Marty Feldstein is calling for Greece to take a holiday from the euro, with an agreement to return to the euro at a lower exchange rate that would basically guarantee a substantial instant devaluation. Paul Krugman argues that this is impossible, citing a piece by Barry Eichengreen from several years ago:
The insurmountable obstacle to exit is neither economic nor political, then, but procedural. Reintroducing the national currency would require essentially all contracts – including those governing wages, bank deposits, bonds, mortgages, taxes, and most everything else – to be redenominated in the domestic currency. The legislature could pass a law requiring banks, firms, households and governments to redenominate their contracts in this manner. But in a democracy this decision would have to be preceded by very extensive discussion.
And for it to be executed smoothly, it would have to be accompanied by detailed planning. Computers will have to be reprogrammed. Vending machines will have to be modified. Payment machines will have to be serviced to prevent motorists from being trapped in subterranean parking garages. Notes and coins will have to be positioned around the country. One need only recall the extensive planning that preceded the introduction of the physical euro.
Back then, however, there was little reason to expect changes in exchange rates during the run-up and hence little incentive for currency speculation … In contrast, if a participating member state now decided to leave the euro area …the very motivation for leaving would be to change the parity.
Market participants would be aware of this fact. Households and firms anticipating that domestic deposits would be redenominated into the lira, which would then lose value against the euro, would shift their deposits to other euro-area banks. A system-wide bank run would follow. Investors anticipating that their claims on the Italian government would be redenominated into lira would shift into claims on other euro-area governments, leading to a bond-market crisis. If the precipitating factor was parliamentary debate over abandoning the lira, it would be unlikely that the ECB would provide extensive lender-of-last-resort support. And if the government was already in a weak fiscal position, it would not be able to borrow to bail out the banks and buy back its debt. This would be the mother of all financial crises.
That doesn’t mean that it’s impossible for Greece to exit the euro; it just means that Greece can’t do so gracefully. Despite all the obstacles that Eichengreen describes, it would very much be possible for Greece to leave the euro, and it still might happen. I don’t know the details of Greece’s political system, but what going off a currency peg looks like in other countries is that you give the executive substantial emergency powers (or he takes them), you freeze all the bank deposits and allow only minimal withdrawals, you revalue the currency, and then you start issuing a series of ill-advised executive orders aimed at stemming the public outrage and economic distortions that arise from these sorts of interventions in the banking system.
Obviously this is less than ideal, and not something that the chief executive with an eye to his popularity rating undertakes lightly. But none of the other things, like cutting spending or raising taxes, seem to be very popular either–and as I understand it, things in Greece are further complicated by rampant tax evasion that makes it very difficult to raise much revenue from new taxes. Is going off the euro obviously politically worse than the fairly radical fiscal austerity measures that Greece will otherwise have to undertake? And if Greece fails to undertake them, will the other members of the euro come through with a bailout anyway? I suspect they’re going to have to, because I’m not sure I see any politically feasible way for Greece to get its budget under control.
It’s worth noting that these difficulties in cutting spending, once people have gotten used to it, are one of the most powerful libertarian arguments against new entitlements, no matter how well-intended those new entitlements may be.
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