The Greek government is trying to remain in the euro zone. What would happen to a revived drachma if the country were to exit? Historical comparisons paint an ugly picture. After the breaking of a long-standing peg, currencies tend to correct by more than is needed to regain competitiveness. The Argentine peso was worth one dollar in November 2001 – as it had been for a decade. Months later it was worth 34 U.S. cents. A Greek currency could easily fall just as far, just as fast.
A large fall is inevitable because of the size of the country’s external imbalance. Greece’s deficit on its current account, the broadest measure of trade, was an extremely big 10.4 percent of GDP in 2010. The deficit implies capital must be flowing in. When insouciant investors bought Greek debt, it trotted in cheaply. Now it comes in the form of bail-outs and loan tranches, accompanied by lectures on spending cuts and structural reforms.
Outside the euro, Greece would be spared the lectures but also deprived of the capital. There would also be capital flight. So the currency would have to fall far enough to rebalance trade by encouraging exports and making imports more expensive. A return to balance might require a real devaluation of perhaps 40 percent, but the inflation brought by the currency’s fall would make for much bigger nominal moves. In Mexico, in the 1995 Tequila crisis, the inflation rate soared from 7 to 35 percent.
Inside the euro zone, Greece faces a programme of planned austerity. Outside, inflation would do much of the work, reducing Greek government spending in real terms. But socio-political distress would be inevitable. If a weak government printed money rather than seeking fiscal balance, it would risk hyperinflation.
Provided that policy disaster is avoided, stability would eventually return. The drachma would find an equilibrium and inflation would decline. Greeks’ savings and incomes would have been eroded. Greece would be poorer but more competitive.
The revived drachma could therefore bring gain as well as pain. Devaluations eventually led Argentina out of perma-recession and Mexico to more rapid growth – after initial deep recession. Greece too could be healed by a time-honoured recipe of currency devaluation, debt default – and a market-determined exchange rate. But the process would be painful.