Whether Greece should leave the Euro

Πηγή: Midterm: Greece Debt Crisis
By Getting Nashty

Greece’s choice of whether or not to leave the European Monetary System (i.e. the Euro) and return to its own national currency is a difficult one. To a certain extent, remaining part of the Euro benefits the country by facilitating cross-border transactions within the Euro zone. However, to a larger extent, it burdens Greece by shackling its monetary policy in a time of economic crisis. In contrast, French and German interests are less conflicted and are strongly in favor of keeping Greece in the Euro zone.

The single currency facilitates cross-border transactions within the Euro zone by eliminating the need for, and the costs of, foreign exchange and hedging foreign currency exposure. However, at a time when the country would like to reduce its short-term interest rates to the lowest possible level so as to stimulate borrowing and investment, by having delegated its authority over monetary policy to the European Central Bank, it is forced to compromise with other ECB member countries, such as Germany and France. Those countries fear inflation in their own economies more than they fear recession in the Greek economy and therefore prefer to keep interest rates higher. Furthermore, because the French and German economies are more developed than the Greek economy, the latter is unable to compete with the former, absent lower wages. Though it’s possible for Greece to reduce wages in nominal terms (e.g. by cutting salaries in the public sector), it is politically difficult to do so. By contrast, if Greece were to return to its own currency, the country would allow that currency to fall in value relative to where it stood when Greece first adopted the Euro. The resulting pain of devaluation would then be spread evenly across the Greek economy, instead of disproportionately on public sector employees. This action would be politically more palatable. Going forward, the country would then regain the authority to set its own interest rates and to further devalue its currency, as necessary to remain competitive. To some extent, the risks Greece faces from unilaterally abandoning the Euro weigh against these benefits. Since the real burden of Greece’s existing Euro-denominated debt would rise as the exchange rate of its currency falls, any Greek withdrawal from the Euro would almost certainly coincide with, or follow, a default on that debt. While default would eliminate a significant burden on Greece, it’s likely the country would then be locked out of the capital markets for some time, putting additional pressure on public finances. It would also cause a crisis of confidence and the flight of capital out of Greece to countries that are more likely to maintain the values of their own currencies going forward.

However, since it’s almost inevitable that after the government defaults on its debts there would be a
run on Greek banks anyway, any concurrent / follow-on decision by the government to abandon the
Euro and devalue its currency would have little marginal cost and remain a net positive decision for the
country.

In contrast, France and Germany face significant risks if Greece were to abandon the Euro. To begin with, a default and devaluation by Greece is likely to encourage similar actions by other heavily indebted European countries, such as Portugal and Spain, whose economies are also less efficient than those of France and Germany. In addition to the losses that French and German banks would suffer as a result of holding much of those countries’ debts, the economies of France and Germany would lose their competitive edge within Europe. This is because as Greece and the other countries that follow it out of the Euro devalue their currencies, their purchasing power in Euro terms would also decline. Demand in those countries for what would then be more expensive French and German goods would decline as well. Conversely, France and Germany would consume greater amounts of what would then be cheaper goods from Greece and the other countries that follow it out of the Euro. This could lead to a renewed recession in France and Germany, whose economies are highly dependent on exports to the less efficient Euro zone members.

Assuming that (A) France / Germany are otherwise indifferent between (i) doing nothing and having Greece default but stay in the Euro and (ii) bailing out Greece but having it leave the Euro and devalue its currency, while (B) Greece is similarly indifferent between (i) defaulting but not leaving the Euro / not devaluing its currency and (ii) being bailed out and leaving the Euro / devaluing its currency, the payoffs to Greece on the one hand and to France / Germany on the other are as follows:

It thus seems that a Nash Equilibrium exists in the lower right corner (Bailout / Don’t Devalue). Clearly all parties would benefit the most by ending up in the lower right corner (Bailout / Don’t Devalue), but if France / Germany believe that Greece will devalue and/or Greece believes that France / Germany will not bail it out, the parties will end up in one of the other corners instead. To avoid this problem, the parties will need to negotiate carefully and build trust, so as to best coordinate their actions for the good of all concerned.