Based on the latest opinion polls, the Greek election could result in a highly confused outcome, with the new government being unable or unwilling to meet any budgetary terms acceptable to the Troika, but also unwilling to leave the euro voluntarily. What would happen then?
Economists like Thomas Mayer (Deutsche Bank) and Huw Pill (Goldman Sachs) have recently argued that, in these circumstances, Greece might resort to a “parallel” currency which would be used for some domestic transactions, while keeping the euro in place for existing bank deposits and for foreign transactions. Thomas is favourably disposed to the idea, while Huw foresees many problems with it.
Although I am not at all convinced that this would be a stable solution, since it might just be a prelude to much higher inflation in Greece, it is the kind of fudged development which can appeal to politicians. It could therefore have a part to play in the future of the eurozone. Anyway, it is destined to be widely discussed in coming weeks.
Let us imagine that the next Greek government refuses to comply with the Troika’s terms, and is therefore cut off from receiving further fiscal transfers to finance its primary deficit. This deficit was 2.3 per cent of GDP last year, and although it is scheduled to be eliminated by the end of this year, this would be unlikely to occur after the arrival of an anti-austerity government. Greece would therefore need to finance a primary deficit of at least 3 per cent of GDP (€6bn a year).
Where would this money come from?
Outside the euro, Greece would have its own central bank, and could therefore require it to print the money to finance the primary deficit. Inside the euro, the ECB would never permit the Bank of Greece to do this. Therefore the Greek government might resort to paying for part of its public expenditure by issuing promissory notes or IOUs which would in theory be transferable back into euros at some point in the future.
These IOUs would not formally be given the status of legal tender, since this is explicitly against the terms of the treaties. However, an informal market might develop in these IOUs, at a very heavily discounted rate against the euro. The IOUs might also begin to be used as an informal parallel currency to facilitate exchange in the economy.
The upshot would therefore be that part of the expenditure of the Greek government would be financed in a devalued internal “currency” which would, for example, reduce the wages of Greek public sector workers, measured in euros. It is not clear whether the unions would be more willing to accept this form of real wage cut than the more normal variety imposed through lower nominal wages. If not, there would be no point in proceeding with the plan.
Meanwhile, what would happen to the Greek banks?
That would depend entirely on the attitude of the ECB. After the effective default of the government on its internal debt, the banks would be insolvent, but the ECB might well be unwilling to impose on the economy the total chaos which would follow the closure of the payments system in the economy, and the elimination of a large part of household savings. That example would simply invite contagion problems in the rest of the eurozone.
The ECB could not lend directly, or permit the Bank of Greece to lend, to insolvent banks. Mayer suggests that the Greek banks could be absorbed into a eurozone “bad bank”, capitalised by the EFSF, which would be eligible to receive finance from the ECB. This would imply that Greek bank deposits would continue to be denominated in euros, and confidence in the system might conceivably be rebuilt, allowing a return of deposits which have recently fled from the Greek system.
Nevertheless, the ECB would probably see its exposure to the Greek “bad bank” rise over time, since Target 2 lending from the ECB would be the only source of finance to cover the balance of payments deficit. This deficit is running at 8 per cent of GDP, though it would fall sharply in the circumstances outlined here.
What would be the point of such a convoluted plan?
It probably would not prevent the Greek economy falling into a much deeper recession as domestic wages are devalued, and government procurement from the private sector is financed in devalued IOUs. There might also be a rise in inflation as people realise that the government is resorting to “funny money”, and seek to compensate for this by raising wages and prices. As Pill writes:
The new Greek note would be exchanged for euros at a very deep discount. In that sense, it would serve as a way of defaulting on internal payments within Greece, rather than as a mechanism to enhance competitiveness. The real exchange rate would not depreciate as the more competitive nominal rate would be offset by the impact of inflation on prices.
On the positive side, though, Greece would remain in the euro and the EU, so it could get back on the “straight and narrow” by gradually moving into a primary budget surplus which would enable it to resume servicing some of its foreign debt. That option would be far harder after leaving the euro entirely.
More important, the catastrophic economic costs which would follow from the closure of the banks and the payments system could be avoided, though only on the sufferance of the ECB, which would further increase its exposure to Greece. The ECB and the eurozone might be willing to contemplate this in order to avoid a humanitarian disaster in Greece, along with enormous risks of contagion to other troubled economies.
I am inclined to believe that a parallel currency could only work in a parallel universe, not the one we currently inhabit. It may be just a stepping stone to the inevitable combination of outright default, inflation, and departure from the eurozone which may unfortunately await Greece. But it would be very nice to be wrong about this.