Monday, June 29, 2015

Grexit: The Economics

So, Greece will default on its foreign loans tomorrow and hold a referendum on Sunday.  (They are even calling it the Greferendum).  Meanwhile, the banks will be closed and people's accounts frozen. The referendum is formally a vote up or down for the austerity package offered by Europe. Informally, it is almost certainly a vote on whether to continue the status quo or state the Grexit.  It is possible that the pressure will become unbearable over this coming week and force the Grexit ahead of the referendum, in which case the vote will be moot.  But the government has frozen bank accounts until the referendum is held.  How long can such a freeze be sustained?  Well, FDR did it for four days, although many states had anticipated him.  Argentina sustained a corralito (little corral, partial freezing of bank accounts for a year, although it was forced to abandon its currency peg after a month or a little more.  So it may be possible to stave off a devaluation until the referendum, but not much beyond it if the vote is no.

So, I wanted to do separate posts on the economics, the psychology, and the politics of it.  The economics is both the easiest and the hardest because I have said it all before and don't have much to add.

To recap, if you want to ruin your economy in one easy step, just over-value your currency.  It can be a remarkably powerful tool.  An over-valued currency ruins your exports by making them too expensive.  It floods the country with cheap imports, undercutting domestic industry.  It lowers the cost of foreign borrowing and encouraged a country to run up foreign debt.  It creates deflationary pressure and thus introduces all manner of distortions as prices are being pressed downward but resist falling.  (Unemployment is one such example.  Large numbers of people working without pay are an extreme one).  And maintaining an overpriced currency requires raising interest rates to keep money in the country and thereby choking off investment.  

But devaluation is painful.  Import prices shoot up.  Foreign debts skyrocket in value, as do foreign debt service costs.  Living standards fall precipitously.  People's savings are suddenly worth much less than they were.  But the deflationary pressure is relieved.  Exports surge.  Domestic industry starts to revive when not artificially undercut.  Rapid recovery is possible.  Paul Krugman has plenty of examples to offer -- Britain, Sweden, South Korea, Argentina.  To which I would add Russia and Iceland.  The most common points of comparison given are Russia (1998), Argentina (2001) and Iceland (2008) because all of those involved huge foreign debt and a default as well as the devaluation.

And here is the thing about Russia, Argentina, and Iceland.  In all cases, the immediate impact was traumatic in the extreme, but recovery was rapid.  Russia and Argentina each saw a sudden burst of inflation with prices rising about 80% in one year (with no equivalent increase in wages) -- and then saw prices stabilize.  No one doubts that the immediate aftermath of a devaluation in Greece will be comparably traumatic.  The real question is whether recovery will follow.

It has been argued, for instance, that default and devaluation worked for Iceland, but will not work for Greece.  Iceland is a tiny country that can get away with floating on the rest of the world.  Greece, although not large, is still too big to scale up.  And besides, although Iceland had the world's most irresponsible banks, its non-financial economy was essentially sound, while Greece has major structural problems.

My main reasons for finding this argument unconvincing are Argentina and Russia.  Both are considerably larger economies than Iceland, and larger than Greece.  And both had serious structural problems, in the case of Russia, almost certainly worse that Greece at its worst.  Default and devaluation worked for them.  And over-valued currency will undermine even a structurally sound economy. And structural reforms are most easily undertaken if any loss of domestic consumption while they are ongoing can be offset by increased exports.

Countering this argument is that that if a country devalues and experiences an export boom, the pressure to undertake structural reforms will be relieved and they can continue old bad habits, as Russia and Argentina have done.  To which I can only say, so what?  Keeping another country's economy deliberately depressed in order to force structural reforms you favor is simply the economic equivalent of exporting democracy at gunpoint.  If a country wished to have economic structures the neoliberal neolibertarians disapprove of and finance them by letting its currency fall, whose business is it, really?  Structural problems will catch up with a country in the end, and it will deal with them in its own way.

Comparisons with Russia and Argentina are probably more to the point, because both are reasonable sized economies and both had serious structural problems that, in fact, they did not address.  Yet both experienced rapid recovery and robust growth after default-and-devaluation.  Once again, it is argued that both had considerable natural wealth to export, while Greece is just a pile of rocks, and that both benefited from high commodity prices at the time, an advantage Greece will not share even if it had commodities to export.  And my honest answer here has to be that I don't know.  Grexit will be very much a leap into the unknown.  But sometimes you just have to go with the devil you don't know.

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