Adjustment and Financing Revisited

February 23, 2012
A worker cleans the paint-splattered entrance of the Bank of Greece, in central Athens Thursday, Sept. 15, 2011. (AP Photo/Petros Giannakouris)

Greece and other periphery countries confront twin crises: a fiscal-cum-banking crisis, which has been the preoccupation of Brussels, and a current account crisis – how to pay for imports given poor competitiveness and no access to credit markets. Martin Wolf at the Financial Times has usefully focused on the latter.

To restore competitiveness, Greece needs a real exchange rate adjustment – achieved through a depreciation of the nominal exchange rate, or domestic deflation; or some combination of the two. Of course, as long as Greece remains in the euro zone, nominal exchange rate depreciation is off the table. That leaves only one path to adjustment: lower wages and prices through deflation. The “guardians of the euro” (hat tip: JA) euphemistically refer to this as “internal devaluation” as if it is a simple matter of lowering wages and prices analogous to currency devaluation. But, make no mistake; unless wages and prices are perfectly flexible, which they most assuredly are not, internal devaluation requires a long, painful period of high unemployment and economic stagnation to induce workers to accept lower wages and firms to reduce prices (see The March of Folly below).

In this respect, in Brussels over the weekend, Greece was offered a choice between “financing and deflation” versus “no financing and default”. Not surprisingly, Athens chose the former, perhaps because the latter is a leap to the unknown: default, exit from the euro zone and re-introduction of the drachma, which would subsequently suffer a chaotic depreciation and hyperinflation as Greeks spurn the new currency, and ultimately he collapse of the banking system. Over time, however, as the costs of internal devaluation rise and resentment increases, a leap of faith to the unknown may look less daunting. Unfortunately, time will have been lost and the politics made more divisive – if orthodoxy has been tried and found wanting, heterodoxy may be more appealing.

To say the least, introducing a new currency in such conditions would be highly “challenging”. My guess is that it would likely have to be introduced at a greatly devalued rate, sufficient, say, to restore competitiveness overnight. Otherwise, people would rush to convert their new drachmas into euro notes, or better yet, the dollar. A significant devaluation that virtually eliminates the risk of further depreciation would raise expectations of appreciation and create an incentive to hold the currency. Unless bank assets and deposits are also converted into the new currency at the same rate, however, banks would fail as Greek borrowers (households and firms) are unable to service their debts. If the process is asymmetrical, with debts denominated in the euro and wages and incomes in new drachmas, the decline in consumption could be insupportable.

The simple analysis of the situation is that the sum of current and future claims on the Greek economy exceeds the real, underlying capacity of the economy to produce goods and services. Since the latter is fixed in the short run (and may fall as skilled workers migrate in search of jobs), something has to give. Greece needs a better balance of financing and adjustment. The options are limited: either the value of claims is reduced (further), or some way is found to boost output – although structural reforms will help, they take time to implement and pay dividends and can be disruptive in the short term. Alternatively, Europe could allow Greece to impose tariffs against its euro zone partners, shifting demand from imports to domestic goods. Of course, such a policy is fundamentally inconsistent with European economic integration.

The choice for Europe may be whether to preserve the euro zone in its current configuration and sacrifice some “symmetry” in the economic union, or to retreat to a smaller euro zone and preserve the symmetry of the economic union. The question is whether the latter is even feasible.


Under U.S. leadership, post-war Europe was given special treatment – debt forgiveness, additional time to adhere to the obligations of membership in the IMF, etc. – to assist it recover from the destruction and trauma of war. The motivations for this asymmetric treatment are complex. Churchill referred to the Marshall Plan as the “most un-sordid act in history”. There was also a recognition that, if Europe wasn’t offered a judicious balance between financing and adjustment, the risk of political instability would increase. This was very likely the deciding factor. After all, as Churchill also noted, at the time an iron curtain had descended on Europe.

The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.

About the Author

James A. Haley is a senior fellow at CIGI and a Canada Institute global fellow at the Woodrow Wilson Center for International Scholars in Washington, DC.