A Vicious Cycle of Debt and Recession

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Dr. Periklis Gogas is a frequent contributor to The Business Thinker magazine. He is an Assistant Professor of Economic Analysis and international Economics, Department of International Economics and Development, Democritus University of Thrace, Greece

“The Dire Straits of Scylla and Charybdis and the Magic Wand of the Drachma”

The problems in Greece are real but it becomes evident that the solutions provided through the “Memorandum of Understanding II” are unrealistic. Every economist knows that in order to cope with a recession one must use expansionary monetary and/or expansionary fiscal policy in an effort to stimulate economic activity. In Greece the situation is very bizarre and unique: monetary policy is implemented by the European Central Bank for the Eurozone as a whole and no one (especially Germany) is ready to tolerate a mild inflation that will help the troubled and heavy indebted peripheral economies of Greece, Spain, Portugal, Ireland and even Italy and Belgium. Expansionary fiscal policy is, on the other hand, impossible as Greece cannot borrow from the capital markets as long-term bond yields soar to almost 25%. On the contrary, the Memorandum implements an extremely harsh and never seen before in Europe austerity program that resulted in severe recession and a 4% decline in real GDP on average in the last three years. Never before in peaceful periods had Greece displayed such frustrating macroeconomic performance.

This difficult situation is dividing Greeks between those that are pro-memorandum (and pro-euro) and those that want to abolish it and return to the drachma along with a cross default. Like Homer’s Odysseus though the safe passage from the strait and the solution is between the Scylla (memorandum) and Charybdis (drachma) the two sea monsters.

Most parties that are now represented in the new parliament are pro-euro and they state that they will exhaust all possibilities in that direction. The average Greek citizen is the one who mostly feels this adverse economic reality: unemployment is now more than 20% sharply up from 6% just before the crisis, average income has shrunk by 20-30%, sales, personal, corporate and excise taxes have all sharply increased. The most important implication of all this dire situation is that the most people feel that all these deep sacrifices are for nothing: After three long years the future still looks bleak. This frustration and disappointment amalgamated in the last elections when the non-conventional socialists and the extreme right multiplied their seats in parliament making them the second largest party in the first case and electing 21 members in the Greek parliament for the first time in the second case. What unites most extremists from the far right to the far left is that they proclaim that the only solution is the return to the drachma and a default on the total debt burden. For many people the drachma is perceived as the magic wand that will bring their lives and income back to the 1990’s or even the 1950’s and 1960’s whene Greece was the fastest growing country in the world with growth rates of 5-6.5% similar to those of present day China. Many Greeks feel that abandoning the euro and being able to have an independent monetary policy can lead Greece faster and safer to growth and prosperity again. “How much worse can we be?” is a common reaction.

The truth is that correlation does not prove causation: the fact that Greece enjoyed high growth rates with the drachma in the decades following WWII, does not necessarily mean that it can do so today especially after a cross default. Moreover, the people that correlate the Greek high growth of the 50’s and 60’s with the existence of the drachma are misled: these high growth rates existed within the monetary system of Bretton Woods where the drachma was tied with a constant rate to the U.S. dollar. Thus, even then, monetary policy was not independent and the situation closely resembled the one of a currency union such like the current Eurozone. That system provided the necessary stability for foreign direct investment to take place and stimulate domestic growth.

Also, the drachma-wand plan is not that simple to implement. Even for an economist the issues involved in the transition from a hard currency to a new one in such difficult times that are combined with a cross default are so complex and risky that no one can be sure of the final outcome. Economic agents are risk averse. We will only undertake such risky proposals only when the degree of risk is very low. Otherwise we stick with the known but less risky situation. The pro-drachma side forgets that Greece is a heavy importer and more importantly an importer of goods for which the elasticity of demand is very low: fuels, machinery, telecommunications, technology, etc. A new currency for Greece will produce a high inflation, strongly devaluing the new and very risky for any foreign market participant currency, resulting in a steep increase in the price of the above goods that are crucial for any future economic growth and development. There are of course many other more subtle but not less important negative consequences: increased cost of transactions, hedging costs, market distortions etc.


Of course this does not mean that the road paved from the memorandum is rosy and correct. The plan that is implemented now is clearly defected as any economist can assure. The memorandum has to be updated, improved and become more realistic in its expectations. It is not strange that any goal so far was not met. You cannot expect growth when you suffocate the economy with severe taxes and pay-cuts. The decrease in wages and all the relevant rhetoric is wrong. Wages represent less than 8-10% of the final goods prices. This is the reason why labor cost is not the main concern of the Greek businesses. If the “high Greek wages” were the real problem (they are currently one third or one fourth of those in Germany or France) then Bulgaria would have achieved very high growth rates and attract significant foreign investment as wages there are only 30% of those in Greece. On the other hand Germany, Sweden and other countries with wages 2-3 times the Greek ones would have become deindustrialized.


What is the solution? Greece needs a new route between Scylla (memorandum) and Charybdis (drachma). What needs to immediately be done is:

  • In the short-run:
    • A real new haircut of 50-60% in the private bond holders so that the debt becomes sustainable.
    • A grace period of 3-4 years in the remaining debt (even without the new haircut) so that the economy and the public sector can stand up to its feet again, restructure, reorganize and grow in order to be in a position again to re-pay its obligations.
    • 100% haircut in Greek sovereign debt held by the European Central bank. This was not included in the last haircut and it amount to approximately 60-70 billion euros almost 20% of total Greek debt.
    • No haircut in pension and insurance funds and small bond holders.
    • Lower tax rates, VAT, personal income taxes, excise taxes on fuel, corporate taxes, etc. with a swift and strong collection procedure.
    • In the next couple of years:
      • The eurobond is a solution to finance the restructuring of the Greek banks and Greek development away from the troika and the memorandum. Yes, a mild EU inflation will be generated but this bond would benefit most European countries that are heavily indebted
      • A new tax system, simple and transparent.
      • Make it easy to set up and run a new business.
      • Bankruptcy protections laws.
      • Efficient and fast judiciary system

Last, but not least, Greece needs to implement plans to make the most out of its most significant comparative advantage: human capital. Greece enjoys one of the highest Ph.D. rates per capita in the world.

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