Readers Question: Would a devaluation help Greece?
If you look at the Greek economy, their exchange rate has been effectively overvalued for several years. This overvalued exchange rate has caused Greek exports to be relatively uncompetitive and has caused various economics problems. Combined with efforts to tackle an unsustainable debt level, the over-valuation has contributed to prolonged recession.
Impact of Over-valued Exchange Rate
- Very high current account deficit (over 10% of GDP)
- Falling GDP – output shrinking since 2008.
- High unemployment close to 50%
If Greece was in a floating exchange rate, there is no doubt that their currency would have fallen rebalancing domestic demand and improving economic growth. (see: why Greece would devalue)
If Greece was in a semi fixed exchange rate (such as the old ERM), there is no doubt that they would have reduced the currency peg and devalued the currency.
The problem is that in the Euro, the only option to devalue is to leave the Euro 0 with all the economic uncertainty that leaving the Euro would entail.
For Greece, the choice has always been between the benefits of devaluing and regaining independent monetary policy vs the cost of leaving the Euro and experiencing the capital flight and uncertainty this would entail.
Summary of Greek Devaluation
In theory, a devaluation would help increase Greek domestic demand and enable an economic recovery.
- Imports would be more expensive causing demand for imports to fall – instead people would buy more domestic goods.
- Greek exports (and tourism) would become more competitive. Therefore, demand for exports and tourism would rise. A substantial devaluation of 50-70% could create many long-term opportunities to develop new export industries and encourage more tourism.
- This boost to domestic demand would also help create jobs and tackle Greece’s dire unemployment.
- Without devaluation, Greece could face years of depression as they are unable to create any boost to domestic demand in the current situation.
- The current policies of austerity have failed to tackle the deficit, but have pushed the economy into a very dangerous deflationary spiral with levels of unemployment which threaten the social fabric of the country.
Problems of Devaluation
- A devaluation of 50% would cause a jump in inflation as imported goods go up. This could cause inflation of up to 50%.
- Inflation of 50% will increase the costs of living and reduce living standards.
- Devaluation involves leaving the Euro. Therefore there is a risk of substantial capital flight as Greek savers try to protect the value of their savings by moving into Euro bank accounts rather than lose value. This capital flight would cause banks to run out of liquidity. There would need to be government backed support for banks.
- The devaluation would increase the effective debt to GDP ratio. It could see Greece’s national debt rise to over 200% of GDP. Therefore, there would need to be a substantial default because outside the Euro, bailout funds would dry up.
Exit would be very painful and difficult. But, staying in the Euro, only seems to be prolonging the economic pain Greece is facing. If Greece did devalue and leave the Euro, they would at least be in a position to avoid the current situation of trying to manage in a single currency which doesn’t work for them.
More Detail Greek Situation
- The Greek economy is in freefall. GDP has fallen considerably since 2008, and they are experiencing depression level unemployment.
- In 2011, Greek Manufacturing output fell 15.5%
- VAT revenue fell 18% in 2011. Simply because 60,000 business and small business have gone bankrupt since the summer.
- Despite the depth of the depression, Greece is still forced to pursue deflationary fiscal policy and monetary policy is effectively deflationary.
- Greece is attempting to restore competitiveness through a policy of reducing costs and inflation, but it will take several years of depressed economy to restore the huge gap in competitiveness. Devaluation would make this rebalancing happen much quicker.
- The Greek inflation rate has fallen to 1.72% average for 2012 (but -1.3% in July 2012 – indicating Greece is slipping into deflation) Greece inflation
- Tragedy of the Greek situation – could it be any worse?