How Greece can devalue without devaluing
February 18, 2010 7:00amby FT
By Laurence Kotlikoff

“Greece is being victimised by its use of the euro. Prices and wages within Greece are too high and can’t readily be adjusted downward. Were the country using its own currency, it could simply devalue.” This, together with profligate government spending, is the generally accepted explanation for the run on Greek bonds.

I know too little about the Greek economy to agree or disagree with this prognosis. The country is clearly running a large official budget deficit, but as a share of gross domestic product it’s roughly the same as that in the US. Its official debt is a much larger share of GDP than in the US. But US implicit government debt may well swamp the corresponding GDP-scaled figure for Greece. (Implicit government debt includes commitments to make future entitlement payments.)

So it’s a puzzle to me that US long-term government bond rates are so low compared to Greek long-term rates. This is particularly the case because the US has full control of its money supply and can print and, indeed, is printing, money at will, whereas Greece has essentially no control over the creation of euros. Nominal interest rates should reflect fears about inflation. No one seems concerned about that possibility in the US, even though the Fed is on course to triple the base money supply by the end of this year relative to its 2007 level.

Domestic price levels

I’m also puzzled by many economists’ presumption that in countries such as Greece and China, which are in formal or informal currency unions, domestic price levels don’t adjust. In the US we’ve witnessed, of late, enormous swings in the price of gasoline - way up, way down, and now back in between. And the past two years has seen essentially zero inflation leaving prices today substantially lower than where they’d be today had there been no recession.

This is hardly evidence of sticky prices. Nor is there strong evidence that wages don’t adjust to market pressures. In the US, median real wages have hardly moved for decades thanks to competitive pressures from China and other exporters to the US.

But let’s take it on faith that Greece is overvalued, by say 30 per cent, thanks to its participation in the euro and that exiting the euro is not desirable (which, indeed, is my view because printing money is an invitation to surreptitiously tax the public). Is there some way that Greece can devalue without devaluing?

Wage and price controls

There is, indeed. The government can implement wage and price controls for, say, the next three months, with these controls covering not just the growth in wages and prices over the next three months, but also their initial levels. Specifically, the Greek government would decree that all firms must lower their nominal wages and prices by 30 per cent, effective immediately, and not change them for three months. After three months, everyone would be free to put prices and wages back up.

This decree would apply to domestic banks so that the servicing of their outstanding loans would also be cut by 30 per cent with adjustments after three months tied to increases in the price level. And the Greek government would be obliged to cut tax payments and expenditures by 30 per cent as well, with these values also adjusting by the inflation rate after three months.

If the Keynesian view of downward nominal wage and price rigidity is right, this decree will alleviate that rigidity and there will be no reason, after three months, for firms to restore prior nominal wage and price levels. Since the real price of imports would rise by 30 per cent (relative to their wages), this would represent a major sacrifice by the Greek public. But this would be no different from the situation that would arise were Greece to be able to devalue by 30 per cent.

German and French governments

In exchange for this sacrifice and a commitment to a schedule of reducing, over time, government spending relative to GDP and raising tax rates, the German and French governments could commit to servicing some fraction (say 30 percent) of Greece’s current public and private external debt with the understanding that this servicing ceases if Greece misses it’s spending and tax rate targets.

Like many quick ideas, this one may have serious flaws. But as economists we know that there is an isomorphism between adjusting prices and wages, on the one hand, and exchange rates on the other. This isomorphism — that the nature of exchange rate regimes does not determine real economic outcomes in perfectly competitive economies — seems to go bye bye in standard discussions of China’s exchange rate policy or Greece’s Euro dilemma. But if the isomorphism is, indeed, not working in practice, perhaps we can make it work via policy.

Related reading:


FT Alphaville on Greece
FT Money Supply on Greece

Laurence J. Kotlikoff is professor of economics at Boston University. His latest book is Jimmy Stewart Is Dead - Ending the World’s Ongoing Financial Plague With Limited Purpose Banking

February 18, 2010 7:00am in Eurozone, Greece | 4 comments

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Report Narg | February 19 10:34am | Permalink
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If wages are cut by 30% and debt stays at the same level there's going to be a wave of bankruptcies. Assuming that debt payments to banks are cut by 30% means that it's actually the banks that will go down because they won't be able to service interest on their own debt; and if debt service to foreign creditors is cut by 30% as well then that's a default. So in summary, no way this idea could work.
Devaluation only works because debt goes down at the same time. Report jan ludvig andreassen | February 19 9:42am | Permalink
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Greece is just another country living beyond it's means and needs to cut living standards. No exchange rate or monetary recipe can hide that fact. The lack of income to support it's consumption is what it has in sommon with the UK and US. All three countries need more foreign direct investment and foreign loans. The trade balance adjustment cannot do the job alone. Report charles monneron | February 19 8:39am | Permalink
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"Its official debt is a much larger share of GDP than in the US. But US implicit government debt may well swamp the corresponding GDP-scaled figure for Greece. (Implicit government debt includes commitments to make future entitlement payments.)"

I doubt Greece would figure better than the US using this latter criterion, as they have the most costly pension scheme of all EU. See http://www.forsakr...Greece%20paper.pdf Report Anthony Palmer | February 19 8:28am | Permalink
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Why a painful Greek internal devaluation? Why not a pleasant (for the Germans) German internal revaluation? All prices and wages increased for a trial period of 3 months.