something’s got to give

December 18, 2009

For all terms and purposes Greece is a country under a fixed rate regime. Yes, it is part of the Euro which is a freely floating currency, but in reality (i) Greece’s state or actions do not affect the Euro rate, apart from creating worries that other more systemically important countries might find themselves in choppy waters, and (ii) the largest part of Greece’s trade is with Eurozone partners, and this takes place on a fixed trivial Euro-to-Euro basis (55% of imports and 65% of exports are with EU partners, of which the bulk is with Eurozone members).

This implicit peg has served well as an anchor for inflation, but might not be optimal in the current circumstances. If one were to give an IMF-style advice to Greece, then one would probably recommend a currency devaluation or resetting the peg (as this IMF surveillance document points out, where advice is given this is towards more flexibility). It would not inflate the debt away, as this is denominated in Euro, but it will (i) improve the balance of payments in the short run, (ii) inflate away wages that are currently sticky, and (iii) reduce the size of the housing bubble which is also sticky due to the unwillingness of sellers to accept reductions. Perhaps this would have been already optimal in a beggar-thy-neighbor fashion, as recession hit the country.

Paul Krugman suggests, in the case of Spain, that the only option is for nominal wages to drop. This is the route that Ireland has taken, but Greece seems to be unwilling to follow due to pre-election commitments. Does that mean that for Greece the only remaining alternatives are (i) exit the Eurozone, get back to the old Drachma and devalue, or (ii) wait for the IMF to enter the frame and force the wage cuts that the government will not?

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One Response to “something’s got to give”


  1. […] lost two-thirds of their value over the same length of time. For all practical purposes Greece is essentially pegged to the Euro, in the same way Argentina was up to the breaking point. The decision to be made (by Merkozy […]


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