The Greek financial nightmare is a reminder of why countries benefit from having their own currencies. In the old days, a flexible drachma could have been devalued to boost exports and economic growth. But today’s euro trades at a single exchange rate that may suit some of its member nations but not others. For Greece, it has become the equivalent of a straitjacket.
So why doesn’t Greece drop the euro and restore its freedom of maneuver? A cheap drachma would boost exports and tourism ― and it might be the easiest means of post-crisis financial adjustment. But separating from the eurozone would mean rewriting thousands of contracts and deals. And it could put Greece in a monetary free fall, perhaps forcing Athens to look east for support to Moscow, Riyadh or even Tehran.
Economists like flexible exchange rates because they allow financial markets ― rather than governments ― to set the prices of currencies. The eurozone’s problem is that although the euro has a flexible exchange rate, it’s a one-size-fits-all currency for the 19 member countries. Local adjustments can only be made through fiscal policies, such as the harsh austerity measures Greece was forced to implement.
To understand Greece’s currency quandary, it’s useful to look back to the 1990s and the pathway to adoption of the euro. Europe decided on a common currency partly because of the difficulty in maintaining looser interdependence through a semi-flexible system called the Exchange Rate Mechanism. This halfway step produced recurring crises.
The ERM was created in 1979 to encourage monetary stability among European nations, which had formed a free-trade zone in the 1950s. The idea was that each member would peg its currency to a European basket; the national currencies would be allowed to fluctuate several percentage points above or below. The system was known as a “floating band,” an oxymoronic term for a system that, to its critics, combined the worst features of fixed and flexible currency regimes.
Britain’s struggles with the ERM led to a debacle in 1992, when speculators guessed correctly that the U.K. couldn’t stay within the limits of the band. Traders pounded the British currency (forgive the pun) until Prime Minister John Major withdrew from the ERM. Hedge-fund titan George Soros is said to have made well over $1 billion in one week betting against sterling. The episode is one reason Britain balked at joining the euro and surrendering its monetary independence.
If Greece should someday restore the drachma, one question would be whether it should be pegged to the euro. Such an arrangement might seem attractive. Athens could speak of its devalued currency as a hybrid “Greek euro.” And there’s certainly precedent: The currencies of Hong Kong, Saudi Arabia and Venezuela are linked to the dollar; those of China, Singapore and Malaysia are tied to a basket of currencies.
The problem for Greece is that a euro-pegged drachma would be an easy target for speculators. Traders would bet that a weak drachma would devalue further and further against the euro. As with Britain during its recurring efforts to defend its currency, attempts to hold the line might just invite more speculation. In this sense, a euro peg might be nearly as limiting for Greece’s economic growth as membership of the euro has been.
What about a completely free-floating drachma, whose price would be set entirely by the currency markets? That might be stable in the long run, but it could lead to wild swings as traders respond to rumors. This sort of unpredictability would be the enemy of the investment and growth that Greece needs.
As Greece is discovering, it’s difficult for small, ailing economies to threaten big, strong ones. Greece’s implicit threat over the last three years has been a “Grexit” ― a Greek withdrawal from the euro that could undermine European solidarity and increase pressure on other weak eurozone members. But it seems that the leaders of Germany and other strong eurozone economies are more worried about another kind of contagion ― the demand for concessions from Portugal, Spain, Italy and other debtor nations that might ensue if Greece’s confrontational tactics were seen as succeeding.
Greece and its creditors need the monetary equivalent of a divorce lawyer who can help reckon the costs and benefits of a breakup. Restoring the drachma would give Greece more flexibility, but at the price of much greater vulnerability. For the eurozone, a Grexit would signal that the promise of monetary union was conditional ― and unreliable. Bad divorces happen when each side is too angry for rational decision-making.
David Ignatius’ email address is davidignatius@washpost.com. ― Ed.
(Washington Post Writers Group)