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Morici: Why and How Greece Must Exit the Euro

Wednesday, 16 May 2012 | 10:11 AM ET
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Austerity is imposing intolerable unemployment and political chaos in Greece, and won’t permit it to repay its debts. Athens must abandon the euro and reintroduce the drachma.

After the euro was introduced in 1999, productivity growth was slower and prices rose faster in Southern Europe than in Germany and other northern states. The more competitive north enjoyed growing trade surpluses and the Mediterranean states deficits.

Trade deficits can instigate high unemployment and curb tax revenues, and to create jobs and finance social programs, many euro zone governments borrowed too much.

After the 2008 financial crisis, European banks and bondholders calculated these economies would never pay down their debts and began demanding higher interest rates on their bonds.

Greece, Italy and Portugal could not sell new bonds at affordable rates, and facing insolvency, required bailouts from richer European governments. Also, Greece imposed losses—so called haircuts—on private bondholders, but not on governments and the European Central Bank holding its debt.

For austerity and debt restructuring to work, Greece must generate new exports and curb imports to accomplish trade surpluses and earn euro to begin paying off its remaining debt.

Austerity and labor market reforms will require at least 5 to 10 years of unemployment at 25 to 50 percent to drive wages and prices down enough to accomplish the necessary trade surpluses. No government can sustain voter support for such a draconian policy.

In Asia and Latin America, governments in similar situations have permitted their currencies to fall in value against the dollar and euro, lowering prices for exports and raising prices imports, and limiting the unemployment that accompanies austerity.

To accomplish the same, Greece must abandon the euro and reintroduce the drachma.

At an initial exchange rate determined by Athens, it must quickly swap paper euro for the new currency, convert existing bank accounts to drachma, and re-denominate all domestic contracts and debts.

Then, simply let the drachma float—the new currency would fall in value enough to make Greece an attractive export platform to northern Europe, and accomplish a trade surplus to pay off its debts, now denominated in drachma.

Bank deposits would fall in value, as computed in terms of euro and dollars, and the potential for loss of wealth would cause depositors to withdraw funds and convert those to euro—a run on the bank.

To curb such capital flight, Greece must impose temporary controls on capital outflows, much as European nations did after World War II. Once the drachma settled to a reasonably stable value on foreign exchange markets, those controls could be gradually withdrawn and then eliminated.

More problematic is Greek government debt, denominated in euro, to foreign bondholders, banks and governments. International law requires those be renegotiated if Greece can’t pay in euro.

If those creditors insist on being paid in euro instead of drachma, Greece will never earn enough euros to pay them; it will be forced to default and unilaterally impose a huge haircut—perhaps 100 percent.

In the end, Greece is a sovereign state, and if compelled by Germany, the ECB and other creditor intransigence, it can impose remarking of foreign debt to drachma and whatever additional haircut it chooses.

If foreign creditors cooperate and accept payment in the new currency, the losses they take will be substantially less than the haircut they will ultimately endure if Greece continues its austerity measures and remains on the euro.

Without the euro, Greece would still be a member of the European Union—much like Great Britain and a few others who have chosen not to adopt the common currency—however, Germany and the others could force Greece to leave if it abandons the euro.

However, if Greece were denied the tariff free access to European markets as a member of the EU, the devaluation of the drachma necessary to accomplish economic stability and repay remaining debts in drachma would be much greater than if northern governments cooperated in the introduction of the drachma. That would make foreign creditors even larger than if Greece stayed inside the EU.

In the end, Greece, Germany and other Greek creditors will be better off accepting the euro has failed and helping Greece readopt its own currency.

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Peter Morici is a professor at the Smith School of Business, University of Maryland, and former Chief Economist at the U.S. International Trade Commission.

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