drachma danger

Currency Reform, Not Inflation

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The drachma: friend or foe?
  • Why it matters

    Why it matters

    With Greece still on the path to bankruptcy, economists are playing out scenarios for the destitute country to survive a possible Grexit.

  • Facts

    Facts

    • Greece’s last chance to receive a bailout deal is a meeting of all 28 European Union member states on Sunday.
    • Capital controls have been in place in the country since last week and will continue at least until Monday.
    • In last Sunday’s referendum, the Greeks rejected the latest bailout package proposed by the country’s international creditors.
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    Audio

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If Europe’s heads of state and government do not let themselves be persuaded into a compromise on Sunday by Greek Prime Minister Tsipras, the country and its banks will run out of money next week.

To stave off a state bankruptcy, it has been suggested that Greece follow the example of California, and pay its employees, pensioners and vendors with promissory notes, or IOUs. But the promissory notes of a country facing bankruptcy might not find broad acceptance, especially not as a currency parallel to the euro.

To simply continue using the euro after an exit from the currency union is also unrealistic. Because after a national bankruptcy, government bonds held by Greek banks would be worthless and the banks would therefore also be insolvent.

The country’s citizens would no longer have accounts to process their payments. The cash in circulation in Greece and bank deposits abroad couldn’t make up for these losses for long.

And after a state bankruptcy, in order to prevent the entire Greek economy from running dry and collapsing, the Greek government would have no other option but to leave the monetary union and introduce a new currency as the sole legal tender.

The government must also by law convert the prices, wages, pensions, bank deposits and debts from the euro to a new drachma.

The obvious thing would be to convert all euro amounts in Greece to the new drachma at the same rate, for example 1:1. But then the Greek banks would remain insolvent because their liabilities, for example the bank deposits of the citizens and companies, would be converted at the same rate as their assets. The banks’ balance sheets would still have the same gaping capital shortfall because of now-worthless Greek government bonds, bank loans to the state and tax claims.

People may argue that a currency reform with different rates of conversion is unfair because owners of checking and savings accounts would be partially dispossessed.

Nothing would remain for the de facto destitute country other than to recapitalize the banks with its printing press. It could then issue government bonds, sell them to the central bank and close the capital shortfalls of the banks with the money from the central bank.

But then the money supply would massively increase and probably inflation, too – especially as the Greeks would already be mistrustful of a new drachma. The drachma would slump in the foreign exchange market, the government could be forced to introduce capital controls again, which would further burden the economy.

A single conversion rate would thwart a stable currency and with it the prospects of an economic recovery.

The alternative is a currency reform, in which the prices, wages, pensions, bank deposits and debts would be carried over at different rates from the old to the new currency.

In 1948, Ludwig Erhard in West Germany depreciated the liabilities of the nation, the banks and the companies to make a new start possible for them after the war-related losses of assets.

In the case of Greece, that means possibly not converting the liabilities of insolvent banks after a state bankruptcy from 1:1, but rather from 1:0.1. The greater the gaps in the bank balance sheets, the lower the conversion rate would be.

If the banks would be recapitalized through such a currency reform, then the new Greek central bank would not be burdened with having to recapitalize the banks with the printing press and therefore unintentionally stoking inflation. The central bank would be free to pursue a stability-oriented monetary policy and to achieve a sufficiently stable environment to allow companies to recover.

In this sense, currency reform would be better than a currency conversion that would lead to high inflation from the outset.

People may argue that a currency reform with different rates of conversion is unfair because owners of checking and savings accounts would be partially dispossessed.

But if a currency conversion fuels inflation, people would lose their savings anyway.

In this bitter situation, Greece’s choice is between unending difficulties or a costly end. The latter, a currency reform, is preferable.

 

To contact the author: gastautor@handelsblatt.com

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