The drachma option for Greece, very simple

Since I am teaching intermediate macroeconomics, yesterday we reviewed what the drachma option was for Greece, very simple version.  Journalism and blogosphere seem bifurcated between (1) audience that looks at pictures of crowds in Greece with caption “something wrong” and (2) audience that goes bonkers over a spreadsheet of banks that hold Greek bonds even though the spreadsheet has no authenticity, contextual information, or really any real relevance because then they can comment about same.  So seems to be a need for simple version of what is going on.

So the drachma scenario.

Before the drachma, the banks.  (Assertions here are suppositions.) Greek banks would be insolvent (assets worth less than liabilities) if loans and government bonds held in portfolios were properly valued (marked-to-market).  In order to continue to function, in an economy that is rule-based (i.e. makes an effort to follow basic rules of accounting and requires audits of banks and other firms to be public), the banking regulator has to insist that the banks be recapitalized.  Otherwise the bank should be shut down and liquidated.  “Hope” is not a good reason to trick new depositors into depositing money into an insolvent bank.  That means some entity (a solvent international bank, for example) has to be willing to buy the insolvent Greek bank and “give” to the bank their own capital so that the bank is then solvent in the accounting sense.  Such a buyer hopes that the assets (loan portfolio and government bonds) will turn out to be worth much more than the mark-to-market current values.  In the Greek case, there is no such buyer.

The buyer of last resort is the government.  So the Greek government “nationalizes” the banks.  Often this kind of process works by creating another entity called a “bad bank” or a “resolution bank” that takes all the bad loans that are not repaying, and tries eventually to collect something on them.  The government commits new capital to the “good banks” so that they can be trustworthy solvent banks (to depositors and other actors).  That is, the government basically says, “Your deposits in this bank from now on will always be redeemable at face value.”  If it works, the banking system returns to normal and the government eventually sells its stake in the bank (it privatizes the bank).  The United States basically did something like this in 2009 during the financial crisis.

Unfortunately the whole problem for the Greek government is that the currency is the euro, and the Greek government does not actually have euros to recapitalize the banks, and other European banks and governments will no longer lend euros to the Greek government to recapitalize the banks.  (And neither will the Greek public.)  Also, probably (sorry, not my field) there are eurozone regulations that prohibit this kind of nationalization.

Just to be clear, you really need banks to have growth… imagine being a Greek business with no access to a local bank…  So the idea that, “Do they really need banks when they have the Internet?” is a non-starter.

The Greek government, then, to recapitalize (“save”) the Greek banks, and thus have a chance at returning to economic growth, will choose to leave the eurozone and instead adopt its own currency, let us call it the drachma (same as the old currency).  Since the new currency is “issued” by the Greek central bank, it can “inject” as much capital as desired into the nationalized banks.  Imagine the government says each nationalized bank will start out with a “credit” or capital of one billion drachma, courtesy of the central bank.  The government will fix an exchange rate (say 2 drachmas for every euro) and each bank will re-denominate all the accounts, loans, and other financial stuff in terms of the drachma.  The government might take the opportunity, as it takes over the banks, to also levy a tax on all deposit holders, of, say, 20% of the value of their deposits.  Remember, the problem for the government is that it pays more for services- army salaries, pensions, public swimming pools- than it collects in revenue, so a deposit tax is a very convenient way for the government to suddenly have a lot more revenue.  Obviously, deposit holders are not going to be happy at this confiscation.

Now when the banks open for business, there will be limits on withdrawals, otherwise everyone will anticipate a drop in value of their drachma (they have seen what happens in other countries), and will try to withdraw all their drachmas and trade them for euros.  There will also likely be controls on exchanging drachmas for euros.  And if the exchange rate isn’t “reasonably right” the drachma might immediately depreciate on a black market.

Some countries have “successfully” (they survived and eventually started growing again, sometimes rapidly) done variants of the above, possibly with less economic downturn than continued bailout-austerity (Iceland, Argentina, Malaysia, Mexico).  For some countries a crisis like the Greek crisis leads to a decade of poor economic performance.  It is hard to claim knowledge about the counterfactual for any given country.  The short-term austerity (cuts in government services and pensions etc.) of the drachma-ization is likely to be just as bad for Greeks as bailout-austerity.  Opinion is divided about medium-term effects.  Greece could see significant increases in tourism, and thus might resume growth fairly quickly.  But a global downturn at the same time (or a resurgence of tourism to Puerto Rico…) might mean the Greek economy does not grow, and instead the government resorts to increasing the drachma money supply, leading to ever-rising inflation.

Glad I do not have to make the choice.

About mkevane

Economist at Santa Clara University and Director of Friends of African Village Libraries.
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