Ativo Capital

Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

The Devaluation of the Greek Euro(Originally Published on February 17, 2010)

Friday, April 23, 2010


Greece joined the Euro in 2001, several years after its birth. The delay of several years resulted because Greece’s fiscal deficit in 1999 was too high to satisfy the Maastricht criteria. Now it appears that Greece satisfied these criteria only because of some accounting shenanigans, somewhat remindful of the off-balance sheet activities of Enron and Citibank’s SIVs.

The basic Greek problem is that costs are too high, which has led to a massive current account deficit, and contributed to the high level of unemployment, and hence to a low level of fiscal revenues. It doesn’t help that tax evasion is extensive.

Assume a counterfactual scenario. Assume that Greece has not yet given up the drachma for the Euro; its parity is 1 Greek drachma = 1 Euro. Everything else is the same as currently, government indebtedness is 110 percent of GDP, the unemployment rate is 9.8 percent, industrial production is down 7.6 percent from a year ago, the current account deficit is 12.4 percent of GDP (whereas the average for the Euro area is 0.7 percent), and the budget deficit is 13.0 percent of GDP, more than twice the average for the Euro area.

Assume Greece were to devalue the drachma. How large a devaluation would itneed to achieve a satisfactory external balance position? Probably twenty to twenty five percent.

If a twenty percent devaluation were necessary to achieve a satisfactory domestic and external imbalance, then it would take a twenty percent reduction in wages and salaries to achieve the same improvement in the international competitive position of the Greek economy.

How likely is it that the Socialist government in Athens can bring off a reduction in wages and salaries of ten percent? Not likely, Greece got into this mess because its polity has been fractious, which goes back a long, long way.

If Greece can’t reduce wages and salaries, then it should leave the Euro for a year or two. But many observers believe that can’t happen because there are no provisions in Maastricht treaty for a divorce or separation.

That’s nonsense. International monetary treaties are good for fifteen or twenty years and when market conditions change, countries do what they believe they need to do. The Czechs and the Slovaks had a peaceful divorce. Slovenia left the former Yugoslavia Republic peacefully, but then it got ugly. Quebec came close to a peaceful secession from Canada.

The Greek competitiveness problem cannot be solved by loans or loan guarantees from Berlin or Frankfurt or Brussels. And it won’t be solved by the Athens equivalent of Chancellor of the Exchequer Churchill in 1926 who thought a little deflation would have eliminated the serious overvaluation of the pound.

Market forces are now in play, there has been a “run” on the debt of the Greek government. No one—well hardly anyone except government controlled entities—will buy the debt of the Greek government. But the Greek government has to finance a fiscal deficit of nearly fifteen percent; otherwise the public service workers in Athens and Thessaloniki won’t get paid. For a while, the Greek government may borrow from the Greek banks.

But wealthy Greeks are too smart to hold most of their liquid wealth in banks in Greece. The next shoe to drop will be a “run” on the deposits in the banks in Athens, including the foreign banks with offices in Athens. The owners of these Euro deposits in Athens will move their money to German, French, and Italian banks in Frankfurt, Paris, and Rome.

The technical issues associated with a devaluation by Athens are trivial. The Government closes the banks for several days and instructs them to re-label all deposits and loans and all other contracts as Euro drachmas. The banks are reopened and a new currency market develops as individuals buy and sell the Euro in terms of the Euro drachma. Many goods and assets then will have two prices, one in terms of the Euro and the other in terms of the Euro drachma. Initially there will be some turbulence in the currency market but prices will stabilize after several weeks, and in eight or ten months the Euro drachma will be pegged to the Euro and then the Euro drachma will be converted into the Euro.

Obviously the politicians in Brussels and Frankfurt, Berlin and Paris are petrified about the contagion effect. The cost structure in several of the other Mediterranean countries may be too high and they face the same painful choices. The financial costs of financing payments deficits while hoping that costs will decline is fanciful.

Consider the menu available to those in Athens, Brussels, and Frankfurt:

–monthly checks from the Berlin, Paris, et al that will enable the Greek government to finance its fiscal deficits.
–a decline in costs and prices in Greece that will lead to a reduction in the current account deficit and an increase in fiscal revenues.
–a devaluation of the Euro drachma.

In the end, all three will come to pass.

Robert Z. Aliber is Professor Emeritus of International Economics and Finance at the Booth School of Business at The University of Chicago. He is the author of New International Money Game (March 2010). He can be reached at [email protected]


  1. Nice to see that Paul Krugman is coming around to the view that Greece could very well temporarily leave the Euro zone:

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