Yesterday, I received an interesting comment on my Grexit post by Frances Coppola, a comment that is actually not that far from my point of view as would seem on first impression. I ‘d like to use this post to elaborate a bit on this interesting subject.

In my view, Grexit involves (among other things) a trade-off between a balance of payments constraint and large limitations on internal economic policy (and the winners and losers in social groups that policy implementation can create). It is true that the Target2 monetary construction, along with a loose central bank collateral framework can accommodate very large capital flows in the Euro area (BoG Target2 liabilities currently stand at more than €100bn, roughly 55% of GDP). Although most of these capital flows are not directly trade related, the sheer magnitude of Target2 accommodation (and the relative strength of the Euro as a reserve currency) do provide a way around balance of payments constraints for Euro countries, at least for a significant time span. Nevertheless, this relative freedom comes with the cost of well known Euro problems (a fit-for-all monetary policy, low labour mobility, small net fiscal transfers) and the prospect of a loss of a large part of sovereignty if a country is forced to borrow from the ESM and sign an MoU.

A return to a national currency (especially for small deficit countries such as Greece) reintroduces a balance of payments constraint on economic growth. The country has to apply an economic policy consistent with a positive (or at least balanced) long-run balance of payments which allow it to improve/stabilize its NIIP and slowly accumulate FX reserves, which is consistent with relative exchange rate stability. Since most deficit countries are currently experiencing large output gaps, one has to look at cyclically-adjusted current account balances, most probably based on the IMF framework. The EC has performed such an exercise which estimates that Southern European countries still have a structural current account deficit:

EC Cyclically Adjusted Current Account Euro Countries

One can even do a back-of-the-envelope calculation based on the long-run import/domestic demand ratio. For the Greek case, this is around 27-30% which implies, given a 10% output gap, that imports would most probably be 2.5-3% of GDP higher if the Greek economy was running at potential. Since external demand is not closely related to the output gap (at least for a small economy) this implies that the external balance would deteriorate by roughly the same amount if Greece were to slowly try to close its output gap.

An initial devaluation of the newly introduced currency would most likely change the above figure, although I am not a fan of external adjustments through relative price changes (it is my belief that most of the external realignment happens through changes in relative income growth). Nevertheless, a devaluation could result in a (slow) favorable sectoral realignment since (as long as the devaluation did not translate into higher nominal wages) it would increase the profit margins of exporting firms and sectors. That would change the sectoral mix towards export oriented enterprises and help improve the structural external balance up to point.

Still, it is true that Greece (or any similar Euro country) would trade more internal ‘policy flexibility’ for a binding external constraint. This constraint would be made stronger by the fact that debt hierarchy (senior official debt higher than 120% of GDP in the Greek case) would not allow tapping external markets, at least in large quantities.It might be relaxed through a mechanism such as ERM II (which I touched on my previous post on the subject). Ultimately, this becomes a political choice, dependent on the constraints imposed by each choice (Euro membership or a return to national currency). What the July Eurosummit made clear is to what extent austerity is a binding policy constraint inside the Eurozone, at least for highly indebted countries.

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