth which he could have never have built up with the Drachma (and he and his family can now live off that because he, unlike many other Greeks, did not waste that wealth by immediately spending it on consumption).

      I guess the point I am making is the same as that Greek politician's point who once said "We all ate the lunch together".

      You are right that this created terrible distortions but as long as the system worked, the distortions were very much in Greece's favor. Obviously, they were not sustainable.

      Just think about all those imported products which are important elements of living standard (cars, motor bikes, smartphones, etc. etc.). Those products could have been imported only on a much smaller scale had there not been the Euro. When my brother-in-law imported a truck from Germany, he paid for it with his own money and would have never thought that, in the final analysis, foreign debt stood behind his purchase. In fact, he would be offended if I tried to explain to him that without the foreign debt and without the Euro, he could never have built up as much wealth as he has. He was literally a workaholic and worked incredibly hard so, in his mind, whatever wealth he had built up he had earned through his hard work. Not false, but not quite true, either.

      We can all guess how much the Drachma would devalue if Greece went for the Grexit. The number of 40% is often mentioned, so let's work with that.

      All those imported products which are key elements of living standard (or living joy when it comes to food stuffs) would become 40% more expensive. You don't think that this would have an impact on living standard?

      I like your phrase that the Drachma will save Greeks from themselves. With the benefit of hindsight, I would say today that the Drachma would have saved Greeks from a lot of the negative consequences Greeks have to suffer today. Not from all of them because I am sure that, with bankers' lending like there was no tomorrow, they would have lent a lot of money to Greece as a Drachma-country as well (see Hungary).

      But one should remember that Greece (and the other Southern countries) were hoping that the Euro would be saving them from themselves (and the Drachma). The Euro was expected to be that straight jacket which would force spendthrift countries to reign in their spending. Well, I guess someone made a little mistake there...

    2. "All those imported products which are key elements of living standard (or living joy when it comes to food stuffs) would become 40% more expensive. You don't think that this would have an impact on living standard?"

      No, I don't. Income has fallen to such meager levels for a lot of us, that it doesn't make a difference anymore. We simply don't make do.

      And for others (like the 30% unemployed) there's no income at all.

      Basically, the people who object to a return to the drachma are those that have amassed wealth, who would obviously rather have their wealth denominated in euros, so that they can buy these "important elements of living standard" like cars and smartphones.

      The beauty of the drachma is that the people who amass wealth because of the distortions in the economy (i.e. protected services who charge too much) are gonna amass wealth in a weak currency because the economy as a whole won't generate wealth. Thus they will bear some consequence for their unfair privileges, which they don't now.

    3. Ok, there is really nothing where I disagree with what you are saying. Clearly, the Euro-distortions were such that not all Greeks participated equally in the Euro-party and certainly not all Greeks share equally in cleaning up the post-party mess.

      A friend of mine who has very good judgement on Greece has been telling me for quite some time now that 'Greece will never change to deal with the Euro sucessfully for the benefit of all Greeks; there is no way to avoid Greece's eventually returning to the Drachma; then Greeks will be poorer, less efficient but - more happy'. The times that I find myself agreeing with him are getting more and more frequent...

      Let me share Austria's experience with you. In the post-WW2 period, Austria was always 'Germany's small relative': not as productive, not as efficient, perhaps not as smart as the Germans. Thus, the Austrian Schilling was always worth quite a bit less than the Deutsche Mark. Austria made up for its shortfalls through a weaker currency.

      In the 1970s, the socialist Chancellor Kreisky was under severe pressure from the business world (particularly from the unions) to let the Schilling go weaker so that the Austrian economy could be competitive and would not lose jobs. Kreisky had a Finance Minister (Androsch) who was a Socialist but he was also someone who understood economics and business. He pursued a policy of more or less linking the Schilling to the DM. His argument was: if we weaken our currency, we will import inflation and become poorer. The pressure on businesses to reform, to become competitive, etc. (and the pressure from his boss...) was enormous but Androsch stuck it through. And Austria's businesses indeed went through a process of increasing productivity.

      Still, Austria was much like a closed economy with closed professions and closed industries (and it had some other similarities with Greece!).

      In 1994, Austria joined the EU and the moment of truth arrived pretty much overnight. 'Closed shops' had to be opened in order to survive. Without the previous experience of living with a Schilling linked to the DM, I doubt that businesses could have accomplished that, but they did so admirably (entire industries had become superflous overnight).

      Once you become accustomed to such a process, one learns from it. With the Euro, Austria didn't wait until it happened in order to adjust. Instead, already by the mid-1990s, a large portion of Austrian banks and businesses began with 'fit-for-the-Euro' programs. Particularly the sleepy and comfy banking industry was more or less turned upside down and awakened to brutal international realities.

      To make a long story short: the fact that Austria has today an extremely productive and competitive private sector (selectively even more competitive than Germany!) is entirely due to these processes. And the overall wealth of Austrians is much larger today than it would have been otherwise. Was it sure that these processes would be successful? Not at all. I remember that, back in the 1990s, I was very doubtful that the closed Austrian economy could adjust to the real and open world.

      I cannot judge whether Greece would have the stamina to stick such a long and painful process through. My above-mentioned friend obviously doesn't think so and he is fatalistic about Greece. To me, fatalism is a word which should be scratched from the dictionary. As long as there is the slightest chance that Greece could stick such a process through, obviously at enormous intermediate costs to the population, I would not give up.

      But I can see why many Greeks have lost stamina by now to think that it is worthwhile to stick such a process through. And perhaps Greece wouldn't even succeed with it.

    4. Well done to Austria.

      However, after five long grinding years of recession/ depression, Greece hasn't opened it's economy one iota, and nor has it battled corruption. As a result, time is running out. Segments of the population are being put into real pressure, and facing the prospect of real poverty. That won't do.

      Part of the blame has to be put on the troika. Being soft doesn't work on Greece. But, hey, if they don't want their money back, what do I care.

      For the record, I don't believe that opening "protected" sectors of the economy will bring growth back. Greece will still need targeted investments and external demand. But it has to be done in the name of social justice.

    5. I agree that simply implementing certain measures like opening protected sectors won't do the job. If a system is used to operating with closed sectors (and particularly if it has become quite skillful at that!), then you can open all the sectors in the world; the system is likely to continue operating as before. It all depends how much 'off the track' a system has gotten.

      Take Italy. I maintain that Italy not only has a very large economy but also an economy where large parts of it are very strong in world markets. Mind you, they have brands and products of worldwide renown. A very large industrial sector which, during Lira times, often was a threat to the German industrial sector. Now, that system has gotton off the track since the Euro but it wouldn't take all that much to get it back on track. There, I believe, the implementation of reforms per se would work. The economy would adjust to the new situation quickly.

      To me, the Greek system has gotten so far off the track since joining the EU that reforms per se won't do the trick. There have to be reforms PLUS a managed process which drives the economy to work appropriately within the reformed situation. That's why I am so much for foreign investments. Foreign investors would greatly contribute to 'managing this process'.

      The first bank I worked for was an American bank which had 3 branches in Greece. The staff was entirely local (with perhaps 2-3 expatriates out of over 200 people). The bank was extremely happy with local staff. The same people who had worked so impressively had worked before for Greek banks. Yet, they always said that in Greek banks, they worked differently and less productively. On paper, maybe the Greek banks had similar processes and procedures as the American bank. The difference was probably how those processes and procedures were 'lived'; how the people could unfold their talents in a different corporate culture.

  2. All this is fine. However the fact remains that the Eurozone is implementing pro-cyclical fiscal policy (fiscal compact) during a crisis.

    This is a policy doomed to fail. It will only bring more private sector deleveraging, less growth, more unemployment, and ultimately bigger public deficits (due to less taxes and more unemployment benefits).

    Maybe we didn't trust the local politicians with "the printing press". But it appears that the European politicians are not to be trusted with the printing press either (albeit for different reasons).

    Right now, I would choose the local politicians as the lesser of two evils.