How the RECOVERY will look like when Greece leaves the euro

Most indications are that Greece this weekend effectively has been pushed over edge by the collective failures of Greek and European policy makers. The combined forces of an European monetary straitjacket, the lack of a coherent European sovereign debt crisis resolution mechanism and weak Greek institutional structures and a lot of badwill on both sides of the issue in the end did it.

And we are now facing bank run, possible banking sector collapse, the likely introduction of capital controls, a Greek sovereign default and potentially also a Greek exit from the euro area.

So there is no doubt that the future looks very bleak for the Greek economy, but there are also good arguments that all this actually might mark the beginning of a Greek economic recovery in the same way the Argentine default and devaluation in January 2002 was the beginning of a sharp recovery in Argentine growth in from 2002 to 2007.

Argentina in 2001-2, Greece today 

it is no coincidence that I mention the example of Argentine. Hence, I have long argued that the present Greek crisis is very similar to the Argentine crisis of the late 1990s and early 2000s. Both countries have been suffering under the combined pressures of a monetary regime that creates strong deflationary pressures and a weak domestic political system.

We can essentially think of this as both a demand and a supply problem. With the monetary system causing a collapse in aggregate demand and weak institutional structures at the same time causing a negative supply shock as well as creating downward rigidities to wages and prices.

In the late 1990s the Argentine’s currency board set-up created serious deflationary pressures and a drop in nominal GDP, which caused a rise in Argentine debt ratios. There was a simple “solution” to this problem – Argentina should give up the currency board and devalue. That happened in early 2002.

Even though the contraction in the Argentine economy continued in the first couple of quarters after the devaluation growth soon picked up and in fact Argentine real GDP growth in the period 2003-2007 averaging nearly 8.5% per year. Obviously we should not forget that GDP dropped 10% in 2002, but that was essentially the impact of the banking crisis that played out ahead of the devaluation rather than a result of the devaluation.

I think that we very well could be in for a very similar development in Greece if the country indeed leaves the euro area. Obviously we are now in the midst of an extremely chaotic political and economic situation and what could become a full scale banking crisis and a disorderly sovereign default. The bank run we effective already have seen on its own constitutes a massive monetary tightening – due to the drop in the money-multiplier – and that on its own is going to have a strongly negative impact on the Greek economy in the coming quarters.

However, Grexit will also remove the monetary straitjacket, which has had caused an enormous amount of economic hardship in Greece since 2008. The removal of this straitjacket will cause a significant easing of Greek monetary conditions, which in my view very likely will cause a sharp rise in nominal GDP in Greece in the coming years. The graph below shows the development in Argentine M2 and nominal GDP on the back of the Argentine devaluation in 2002.

I think we might very well see a similar development in Greece on the back of Grexit and given the price and wage rigidities in the Greek economy we are likely to see a sharp recovery in Greek real GDP growth – after the initial deep recession, but my guess is that Grexit will be the beginning of the end of this recession.

The graph below shows the development in real GDP in Argentina eight years ahead of the default and the devaluation in 2002 and in eight years following the initial collapse. The graph also includes Greek real GDP. “Year zero” is 2001 for Argentina and 2014 for Greece.

Argentina Greece RGDP

The recovery will not primarily be about exports

Hence, I believe there is good reason to think that a potential Grexit will be the beginning of a sharp recovery in Greek growth – following the initial sharp contraction. However, I would like to stress that contrary to the common-held view such recovery will not be about Greece becoming more “competitive” due to the drop in value of the “New Drachma” (I easily see a 70-80% devaluation following Grexit).

Rather we are likely to see a sharp recovery in domestic demand as a likely sharp rise in inflation expectations will cause a sharp increase in money velocity. This combined with the expected increase in the money supply will cause a significant easing of Greek monetary conditions, which likely will spur a strong recovery in Greek growth.

This is exactly what happened in Argentina. This is from Mark Weisbrot and Luis Sandoval’s 2007-paper on “Argentina’s economic recovery”:

“However, relatively little of Argentina’s growth over the last five years (2002-2007) is a result of exports or of the favorable prices of Argentina’s exports on world markets. This must be emphasized because the contrary is widely believed, and this mistaken assumption has often been used to dismiss the success or importance of the recovery, or to cast it as an unsustainable “commodity export boom…

During this period (The first six months following the devaluation in 2002) exports grew at a 6.7 percent annual rate and accounted for 71.3 percent of GDP growth. Imports dropped by more than 28 percent and therefore accounted for 167.8 percent of GDP growth during this period. Thus net exports (exports minus imports) accounted for 239.1 percent of GDP growth during the first six months of the recovery. This was countered mainly by declining consumption, with private consumption falling at a 5.0 percent annual rate.

But exports did not play a major role in the rest of the recovery after the first six months. The next phase of the recovery, from the third quarter of 2002 to the second quarter of 2004, was driven by private consumption and investment, with investment growing at a 41.1 percent annual rate during this period. Growth during the third phase of the recovery – the three years ending with the second half of this year – was also driven mainly by private consumption and investment… However, in this phase exports did contribute more than in the previous period, accounting for about 16.2 percent of growth; although imports grew faster, resulting in a negative contribution for net exports. Over the entire recovery through the first half of this year, exports accounted for about 13.6 percent of economic growth, and net exports (exports minus imports) contributed a negative 10.9 percent.

The economy reached its pre-recession level of real GDP in the first quarter of 2005. As of the second quarter this year, GDP was 20.8 percent higher than this previous peak. Since the beginning of the recovery, real (inflation-adjusted) GDP has grown by 50.9 percent, averaging 8.2 percent annually. All this is worth noting partly because Argentina’s rapid expansion is still sometimes dismissed as little more than a rebound from a deep recession.

So you better get ready for the stories in the media following a potential Grexit that this will be “good for Greek tourism” and “feta exports”, but if you study monetary history you will know that this will only be part of a the story and looking ahead over the coming five years it is much more likely that the story will be a sharp recovery in Greek domestic demand.

But don’t forget Greece’s quasi-Constitutional problems

Concluding, I am probably more optimistic that a potential Grexit will cause a recovery (after the initial contraction) in the Greek economy than most economists who tend to stress Greece’s structural problems. That, however, does not mean that I don’t think Greece has structural problems. In fact I believe the Greece has very serious structural problems and I will even go so far as to say that Greece’s deep structural problems are a result of fundamental constitutional problems.

Hence, at the core of the problems that have dominated the Greek economic development for decades (if not centuries!) is a flawed political system. Therefore, if Greece wants to avoid ending up as present-day Argentina – where the initial positive effects of monetary easing has been “replaced” by overly easy monetary policy and large political uncertainties – then there is a need for fundamental constitutional reform to reduce the role of government in the Greek economy and constrain the unhealthy relationship between economic and political interests.

So yes, monetary easing can solve the demand problems in the Greek economy (I think that actually was under way prior to Syriza winning the parliament elections), but monetary easing will not do anything about Greece’s structural and constitutional problems.

Finally, on a personal note I must say I have a very deep sympathy for the economic and social suffering of the Greek population and I full well understand their justified frustration they have with European and Greek policy makers who so utterly have failed in the past seven years. I equally understand the frustration of German, Danish and Slovak tax payers who directly or indirectly over the past seven years have been asked to pick up the bill for numerous badly designed bailout packages. They have done very little good to Europe or Greece.

But I mostly hope that we would give up the national stereotyping and instead study the fundamental economic and monetary issues. The Greek crisis is not about the Greeks being “lazy” (in fact Greeks work a lot more than the Germans…) or corrupt, but it is about the serious monetary policy failures of the ECB and a generally badly designed monetary policy framework in Europe combined with the failures of the Greek political establishment.


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  1. Anon.

     /  June 28, 2015

    Greece is a net importer of food and petroleum. After transitioning to the drachma, where will they find the euros/dollars to pay for these?

  2. The big difference between Greece and Argentina is that Argentina never gave up the peso whereas Greece gave up the drachma. As a result it was relatively easy for Argentina to peso-ify. It won’t be easy for Greece go through the process of de-eurofication.

  3. JKH

     /  June 28, 2015

    What do you think will become of Greek central bank Target 2 balances following exit ?

  4. sumnerbentley

     /  June 28, 2015

    Good post, but there’s something wrong with the vertical scale on your first graph, the changes are off by an order of magnitude.

  5. sumnerbentley

     /  June 28, 2015

    BTW, It seems unlikely that Greece would leave the euro.

  6. Max

     /  June 28, 2015

    What does “70-80% devaluation” mean? I know what it means in the case of a currency peg, but I don’t know what it means in the case of a newborn currency.

  7. Max

     /  June 28, 2015

    It seems to me that a Greek worker, for example, if he accepts drachmas instead of euros, would demand an amount of drachmas which exactly equals his old euro pay. Anything else would be irrational. It doesn’t matter what the ratio of drachmas to euros is; it changes the arithmetic but not the economics.

  8. Mark

     /  June 29, 2015

    Italians also work more than Germans if you believe the statistics. But you obviously do not live in Europe, otherwise you would know how to compare a German and Italian/Greek working hour (these include maybe 50% “breaks”).

    One example from a friend in Spain: He works as a firefighter. He works about 3 days a week and is in the work buildung all the time (even sleeps there). He is a passiante rock climber and very good at it. He considers himself very lucky to have this job.

    Elsewhere in Europe he would work a bit reduced regular work hours and be on standby during some of the nights or weekends. He told me that this just does not work in Spain. No one would show up in an emergency.

    I also think that leaving the euro is the right thing to do long term for the Greek. They will never be as competitive as Germany unless the Germans buy up all of Greece.

    Also, I do not think that the problem in Greece is mainly a constitutional one. It is the mentality there and this will be very difficult to change. They believe in the utopian promises of politicians like Tsipras. Maybe they will have to experience a deep crisis without help from the EU first. Maybe they will never learn.

    What would have been good for greece is if they really implemented economic reforms, would have abandoned the privileges of the oligarchy and maybe then defaulted on part of the debt.

    Now I expect that they will not even have enough money for food and medicine for some time. One can only hope Tsipras will be replaced quickly and replace by more moderate politicians. But I see no promisind alternatives…

  9. To clarify, what do you reply to the obvious response that Argentina is a mess right now, and the monetary easing didn’t turn out very well?

    • Maurizio,

      I think I make that point clearly. Giving up the currency board was the right decision, but not replacing it with a rule based monetary regime was a failure. And as I also argue Greece like Argentina have serious institutional or even constitutional problems that need to be taken care – regardless of the monetary regime.

      • Maurizio Colucci

         /  June 29, 2015

        Thank you, and sorry, I had missed that part of your post.

  10. Maurizio Colucci

     /  June 29, 2015

    An important question seems to me this: if Greece has not been capable of doing structural reforms now, what makes us think that it will be able to make them when it regains the capability to do monetary easing?

  11. If Greece were to introduce a new floating currency, and generally have sensible policies, Grexit would lead to recovery, though not as strong as Argentina’s.

    But Tsipras is likely to introduce some kind of pseudo-euro with a dual exchange rate – one-for-one for parties approved by government committee, and somewhere north of two to one for others. He has just set up such a committee to decide which importers can make payments abroad from their Greek bank deposits. Tsipras has managed the fiscal house better than expected under creditor pressure. But without creditor pressure, left truly to his own devices, he’s likely to make all sorts of policy choices.

  12. Forget Argentina.
    What about Denmark, the smat little country that stayed out of the EURO ?

  13. Great reading yyour blog

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