Should Greece Exit the Euro Zone?

by Gary S. Becker

The Becker-Posner Blog
May 20, 2012

Countries run balance of payments deficits when their tradable goods are expensive on world markets because their producers are not sufficiently cost effective. These deficits cannot continue unless other countries are willing to help finance these deficits indefinitely by lending money to deficit-running countries. This is unlikely, unless either the deficits are small or a country has an excellent record on debt servicing. Otherwise,countries with balance of payments deficits must reduce their deficits. One option is to devalue their currency if they control its value. Devaluation makes exports cheaper to other countries and imports more expensive to domestic consumers and companies. These effects both tend to cut the trade deficit. Another way to improve international competitiveness is to have sufficient reductions in wages and prices that make the cost of goods more competitive internationally. Still another way is to lower production costs through improved efficiency.

I mention these types of adjustment as a background for discussing whether Greece should exit from the euro. There is no good solution for Greece, only least bad ones, given Greece’s extensive foreign debt, and lack of competitiveness of its goods in the EU and elsewhere in the world at the present international value of the euro. I have concluded that the better of the two basic dismal alternatives is for Greece to leave the euro zone, and return to the drachma. IMF estimates suggest that Greece needs a devaluation of at least 15-20% against the euro zone average, and much more against Germany just to balance its current account. A greater devaluation would be needed to stabilize its international debt. These are not firm estimates since needed currency adjustments are notoriously difficult to calculate, but there is no doubt that imports will become significantly more expensive to the Greek population.

Before the euro was launched I was skeptical that it could succeed (see my “Forget Monetary Union-Let Europe’s Currencies Compete”, November 12, 1995, reprinted in The Economics of Life). I said, among other things, “Competition among currencies helps discipline irresponsible governments by reducing their incentives to …finance budget deficits arising from dubious expenditures, such as inefficient state enterprises… and in order to penalize and discourage irresponsible government-based monetary and fiscal policies.” Not a bad description of what ails Greece! A single currency also makes it difficult for countries to restore competitiveness to their export sector, when they are subject to negative shocks that require their wages and prices to fall relative to those of other countries.

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