Greece’s Least Bad Option Looks to Be Internal Devaluation: View

Bloomberg editorial view

… because the immediate costs of an exit would be enormous…

… resurrecting national currencies and regaining control of monetary policy would create as many problems as they solved….

… chronic trade deficits, which must be financed through continued borrowing…

… leaving the euro would be an even bigger economic disaster…

… the new drachma would instantly depreciate…

… A combination of increased value-added tax and lower payroll tax (Greece could easily do both) mimics a currency devaluation…

… They must hold growth in wages to the euro area’s rate of inflation plus any increase in national productivity…

Greece and some other euro-area economies face years of financial struggle even if they manage to restructure their debts. Their prospects are so bleak that, according to one school of thought, they would be better off outside the euro system, despite the immediate costs of leaving.

We disagree, and not just because the immediate costs of an exit would be enormous. Even after that penalty was paid, resurrecting national currencies and regaining control of monetary policy would create as many problems as they solved.

The euro secessionists’ reasoning goes like this: Suppose Greece somehow resolves its short-term debt problems through default or other means and brings its budget deficits back under control. It will still have to deal with a crippling lack of competitiveness.

Labor costs in Greece have risen much faster in recent years than in Germany and the rest of the euro core, making its exports expensive and imports cheap. The result is chronic trade deficits, which must be financed through continued borrowing.

If Greece still had a drachma to devalue, it could cut the price of its exports and raise the price of its imports that way. Because it doesn’t, it has to restore competitiveness more brutally: by cutting wages, which in turn requires persistently high unemployment to suppress workers’ bargaining power. The present recession is bad enough, goes the argument. Extending it indefinitely would be politically impossible and an economic disaster. That leaves an exit from the euro system as the only choice.

The trouble is, leaving the euro would be an even bigger economic disaster. It would cause a run on Greek banks as depositors rushed to move their euros abroad before the balances could be converted to drachmas. Also, Greek borrowers would still owe euros to foreigners. Because the new drachma would instantly depreciate, the borrowers would have a diminished capacity to service those debts, causing new waves of bankruptcies.

On balance, debt restructuring plus “internal” or “fiscal” devaluation -- difficult as it may be -- looks preferable. Explicit wage cuts, and the recession needed to induce them, don’t have to carry the whole burden of cost adjustment. A combination of increased value-added tax and lower payroll tax (Greece could easily do both) mimics a currency devaluation by raising the price of imports relative to the price of exports, lowering real wage costs by stealth. They should be part of the mix.

True, once the accumulated cost gap has been closed in this way, Greece would have to maintain competitiveness by keeping wages under tight control. In this ongoing effort, a floating exchange rate might look helpful, but in practice it would be a mixed blessing.

In theory, persistent cost inflation can be smoothly offset by a steady devaluation of the currency, but many countries have found controlled depreciation hard to achieve. The typical result is high and variable inflation, recurring currency crises, fluctuating competitiveness and needless economic uncertainty. This experience is what commended the euro to many countries to begin with.

Inside the system, the peripheral countries have learned a harsh lesson: They must hold growth in wages to the euro area’s rate of inflation plus any increase in national productivity. In countries such as Greece, this demands a new approach to wage bargaining by employers and unions. Overall, though, it should be no more difficult than managing a floating currency. And on this path the reward for success is greater: lower inflation rates and, with luck, faster economic growth.

None of this alters the fact that Greece, so slow to learn the new rules, would have been better off not joining the euro system in the first place. But it did join, and its best bet now is to make it work.

To contact the Bloomberg View editorial board: view@bloomberg.net.