Devaluation and the Real Exchange Rate

Why should have greece people wanted to have their industry more competitive? As long as you have ample public services, social benefits, unemployment benefits, there is no reason to do anything about your situation.

I don’t understand why sticky wages in Greece imply a lack of rational expectations. One is neither necessary nor sufficient for the other.

It seems that each price has a degree of stickiness. The euro/euro “exchange rate” is at one extreme of the stickiness continuum. At the other extreme there are pure commodities traded daily in free markets and floating currencies. Going to the drachma would result in instantaneous adjustments to exchange rates. Wages and entitlements in Greece may be sticky, some contractural obligations may be fixed. There is no doubt that leaving the euro would affect relative prices throughout the Greek economy, probably in a helpful way. Provided Greece is not torn to pieces by violence.

But Cochrane has a point too. How did wages, entitlements and “rents” get so far out of line? This must represent some kind of political power. If the politics doesn’t change, then the uncompetitiveness will re-emerge. And surely the parasites on the Greek economy are making contingency plans for a devaluation at this moment. Those plans probably include strikes, slowdowns and violence.

Sovereign labor cartels usually block the fall in wages. In this case the devaluation causes a contraction of the labor supply instead of a fall in wages.

The post doesn’t mention it, but much of the Greek debt is denominated in euros. If Greece goes back to the drachma and devalues it by half, they double what they owe those holding Greek debt in euros. If they can’t pay the interest on that debt today because it’s so large, think of what those interest payments are after the drachma reinstitution & devaluation.

Of course, they’ll default on some of that debt, but I’d think it would be much larger if they leave the eurozone.

Bloomberg Businessweek, Jan. 9 – 15, 2012, p 12, “Don’t bring back the drachma” editorial made a lot of sense to me. One of the first adult, sensible discussions of the pros and cons of Greece leaving the eurozone, and from an unlikely source!

It starts by giving the usual arguments for leaving, then says this: “The trouble is, leaving the euro would be an even bigger economic disaster. It would cause a run on Greek banks as depositors rushed to move their euros abroad before the balances could be converted to drachmas. And Greek borrowers would still owe euros to foreigners. B/c the new drachma would instantly depreciate, the borrowers would have diminished capacity to service those debts, causing new waves of of bankruptcies.

“Difficult as it may be, debt restructuring plus ‘internal’ or ‘fiscal’ devaluation looks preferable. Explicit wage cuts, and the recession needed to induce them, don’t have to carry the whole burden of cost adjustment. A combination of increased value-added tax and lower payroll tax (Greece could easily do both) mimics a currency devaluation by raising the price of imports relative to the price of exports, lowering real wage costs by stealth….

“In theory, persistent cost inflation can be smoothly offset by a steady devaluation of the currency, but many countries have found controlled depreciation hard to achieve…a floating exchange rate might look helpful, but in practice it would be a mixed blessing.

“Inside the system, the peripheral countries have learned a harsh lesson: They must hold growth in wages to the euro area’s rate of inflation plus any increase in national productivity….”