Euro Exit: New Greek Drachma Q&As

For Greece, the objective of introducing a parallel currency (or scrip) along the lines of the scrip that was introduced in Worgl during the 1930s depression would be to bring about an orderly depreciation of its currency over time. This is going to be risky, since there are few precedents about just how to engage in such an exit. There are going to be many problems, but the Greek government will need to feel confident that Greece can overcome two key problems if such an action is to be worth the effort. First, how to get people to use a currency that is going to depreciate; and second, how to prevent wages and prices from immediately jumping to a level that erodes the very gain in competitiveness that a new currency is intended to create. In TH’s view these problems can be overcome.

For concreteness, suppose that Greece was to introduce the New Greek Drachma. The authorities pre-announce that the currency will be legal tender, but that payments in euro will not be prohibited, nor will they drachmaise euro deposits, loans or euro denominated debt. They also pre-announce that one drachma will be worth one euro on day one and that, from then on, it will depreciate on a scheduled path, at an annualised rate of, say, 15% per year. It will be issued by the Bank of Greece – Greece’s central bank and can be used to pay Greek taxes and utility bills. For simplicity let’s also assume that the Bank of Greece is fully credible – run by someone respected for establishing central bank credibility during a period of adversity (John Crow – Canada’s central bank governor in the early 1990’s — comes to mind).

Now let’s consider the first of the two problems:
Q: why would people hold drachma? Won’t people just bankrupt the Bank of Greece by converting their drachma to Euros and profit by buying back the drachma at the depreciated rate?

A: In this respect, the Bank of Greece now faces a problem similar to that faced by the mints during the bimetallic period. Milton Friedman noted a similar problem with the bimetallic standard (a silver and gold standard) in an article in the Journal of Economic Perspectives :

Though either silver or gold could legally be used as money, in practice it might be that only one of the metals would be so used. In addition to their use as money, both silver and gold had important nonmonetary uses—for jewelry and industrial use. When the market price ratio differed substantially from the legal ratio, only the metal that was cheaper at the market price than at the legal ratio would be brought to the mint for coinage. For example, if one ounce of gold sold on the market for the same number of dollars as 15.5 ounces of silver when the legal ratio was 16 to 1, a holder of silver would do better by exchanging his silver for gold at the market ratio and taking the gold to the mint than by taking the silver directly to the mint.

 

To put the matter in another way, if the mint were a two-way street at a 16 to 1 ratio, an obvious get-rich scheme would be to bring one ounce of gold to the mint, get 16 ounces of silver, sell the silver on the market and with the proceeds buy more than one ounce of gold, pocket the profit and keep going. Clearly the mint would soon be overflowing with gold and out of silver. That is why the mint’s commitment under a bimetallic standard is solely to buy silver or gold (that is, coin freely) at fixed prices. If asked to redeem legal tender currency (whether coins or notes) in specie, it is free to redeem it at its discretion in either metal.

Thus, just like the mints of old, the Bank of Greece would have to be a one way (not two-way) street and convert euro to drachma but not the other way around. That would mean the new drachma wouldn’t be fully convertible into euros or any other foreign currency. That would have to come later when the equilibrium exchange rate was reached.

There is also the question of why anyone would use the drachma in the first place? One reason is simply that borrowers would not want to borrow in euro, because it leaves them with a currency mis-match problem. Let’s say that the borrower is a Greek restaurant that borrows in euro to expand his business. With the new drachma in place he might expect to receive his revenues in drachma, but must repay a euro loan. If the loan is for one year, his effective rate of interest is 10 percentage points higher than if he had a drachma loan. So he is much better off in drachma. The reverse is true for holders of drachma though.

The second problem is this: suppose that everyone knew that the currency was going to lose 15% of its value by the end of the year (and they would because the government has pre-announced this), then wouldn’t stores just add a 15% premium to all euro prices, otherwise why would they accept drachma at the official exchange rate (which would be 1 drachma for 1 euro on day one and then depreciating by an annualised 15% per day).

A: There is probably some psychology at play here, but TH reckons that, if on day one, the BoG issues drachma at an initial ER of 1 drachma per euro and the government of Greece accepted drachma for every 1 euro of tax obligations and utility bills, etc, that this might be enough to anchor prices on that day. People would accept drachma at par because they can pay taxes and bills at par – there would be no need to add a premium on prices. Of course, from every day on the drachma would be depreciating at an annualised rate of 15%, but the same point would be true – drachma prices would be anchored. In this respect, there is great benefit to keeping the economy euroised, at least initially – it creates a demand for the new currency!!! People are better of paying taxes and utility bills in drachma than in euro and by accepting payment for citizens euro obligations at the official exchange rate (i.e. not charging a 15% premium), the government creates the incentive for private citizens to do the same.
The loser is the government. TH knows that the government of Greece has external euro liabilities, but that is a problem for the debt restructurers. Indeed, IMF programs used to involve debt assistance in return for adjustment, which typically meant exchange rate adjustment, which was needed to restore balance of payments equilibrium – for more on that you need to be reading James Haley over at the New Age of Uncertainty.

There is also an issue about whether the 15% rate of depreciation would be too much? It’s about 0.04% per day (20% would be about 0.05% per day). In TH’s opinion 15-20 percent would be enough to dissuade people from holding drachma as a store of value, but probably not enough to dissuade them from using it as a medium of exchange. The drachma would circulate but euros would stay in the bank (probably a German one!).

Thus in TH’s view the problems with a parallel currency in Greece are not insurmountable. Moreover, it is more likely that, by following this plan, Greece will be able to unscamble the scrabled eggs of currency union, than it is that Germany or any of the other major euro area partners, will agree to the fiscal transers required to form a true fiscal union.

 

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