By Roberto Rigobon, The Hill
I recently spent several days in Europe, where everyone, everywhere seems to be asking the same question: will it be costly for Greece to exit the Euro?
And if so, why? I believe that leaving the Euro will be very costly for Greece, and I also believe that the transition to a new currency will be extraordinarily difficult. I believe it will be difficult because the current macroeconomic situation in Greece is problematic and not necessarily because a change in currency is by itself a problematic event.
The introduction of new currencies has happened many, many times before and it is only when the underlying economics of the situation are difficult that the transition itself becomes problematic. The introduction of a new currency is only costly in certain macroeconomic circumstances.
There are three distinct scenarios in which currency transitions can and have occurred: first, during good times (or “calm” times if you prefer); second, after hyperinflation; and lastly, when the new currency is unwanted. Let’s look at each in turn.
Transition During Calm Times: The first type of transition has already occurred in Greece. You remember 1997? They had the Drachma. In 2000? It was the Euro! They introduced a new currency and there was no disruption whatsoever. Why? The macroeconomic environment was quite benign: Inflation and interest rates were low, fiscal deficits were at bay, and the economy was growing. In this world, the exchange rate was expected to get stronger and changing the currency of denomination was a welcomed event. In fact, the procedure was very simple: The government started paying their bills in the new paper money – they paid services, unemployed, retirees, and wages in the new currency. Then they told the banking sector that any cash withdrawal would be in the new currency. With these two simple actions, in a span of few months, the economy was flooded with new pieces of paper.
Transition During Hyperinflation: Things are different if the economy is in the midst of hyperinflation during the introduction of a new currency. There have been several examples of currency introductions in this type of situation. For instance, the German’s Rentenmark, Brazil’s Real plan, and Argentina’s New Peso, Austral, and again the Peso. In these cases to solve the hyperinflation, a new currency and a stabilization macroeconomic plan were announced. The promise that the economy is going to get better implies that the transition to the new currency is smooth – and very fast. The adoption of the dollar by Ecuador at the end of the ‘90s is a very good example of how fast the currencies are substituted and how small the economic impact is in this type of case. In these countries, the economy was eliminating a very bad currency whose value was expected to plummet, and the newer currency was expected to be stronger, or at least stable. As in the previous case, the important issue that makes the transition costless is the high demand for the newer currency.
Transitions to Unwanted Currencies: This is the situation Greece finds itself in. Greece still has a large unemployment rate and its current account is almost closed (meaning it is close to zero). This means that to return to equilibrium – zero current account and “full” employment – the economy needs an expansion in demand and more importantly a real exchange rate depreciation. How to achieve the depreciation within the Euro? With a lot of pain – in the form of recession and unemployment. This explains the current state of affairs. The situation has become unviable and has led to the current discussion of exiting the Euro. However, an exit will require a currency depreciation! That means that the new currency is going to lose its value when it is introduced. How then can we exchange beautifully designed and trusted Euros, with an ugly bill with an even uglier picture of some infamous Greek celebrity? Under no circumstances, will the new pieces of paper be equally accepted. No one is that stupid. And that is why a change in the currency of denomination is so difficult in the current situation in Greece.
Can it be done in Greece? Of course! Again, you follow the same procedure but you do not call it a new currency – at least not at the beginning. All the payments by the government (for services, wages, pensions, and unemployment) are made by a piece of paper that looks like a 20 Euro bill, except they are not bills. It has the same shape, other colors, but it is supposed to be a bond which pays no interest rate, it is fully negotiable, and has a maturity of one year. For reference look at the patacones created in Argentina at the end of the ‘90s. The price of these “bonds” is less than one; hence there is already an exchange rate between the bonds and the prevailing currency. When enough of these papers are around, you decree that the previous currency cannot circulate anymore, you degree a change in all contracts, and you now call your bonds a currency. Usually capital controls are introduced as well. This is economically costly because panic ensues: at what exchange rate will the conversion take place? Furthermore, because the new currency is expected to continue depreciating agents are trying to get rid of the new papers. Expectations of inflation increase, pushing expectations of depreciation even higher, and achieving a real depreciation quite costly.
Greece is in this state, and therefore abandoning the Euro will prove disastrous. Not because changing a currency is costly itself, but because the macroeconomic environment makes the transition to anything very costly. The future for Greece includes pain – regardless if they stay in the same currency, whether they put or not capital controls in place, and even if they decide to abandon the Euro.
Rigobon is the Society of Sloan Fellows professor of Management and a professor of Applied Economics at the MIT Sloan School of Management.
