Why depreciation is the wrong medicine for the Greek economy

At an event in Hamburg in February 2016, German Finance Minister Wolfgang Schaeuble mentioned the suggestion he had offered Finance Minister Evangelos Venizelos in 2011 for a short-term Grexit. Schaeuble’s rationale, among others, is that exiting the euro would allow the country to depreciate its currency. This would be a one-off blow to the Greek economy, which would spare the country the “never-ending procedure” of austerity measures, he argued.

Behind this seemingly sensible argument, however, there lies a bitter truth: Devaluing a country’s currency helps the economy to return to development and raise employment, but only under certain conditions, which Greece, unfortunately, does not fulfill. And should the country desire to acquire them, the financial “pain” would be the same, if not worse, than that caused by the memorandums. The difference is that now the country is a member of a strong, globally acknowledged currency, whereas with the drachma the Greeks would have to pay an additional charge, in the form of austerity measures, so that the new currency’s credibility could be established. 

The recurring talk of a return to the drachma shows that the theoretical arguments in favor of this are not sufficiently convincing. Let us take a quick look at what happened in three previous cases, in Greece, Britain and Indonesia. In Britain the depreciation of the 1990s was successful because the country’s economy is based on exports. In Indonesia in the same period the depreciation turned into a deep depression, with GDP dropping 14 percent and high inflation, because it did not manage to increase exports. 

In Greece, revisiting the drachma’s history over the last 50-60 years allows us to draw the following conclusions: 
First, from 1961 until 1973, when the currency was fixed at 30 drachmas to the dollar, the average annual growth rate was around 7 percent. 

Second, from 1974 a gradual depreciation of the drachma started, reaching its peak during the 80s and lasting for a good 15 years. During this period, the drachma depreciated by 70 percent while average annual growth dropped to zero. In addition to this, despite the accrued depreciation of 70 percent from 1980 to 1990, and in spite of the two official depreciations of 15 percent in 1983 and another 15 percent in 1985, net exports dropped and the trade balance deficit soared. In other words, competitiveness was diminished. At the same time, inflation reached 25 percent and interest rates hit 35 percent, putting a stop to any commercial activity. 

Third, the 1983 depreciation of 15 percent was followed by a 1.1 percent recession that year.

Fourth, the 1985 depreciation of 15 percent brought about 2.5 percent growth that year and barely 0.5 percent in 1986, to be followed again by recession (-2.3 percent) in 1987.

This is more or less how the 1980-90 decade was lost, between two depreciations and zero growth. This is why stability programs (austerity measures) were introduced by the then economy minister Costas Simitis. These programs were deemed necessary for the stabilization of the economy, following the official depreciations of 1983 and 1985.

Fifth, after 1998, the country prepared to join the euro and the economy’s behavior changed. The 1998 depreciation of 12.6 percent did not bring about a recession. Neither did the 2000 drachma devaluation of 3.5 percent (in view of the euro). On the contrary, the association of the drachma with the “powerful” euro brought annual growth of approximately 3.5 percent and inflation of less than 3 percent that lasted for around 10 years.

Harsh reality together with economics teach that the devaluation of a currency may help, provided that the country does not import more than it exports, and mainly that it does not import a lot of raw materials or intermediate materials that have to be processed. A country with such issues that proceeds with depreciation will be plagued by inflation. 

That is what happens when the wrong medicine is prescribed. The depreciation of a currency is aimed at making exports cheaper. The rise in exports will lead to a production boost and this in turn to a rise in employment. This chain of events leads to an increase in commercial activity, through investments, brisker consumption and higher revenues. 

What can go wrong in this chain? When a country has no production and imports more than it exports, then depreciation makes exports more expensive. If, for example, a textile factory imports fibers and dyes to export finished material, the depreciation will not make it more competitive, it will shut it down as the yarn and the dyes will become too expensive. 

So in a country with a negative trade balance that imports a lot of raw materials, depreciation raises production costs and creates inflation. The raised production costs annul part of the competitiveness that was achieved by the depreciation. Should the inflation be transferred to salaries, then all the gains from the depreciation will be lost because, in the end, nothing became cheaper. 

Harsh austerity a one-way street 

The steps that a country such as Greece should take if it wants to engineer a successful depreciation are the following: 

First, there must be no rise in salaries. Nominal cuts might be necessary. As a result, the inflation rate would be equal to the reduction in real income, in the best of cases.

Second, a change of the financial model – i.e. the country must switch from an imports model to an exports model. This cannot happen overnight. Many businesses will have to shut down and the labor market will see great changes, such as deregulation of markets and services.

Third, because borrowing will become more expensive, the budget will have to be balanced as much as possible. This means there must be no deficits. Additionally, higher taxes and spending cuts will be imposed. However, the drachma and depreciation might deal with the issue of competitiveness (and growth), provided that some conditions are met; but it does not solve the problem of funding. Moreover, if new money is minted, this will result in inflation, whose rate will have to be automatically turned into cuts in salaries and pensions. Otherwise, if raises are allowed, then more new money will have to be printed, inflation will rise again and a new depreciation will be necessary for a cheaper economy… a vicious cycle that will end either in bankruptcy or harsh austerity measures. 

In other words the measures mandated by the memorandum would be inevitable and would have to be implemented strictly – but without the funding that came with the memorandum. In any case, right now there is internal devaluation taking place within the eurozone. If Greece did not have the euro, a tough economic adjustment program through austerity measures would still be necessary. Otherwise, the inflation due to depreciation would offset the benefits of the competitiveness after the depreciation. Now, Greece in the euro area cannot depreciate its currency in order to make its products and services more competitive. But it could directly reduce the prices of all components of the domestic GDP. To put it simply, if you cannot increase the purchasing power of others, you must decrease your own.

In other words, the first step toward fiscal consolidation is recession through austerity measures. Economic theory sometimes seems to adopt medical tools. Scientists have harnessed the powerful side effects of natural toxins for use in medicine, such as snake venom to control hypertension. In the correct dosage, this toxic substance has a good side effect that controls the blood pressure. In a higher dosage, it can be lethal.

During the recession period (the “good” side effect of the medicine dubbed “austerity”), the country should implement all necessary reforms which will provide a base for the upcoming sustainable recovery. This is the reason why the government must implement the reforms as soon as possible aiming at ending the recession period on time; not earlier because competitiveness will not have been restored, nor later because the economy will be trapped in a spiral of recession. As some doctors say, a painkiller may reduce your headache, but an overdose may kill you. In any case, the problem was not the painkiller but the way it was used.

Greek governments have preferred to accept austerity measures particularly through tax increases and reductions in pensions and wages rather than proceeding to reforms and speeding up the implementation of the MoUs. Instead of this, they entered into long-term and overnight negotiations with the troika in an attempt to postpone the political cost of the reforms for later. Thus, the recession period was prolonged, the debt increased, the financing needs remained unmet. This tactic leads to new MoUs and the prolonging of the recession period and increases the the chances of spiraling into recession and default. On the other hand, without a new MoU, a default can be considered a certain outcome.