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Dr. Periklis Gogas is an invited contributor to The Business Thinker magazine. He is Assistant Professor at Democritus University of Thrace, Greece, teaching Macroeconomics, Banking and Finance

The adoption of the euro as the common currency for the participating EU countries was hailed by politicians, academics and business people as a very important step-forward towards the ideal of European economic integration through the implementation of Robert A. Mundell’s Optimum Currency Area theory. The new currency was a greater success than many economists expected. Outside the EU it has become the second -after the dollar- reserve currency for many central banks and close to thirty nations worldwide chose to peg their currencies to the euro. The new currency helped to eliminate exchange rate risk and minimize transaction costs within the Eurozone, boosting intra-EU trade and efficient capital allocation.

The effects of the new currency in member states were not uniform though. In Greece, as a notable example, the introduction of the euro in 2002 led to significant price increases as the consumers had no experience and minimum information for the transition. Goods that used to cost 100 drachmas (equal to €0.29) now were retailing at €1. Thus, while the official rate was set at 340.75 drachmas per euro, the market conversion was done at 100 drachmas per euro. That was equivalent to an informal de facto appreciation of the drachma by 240%.  To different degrees this happened to other Eurozone economies as well. In Greece, this steep price increase was treated by consumers as what economists call a “temporary shock” or “transitory income effect”. Thus, it was perceived –wrongly- as a temporary decrease in their real income. According to the permanent income hypothesis of Milton Friedman, households and businesses react to such temporary shocks by trying to absorb this short-term income drop through debt. According to the theory, people do not like sharp temporary changes (both upwards and downwards) of their consumption and they try to compensate by spreading the effect of the temporary change to many periods ahead so that there is little effect on consumption spending behavior. That is exactly what happened to Greece. Households started to accumulate debt hoping to repay when economic conditions improved. The optimism from Greece’s participation in the Eurozone, the steady growth and other purely emotional factors such as Athens’s future hosting of the 2004 Olympic Games created a general feeling of optimism that things are going to get better. Moreover, these feelings were fueled further by an unprecedented credit growth in the early 2000’s. This credit growth was supported by the ease with which Greek financial institutions could access funds from the broad European unified capital market, thus magnifying their balance sheets through leveraging. Because of that, everyone was living an unfounded euphoria. Consumers did not decrease their consumption; they were now able to even consume more through an endless list of consumer loans – the ingenuity of the financial institutions at the time is legendary (vacation-loans, wedding-loans, etc). This recently proved to be catastrophic: Greece, like other peripheral economies within the Eurozone, faced a productivity gap as compared to the big core economies. For the monetary union as a whole to be successful, economic convergence was necessary in both the government finances (deficit, debt) and the private sector economic performance (productivity, innovation). The fake euphoria that followed the introduction of the euro with the “easy money” (easy but borrowed) created a wealth illusion that disoriented both the private sector and the government from focusing on growth and decreasing the productivity gap from Greece’s EU partners. Even worse, productivity differences and asymmetric GDP cycles from the leading EU economies were treated by borrowing more money.

In a currency area, like the EU, the tool of monetary policy is lost for member states. ECB’s monetary policy is designed to facilitate the major EU economies as they produce the bulk of Europe’s GDP. To the degree that small economies like Greece face any adverse GDP fluctuations that are asymmetric to the big economies for which monetary policy is designed, they can only be addressed by national governments through fiscal policy. Greece –like other small economies within the EU- tried to absorb such cycle asymmetries by running deficits and increasing debt.

Greece’s recent debt and mostly productivity problems in a large part have to do with what followed the introduction of the euro. The steep domestic price increases were equivalent to a large appreciation of the home currency as we have seen above and that produced two major problems: first, based on loose credit policies consumers did not decrease spending but absorbed the price hikes through borrowing -in effect from abroad- and second, the already low productivity was coupled by a huge de facto appreciation that made Greek goods expensive and decreased exports. The resulting current account deficits were further financed by more debt.

About the Author:
Dr. Periklis Gogas is a faculty member at Democritus University of Thrace and an adjunct lecturer at the Greek Open University teaching Macroeconomics, Banking and Finance. He is also a Financial Consultant for Gerson Lehrman Group, Austin, Texas. He received his from the University of Calgary with supervisor Dr. Apostolos Serletis and worked for several years as the Financial Director of a multinational enterprise. His research interests include Macroeconomics, Financial Economics, International Economics and Complexity and Non-linear Dynamics.

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