Goldman Sachs has argued that the transition of Greece to its new currency won't improve things; on the contrary, it is likely to make things worse. The main problem is that no one would be willing to hold such a new currency so all the meaningful trade would occur in harder, existing currencies.
No, this guy isn't Pythagoras. It's his former boss, Zeus.
I completely agree with that. And unlike many fellow Euroskeptics, I don't really believe that Greece would be doing well or substantially better today (financially) if it had not switched to the euro. In the long run, as long as we have two currencies that are sustainable as major means of payment and storage of value, the conversion from one to the other is just a matter of a change of units – just like the conversion from pounds to kilograms and vice versa – and it doesn't change any underlying dynamics.
That doesn't mean that I necessarily assume that Greece will be able to keep the euro – something that the Greek electorate prefers because they realize that the euro is a major magic bullet allowing the nation to live as a bunch of freeloaders sucking the blood from other (mostly European) nations. But if they're forced to switch to a new currency, it won't be a step that will improve their lives.
Let me be add a few more words about these ideas.
We may begin with the future drachmatization. Why won't it be a great thing for the country?
You must understand how and why currencies were born. People began to store gold, silver, or marten pelts because they had some quasi-certainty that these old commodity currencies would allow them to delay the consumption and later, they may be employed to buy a certain amount of stuff that they would need to survive – or to preserve their luxurious lifestyle they are used to.
That's why precious metals and similar scarce objects were used as early currencies. Later, nations were switching to the paper money that were first backed (mostly) by gold, and only when these systems got sufficiently stable and reliable (because lots of habits, price stickers, and future contracts implicitly assuming some expected or stable value of the currency in the future), the money could have been disconnected from the gold and the true fiat money systems were born.
But if you are a nation that is pretty much broke and you issue a new currency, people will inevitably ask: What is the actual value of the banknote? How much oil can I buy for that? And what will the value be next Christmas? These are important questions – they are the most important and literally existential questions connected with any currency. And if the answer is highly uncertain, it may be translated as "quite possibly nearly zero".
And if the answer is "quite possibly nearly zero", it means that no one – no Greek citizen, no Greek company, and even more clearly, no foreign citizen and no foreign company – will be willing to store this new currency. So if this currency is used at all, it may only be used to make a transaction, but the person who receives the new drachmas will probably immediately convert them to something else, being afraid of a possible steep drop of its value. Similarly, no one will lend the drachmas to anyone at a small interest rate because the "adequate" interest rate may very well be astronomically large, due to the expected devaluation or inflation.
For this reason, there won't be any large wealth stored in the form of the new drachmas and there won't be any medium-term or long-term contracts that would link the value of the drachma today with the value in the future. People would still store the wealth in "something else" and they would be planning their financial future in terms of "something else". They wouldn't think about the future in terms of the new drachmas. This would give the new drachma a very small "inertial mass" and this small "inertial mass" would imply that the value of this new currency would indeed fluctuate dramatically, like leaves in the strong wind. And most likely, the expectations for a steep drop would turn out to be a self-fulfilling prophesy. This drop would be unavoidable.
If you are in charge of a nation and you want to introduce a new currency, you must guarantee in some way that people will agree that it has some value so they are ready to accept the coins and banknotes for their products and services. The new currency must either be backed by something (and not just formally: you must really be able to fulfill and enforce the rule that everyone can get this "something" for the banknotes, even if almost everyone decides to pick the underlying assets at the same moment; otherwise the "backing up" is just a silly and clearly untrue demagogic promise), or it must be close to a "relabeling" of an old currency that was already stable. In other words, it must be a de facto continuation of a previous currency.
There is simply no other way to introduce something that people agree to have a large enough and more or less stable value. So if Greece were very wealthy, it could back its new currency by lots of gold or lots of the foreign currency reserves (dollars, euros, and optimally even Czech crowns).
But an important point about the current situation is that Greece is broke. It doesn't have the hundreds of billions of dollars of excess wealth (which you may convert to any other unit – euros, korunas, tons of gold, whatever you like: this conversion won't make any material difference) that would be needed to meaningfully back up a new currency. This absence of wealth is really the reason why people are thinking about the new currency in the first place.
However, being broke (while having a dropping GDP as well, and – which is the most damning thing – a nation dependent on the support from the government) is a very bad reason to introduce a new currency. Such a new currency won't "make it" in the de facto economy.
I would expect the gold bugs to understand these things. If Greece wants to introduce some good currency for them, it should be gold, the gold bugs should normally say. But if they introduce gold, it won't bring them any salvation relatively to the euro. The gold-euro price ratio is pretty much constant on the annual basis (at least relatively to the changes that would be expected for the new drachmas). And the problem is that Greece just doesn't own the thousands of tons for a meaningful gold economy that would match to "what they are used to".
We may mention tons of examples of currency reforms and in all the cases, the new currency inherited some perceived value from the previous currencies. The history of the Czech crown is a lot of fun – it dates back to the old times when the coins in the greater German realm were made of silver or gold which gave them the value. Various rational conversion factors may be traced to link the Austrian-Hungarian crown to the metallic coins. And ironically enough, Czechoslovakia was the only successor state that really kept the name of the Austrian-Hungarian currency (although the name Austria-Hungary omitted any mention to Czechoslovakia). The other successor states of Austria-Hungary had to provide the people with a similar type of continuity, although with different names.
The Czechoslovak crown would continue through the Protectorate of Bohemia and Moravia (it was just renamed again), liberation from Nazism, through communism, and during the 3 years after the Velvet Revolution. The Velvet Divorce meant that the split of the currencies was getting inevitable as well because the cash was being concentrated in the Czech banks – due to the worries that the Czechoslovak crowns located in Slovakia would become "different" and get devalued at some point. That was a self-fulfilling prophesy, of course – although throughout its history (which is over because Slovakia uses the euro today), the Slovak crown only was 20-30 percent cheaper than its Czech counterpart. The history of the separation of the currencies is fascinating – and it was done in a perfectionist way that may be used as a textbook for anyone (Greece?) who would think about something similar. I recently read a book about this history (how the stamps were printed in Latin America and kept in secret basements already from mid 1992 etc.). But it's true that both Czech and Slovak currencies were de facto inheriting the perceived value and its stability from the Czechoslovak crown (which was inheriting – if we study the chain in between – the perceived value from gold and silver).
Analogously, when the European countries were switching from the euro, a condition was that the exchange rate with the euro had to be kept nearly fixed for a few years before the transition. This is really needed for things to work.
When the Czechoslovak currency union split, the currencies could have diverged, but they didn't diverge much. A broader point is that in the short and medium run, one really had to expect the changes of the value to be "small". If you can't guarantee such things, you simply can't convince the people to trust this new currency. Many people are proposing the new drachma exactly with the would-be clever tricky expectation that "you won't be able to convert the numbers to euros or dollars". But everything has some value (the market still exists and is called the "black market" if an unwise government tries to suppress trading) and if someone doesn't allow you to ask and find out what the value of the drachma will be in 2015 or 2016, the most likely reason is that the value is going to rapidly drop towards zero (it's much less reasonable to expect the currency's value to go to infinity if there's almost no wealth to back it up and if there are lots of hungry throats at the same moment), and if this is believed to be the case, almost no one will actually adopt this new currency.
New currencies can't really "miraculously solve material problems". If the new currency were assumed to be something else (or more) than a conversion of old problems to new units, it would mean that the value of the new currency doesn't seem to be "guaranteed to be separated from zero", and for that reason, it won't be adopted! Everyone will try to get rid of it immediately and no one will try to get it and hold it.
I need to emphasize that the idea that "the economy expressed in another currency" is just a unit conversion applies in the case when the two currencies have different inflation rates. In that case, the conversion factor is time-dependent. But as long as the "inflation rate differential" or the "rate of the change of the currency exchange rate" is predictable (e.g. because it seems to be almost constant), you will be able to convert from one currency to the other even if you discuss economical dynamics over an extended period of time.
The whole idea of a country that is broke and wants to solve some material problems by introducing a new currency is silly. There is nothing wrong about using a foreign currency – tons of Muslim states "think" and "save" in U.S. dollars although most people hate America over there; and Kosovo and Montenegro are using the euro even though they are formally not members of the Eurozone. And if the adoption of a stable foreign currency isn't good enough to solve your problems, it's probably because your problems are deeper – and require deeper, more tangible fixes – than a numerical change of the unit or its name.
Now, a few similar comments about the past. If Greece hadn't had joined the Eurozone, it wouldn't have avoided its current/recent huge debt problems, either. Just look at the graph above. It shows how the Greek government's debt divided by the annual GDP of Greece evolved between 1970 and 2010.
Between 1967 and 1974, Greece enjoyed the economically sound and responsible – although undemocratic – government. Democracy was restarted in 1974 and the debt began to grow away from the 20% level although you could view these increases as noise. Things changed in 1981 when Greece joined the European Union. That was the essential event that allowed the debt to increase. Why was it happening?
Simply because Greece was introduced to the "Western European family" of nations. So it got closer to them which made it feel that it may have increased the borrowing rate. Imagine you have a sibling who primarily likes to drink ouzo and he or she moves to your house. Suddenly, he or she gets closer to you and this political proximity makes it more natural to borrow. After all, shouldn't you be living equally wealthy lives if you're siblings in the same house?
Even in the case of the EU entry, I don't suggest that such a membership is a necessary condition for the increasing debt but if there were such an extra reason for Greece to become a hugely debt-growing country, it was the EU entry, not the adoption of the euro.
The graph clearly shows that the majority of the Greek debt building occurred between 1980 and 1993 – the debt-to–GDP ratio increased from 22% to 98%. That's a qualitative change of a sort. In 1993, the growth slowed down dramatically. It was required for Greece to be admitted to the Eurozone. Some of the macroeconomic figures were fabricated and even the graph above may be misleading for those reasons but at least to some extent, I do think that it is fair to say that 1993 was the beginning of moderation in the insanely huge budget deficits – in Greece and elsewhere.
Why 1993? Because in November 1993, The Maastricht Treaty (signed in February 1992) came to force. This is the treaty that accelerated the political integration of the EU and that's why we often quote it as the turning point that sent Europe in a wrong direction. But I think it is fair to say that it also contained some rules – like the required sound fiscal policies – that improved things and slowed down the growth of the debt, at least temporarily before these parts of the treaty were recognized as dirty toilet paper that may be discarded if you want to do it.
Greece joined the Eurozone in 2001 and you may check the graph above: it didn't mean any new substantial acceleration of the growth of their debt. In fact, the years 2000-2003 saw some kind of a slow decrease of the debt. Between 1993 and 2007, the debt grew from 98% to 105% – a very small increase for 12 years. The average budget deficits were just 0.5% of the GDP or so higher than what is needed for the preservation of the ratio.
You may see that the new rapid growth, from 105% to 143%, occurred between 2007 and 2010 in the wake of the mortgage crisis in the U.S. and the related debt hysteria in America and Europe. At the level 143%, the Greek debt was suddenly considered almost unsustainable but it isn't really the case. Even the current debt above 170% of GDP may be repaid – the percentage may decrease for years, as the two years of Samaras' government showed. It's about the desire.
Because the growth of the debt was minimal between 2001 and 2007, I hope you will agree that the euro wasn't causing existential debt problems to Greece in those years. If the euro should be blamed, it should only be blamed after 2007. But should it? What would have happened if Greece continued to use the drachmas?
Up to the 2008 crisis, the euro-drachma exchange rate would continue according to the predictable patterns. The drachma would pretty much devalue by X percent relatively to the euro (or the deutschmark) each year. What would have happened in the parallel world with drachmas in 2008 when the panic erupted?
The drachma would "almost instantly" lose some additional (previously unexpected) value (not included in the variable X above) relatively to the euro, say Y percent, because of the extra risk that the whole drachma system will be in deep trouble. What about the bonds? Well, if the bonds were denominated in the euros (or another foreign currency), they would behave almost just like they behaved in our parallel world. Equivalently, the yields would increase, making it harder to service the debt.
But the bonds would probably be denominated in the drachmas. What would happen with their price? In the parallel world with drachmas in 2008, the price of bonds, when expressed in the euros, would drop by those Y additional percent as well – because the bonds only promise you to get a certain amount of drachmas on the future day and the drachmas suddenly mean Y percent less than a year ago. Equivalently, the total yields or interest rates would be much higher in the drachma parallel world, by those Y percent.
These yields evaluated with the existing bonds can't abruptly drop again. There is always a risk that this devaluation we saw in 2008 would be repeated many times in the future. So the borrowers would demand higher interest rates on the drachma-based bonds – the increase would be even higher than it was in our world with Greece in the Eurozone, by some multiple of Y percent.
But in 2007 or 2008, Greece already depended on the persistent renewing the debt. You issue new bonds in order to repay the old ones – and the total number of bonds that are out there isn't changing too quickly. Greece was in no way able to repay all the debt (over 100% of GDP) quickly, like in 5 years. So it would have been harder for Greece to service its debt. While it's true that some of the old lenders would lose money and "share" the problems, the new lenders – that Greece indisputably needed because most of its debt was here to stay for decades – would demand higher interest rates (than they were offered now) in order to compensate for the similar drops of the currencies that may occur again.
What would the debt-to-GDP curve look like in the parallel world where Greece uses drachmas? Because the bonds were denominated in the drachmas and the GDP would be approximately constant in drachmas in 2008 etc. (optimistically: I am being generous here), there would be neither an abrupt rise nor abrupt decrease due to the size of the old debt. What about the expected rise of the debt-to-GDP ratio per year after 2008?
Well, in the parallel world in 2009 or so, Greece would have to borrow at a higher rate, e.g. 30% for 3-year bonds or 25% for 5-year bonds, if the bonds were denominated in drachmas. By 2015, most of the existing bonds would have been issued after 2007, so they would promise these huge interest rates. Over 20% of the economy would be going to debt servicing in 2015, anyway. The growth of the debt would be unstoppable by now.
The curve would look a little bit different than the curve enough for the years 2007-2015. But in 2015 or the future, there wouldn't be any substantial difference. It's really obvious why there couldn't be one. The long-run real interest rates are always dictated by the free markets. As long as the lenders lend consensually, they simply want to be compensated for all their risk (of bankruptcy and/or devaluation of the currency in which the bond is denominated, if they are foreign lenders forced to go into an exotic currency). For this reason, you can't change anything substantial by a different currency in the long run. It is always just a conversion to different, time-dependent units, and those units cancel if you compute the debt-to-GDP ratio.
So the impact of having a different currency is always just a short-term effect – distributed over the duration of the bond. What is the effect? Well, if some unexpected panic erupts, like the 2008 panic, the holders of the bonds who actually had the Greek bonds during the panic will lose. They were unlucky to have "risky bonds" in a "risky currency". However, assuming that this drop was a one-time event, the holders of the bonds after the abrupt drop are lucky guys: they are getting higher interest rates because the interest rates they will be offered will be increased due to the recent bad experience of the unlucky holders (their bad experience is the reason why people will be unwilling to lend to Greece, and that will improve the conditions for those who will – even though they may face no extra risks in the future).
The unlucky holders of the bonds lost something; but someone else who was going to lend later profited. Which term is bigger? It may be seen that in real terms, these two terms exactly compensate each other (up to unpredictable noise) as long as the lenders and borrowers efficiently evaluate their risks and as long as the sales are consensual. The only redistribution that takes place in the parallel world is a redistribution of the money from the "unlucky holders" (who were holding the bonds during the one-time drop) to the "lucky holders" (who bought the bonds after the drop). That's it. This redistribution is analogous to the flow of money from the holders of losing lottery tickets to those who won – what's particularly analogous is that it is effectively a zero-sum game and the winners and losers are basically random. There is no overall effect for the Greek government.
The folks who suggest that Greece may solve its debt problems by switching to the new currency are apparently assuming that the "N euros" on the bonds may be changed to "N Greek euros" which will be worth "N/3 euros" or something like that, and in that way, Greece will reduce its debt to its one third. It's cute but the bonds still say that Greece will have to pay "N euros" which is only equal to "N euros" and not "N/3 euros". So if Greece only pays "N/3 euros", in whatever form, it violates the contract with the lenders and doesn't do anything that the lenders would agree to be a fair replacement of the original contract – and that's obviously a full-fledged, dirty default. You just can't reduce your existing debt problems by switching to a new currency. It's just like in the pizza joke about the blonde. "Would you like to cut the pizza to four pieces or eight pieces, Madam?" – "Only four pieces: eight is too much for me to eat," she answers. Sorry, it doesn't work this way! Pizza may be measured in kilograms (and the number of kilograms which matters is the same for the 4-piece pizza and the 8-piece pizza) and the debt is similarly thought of in "real terms" and the choice of the unit just doesn't matter. What matters is whether the borrowers' alternative solutions are acceptable for the lenders – whether they subjectively have the same value – or not. If they're not, then it's too bad – it's default if you can't fulfill your obligations.
Also, we often say that the constant devaluation of the Southern national currencies was restoring their competitiveness. Well, this claim may look OK as long as the income of the people is dominated by salaries that are decided by profit-seeking companies. Indeed, if you are an employer who pays the salaries in a currency that is losing value, it's good for you because you are effectively paying them less and less, which lowers your expenses and probably increases the profit – if you have the same revenues.
However, if and when this proper capitalist system works – when the employers may simply fire someone who doesn't contribute any profit to the company – then the devaluation isn't really needed. Whatever the currency is, the employer may dictate a lower (or not too quickly increasing) income for the employees, anyway! So in this ideal capitalist world without government-decided salaries and without any major control of the labor unions and similar criminal organizations, it just doesn't matter whether the currency is decreasing. The salaries are determined by the supply and demand on the labor market, anyway – whatever the currency is. And the conditions on the labor market are co-dictated by the profit that the employers are able to make with the marginal employees. Once again, a different currency is just a matter of a unit conversion.
The opposite extreme is a country where the salaries are unrelated to any "profit". The salaries are de facto dictated by labor unions or the government that doesn't care whether the conglomerate of the employees generates any "profit" as long as the behavior of everyone is politically defensible. But the absence of people who determine the salaries by their requirement that they make a profit is the actual lethal defect of this system (socialism or communism).
When people find out that they can vote themselves money, it's the end of the republic, Benjamin Franklin said. And if they can vote themselves money, they can decide in any way they want – in particular, they may decide to enjoy a Z-percent annual growth of the real incomes. Imagine that they want to see a 4% growth of real incomes. If they work in a nation that is also seeing a 10% inflation, they will demand something like 14% growth of the nominal wages. Of course that if you "impose" something as insane as a 4% annual growth of real wages in Greece, you will inevitably grow a huge, rapidly increasing debt. And that's what inevitably occurs if and when the citizens' "demands" to live increasingly luxurious lives are more important determinants than the condition to have nearly balanced budgets – or, in the case of commercial employers, to generate a profit.
In this government-dominated system, the currency is irrelevant, too. We have seen that the choice of the currency for competitiveness is irrelevant both in the capitalism-dominated and government-dominated systems. It is irrelevant in their real-world combinations, too.
As we saw when I discussed the evolution of the "bonds in drachmas" after 2008, someone's having a separate currency only changes the character of things temporarily, at the time scales where the unexpected drops and jumps take place. But in the long run when these drops and jumps may be accumulated and their sum predicted (not perfectly, but to some extent, and people on both sides of all loans and transactions have similar fuzzy expectations), there is no difference between a Greece using the euro and a Greece using the drachmas.
If you wanted to talk about a situation in which the effects of a separate currency remain visible in the long run, then you are talking about a hypothetical parallel world in which the fate of the Greek currency is completely unpredictable. But once again, it probably means that its value may converge towards zero at a much faster rate than we were used to – it may mean that unstoppable, accelerating hyperinflation is going to be started relatively soon (which will render the currency unusable) – and that's a similar fatal collapse as the debt default. As long as you avoid this scenario, the national currency just can't make a difference in the long run!
I am no big fan of the euro (and I will be reborn as a big Czech crown supporter in 2016 if President Zeman fulfills his promises and fires all the nasty Czech crown weakeners from the Czech National Bank LOL, even though Zeman also says that he wants to fill the board with the supporters of the euro) but all this talk about the euro's being the main culprit is heavily exaggerated – I would really say that it is totally wrong. The economy needs some predictable (i.e. mostly stable or uniformly devaluing) currency. Without a loss of generality, you may always assume that it is the euro or the U.S. dollar.
What would actually happen if Greece stayed out of the Eurozone would be that the interpretation of its troubles (that would exist, anyway) would be different than it is today. It wouldn't be "one of the advanced nations in the glorious rosy civilization of the future that we call the European Union or the Eurozone". Instead, it would be on par with Argentina and people wouldn't think that it's such a big deal or such a great surprise if such a country goes bust.
This demonization of the euro is silly. Greece's economy has many nearly lethal, structural problems – and Syriza's program is to add all the remaining lethal, literally c*mmunist defects that Greece hasn't had so far, too – and the demonization of the euro is just one of the tools to sweep the real, tangible problems (such as the huge problems called Tsipras, Varifuckis, Syriza, and every member of it) under the rug. The euro is just a sensible choice of the unit, a basically functioning economy may always adapt to all such choices (such as the name, value, and expected rate of devaluation of a currency), and if Greece seems hopeless when quantified in the euros, it will seem hopeless when quantified in the new drachmas, too!
So even if Greece undergoes a full bankruptcy, it should still try to use some predictable currency. Building a new economy centered around a "completely new" currency from scratch is a hard task for many reasons, including some of the technical reasons summarized by Goldman Sachs (and the beginning of this blog post).
Off-topic but political: this 5-day-old Russian viral video "I am a Russian occupant" who has improved every land he has entered has collected 3+ million views so far. It's fun but I couldn't resist a comment over there that with the 1968 Warsaw Pact invasion to Czechoslovakia in mind, the idea that the Russian soldier has improved every place he has stepped into is highly exaggerated. ;-)