The continuing financial difficulties of Ireland, Portugal and particularly Greece-all of which were bailed out by the International Monetary Fund-have led some to ask the unthinkable: Does it make sense for Greece to leave the euro zone and go back to the drachma, the currency it had before it adopted the euro in 2002? Although it is difficult to answer this question unambiguously, some understanding of economics does shed valuable light on the underlying issues.
First, some facts. Relative to economic powerhouses such as Germany and France, Greece has always been a straggler. In addition, past Greek governments have kept promising generous benefits to the country’s citizens. This required governments to significantly increase public spending even though income tax receipts and other revenue were not sufficient to balance the budget. Tax evasion was and continues to be a major problem in Greece.
When Greece adopted the euro in 2002, the serious budget imbalance did not ring alarm bells for politicians because they were able to borrow on the international market to finance the increased domestic spending. And borrow they did. This unrestrained borrowing, combined with an inability to pay creditors and a recessionary economic environment, is the source of Greece’s current sovereign debt problem.
The severity of the problem was recognized by the IMF and the European Central Bank, and the IMF bailed out Greece in 2010 with a non-trivial rescue package. Even so, reductions in domestic spending and increases in taxes have not yet had the desired effect. Therefore, Fitch, a rating agency, recently cut the nation’s debt rating by three notches, and the yields on Greek 10-year bonds in May reached 16.8 percent, which is more than twice what they were a year ago. This makes it highly unlikely that Greece will be able to borrow on the international market, so it looks very likely that the IMF and the ECB will have to deal with the Greek debt problem once again.
A second bailout will almost certainly come with requirements that will be extremely painful for Greece. As the prominent economist Martin Feldstein has noted, the required reduction in the fiscal deficit will plunge Greece into a deep and prolonged recession that, as a member of the euro zone, it cannot offset with a currency devaluation.
This inability to devalue the currency is a key part of the problem for Greece. The Economist has pointed to some options for dealing with Greece’s debt problems. One would be for the IMF and euro-zone nations to provide fiscal transfers and bailout loans. A second option would be to ask banks and creditors to "volunteer" to roll over their holdings and maturities of Greek debt.
Although these options would buy Greece some time, they would be difficult to sell to European-particularly German-voters, and they do not address the underlying solvency issue. The only meaningful option now is to allow Greece to restructure its debt. This would immediately bring down the nation’s debt burden but also would impose large losses on private creditors. This is probably why the ECB is opposed to this sort of restructuring.
If debt restructuring is not an option and Greece is punished with further austerity measures, then it would face many years of prolonged economic pain with large spending cuts, high taxes and massive unemployment. A single European currency denies Greece the ability to adjust its monetary policy to local conditions; it eliminates the natural response of the currency to what Feldstein calls "shifts in global demand and in productivity trends"; it encourages Greece to run large fiscal deficits; and it does not allow Greece to reduce its large fiscal deficit with a currency devaluation.
Given this state of affairs, it makes sense for Greece to exit the euro even though there would be certain short-term costs. More generally, it looks increasingly likely that in the next decade, one or more nations like Greece will either voluntarily or involuntarily leave the euro zone.
Amitrajeet A. Batabyal is the Arthur J. Gosnell professor of economics at Rochester Institute of Technology; these views are his own.
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