ecos by RahulKeshav


									Austerity - the Euro or the Dragma? A Greek thought experiment

A note by AJ Smit

Austerity is a reality in Europe and especially in Greece. The question is who are responsible for austerity
in the first place and who have to bear the consequences of austerity? What nobody seems to know, or
those who do know conveniently forget, is that it all began in January 1999 with the creations of the Euro-
zone. Gone were the days of the lire, Dragma, Peso, Frank, Mark and others. Jubilant politicians and
powerful business executives hailed their success – the creation of the EURO. But from the very same day,
and in the years beyond, we had the Latinos still having their siestas, the Zorbas their fun, others their
spaghetti and even those who enjoyed exquisite food, wine and perfume and those that like saving. The
party lasted until 2008 when the trouble started in the Euro-zoo with Greece first baddy.

Who are the 15000 Greek state workers that will lose their jobs or those that lose some of their livelihoods
by cutting the minimum wage by 20%? Who will suffer for many years to come as austerity deepens? Who
gained on the rebound of international financial markets after the austerity deal was struck? As one asset
management guru recently proclaimed in a South African newspaper – the average Greek will be worse off
if Greece return to the dragma “.... you should ask yourself do you want a few units of a strong currency or
many units of a weak currency?” Obviously the guru wants many units of any strong currency, point.
Those that bear the consequences of austerity would probably prefer their own devalued dragmas to
decide for themselves how much of their precious dragmas they want to spend, or can afford to spend, on
non-Greek goods and service instead of losing their jobs.

So what is this all about? First people vote for politicians because they think they can trust them. They
think that the policies politicians initiate (in this case the Euro) will be good for them. Second business
executives, for their own good reasons, supported the politicians on the Euro issue. Are they really
concerned about those that suffer today under austerity or do they rather think that those who work for
them get up in the mornings and think; “today I am going to make more bottom-line profits for my
executives so that they can earn more millions in bonuses”. Well employees don’t really think this way.
They have to work to earn a living to buy things they need. It is the employees that are frustrated with
austerity, that take to the streets (sometimes in violent fashion) to protest against austerity, not the
politicians (or business executives). Then there are those not so Greek that ask – how can they do this?
Austerity is for your own good! But is the Euro really for good for the austere?

One have to realise that in all this mess there are some good, bad and ugly. What people want is a world
where they can buy and sell where and whatever they want. This is good because it is known since the 17 th
century that free trade, provided that it is fair, is better than protectionism. This was, and is, good for the
world because it has put millions of people who had no jobs and were desperately poor into jobs even
though those jobs, in the eyes of many, pay sometimes very low wages. The bad is that mercantilists’
governments sometimes think that trade is not a good idea because they belief imports are bad and
exports are good, thus they panelise imports and subsidise exports. In many cases this mercantilists’ idea
has turned ugly, as we have seen during the great depression and with some hints of this thinking after the
2008 worldwide financial crisis.

As nations trade with each other they exchange one currency for another – this is now if they are not part
of the Euro. Normally the currency of countries with surpluses will get stronger and those with deficits
weaker. This way the balance between the surplus and the deficit countries are restored. The bad is that
governments can interfere in this automatic adjustment by accumulating massive amounts of foreign
currency which then short-circuit the automatic adjustment process. This can eventually turn ugly for
themselves and for those that trade with them. In this case free trade is no longer fair or good for the
unemployed and the world and free trade becomes a zero-sum game. The exports of a country remain
cheap (good for people in other countries who buy it cheaply) and imports expensive (bad for the people
of the mercantilist country who have to pay for these expensive products and services).

A bad thing that can turn ugly is when the smart international financial mangers become greedy because
they play with other people’s money. International fund executives propagate that free capital movements
is good for all, but especially for them, because, without fee movement of capital they can’t really play the
international money game. This is an old movie; the Asian crisis of 1997, the Brazilian currency crisis and
the South African currency crisis of 2002. There is a remedy however when funds managers get greedy –
capital controls.

With free capital movements, in the bag, comes the desire to have low risks and stable (preferably low)
interest rates. What is better for a business, to hold bonds (or other financial assets) denominated in
higher risk Dragmas or lower risk Euros? Does it not make sense for government borrow on the back of
cheap euro bonds, which is easy to come by, because it does not reflect the risk profile of their past
spending behaviour? Buying euro bonds of Greece has a different risk profile than buying Dragma bonds.
For most part, the nature of such a beast is to borrow as much as you can, when it is cheap and easy to
come by. This is especially true when you are used to more expensive borrowing that was difficult to come
by. Where did all the debt of Greece, Spain, Italy, Estonia and Ireland come from? Was it not because of
the creation of the euro that replaced, Dragma, Peso and Lire bonds with Euro bonds? Euro bonds are
after all far less risky that dragma, peso or lire bonds?

With the desire for free capital movements and preference for low and stable interest rates comes the
ultimate desire – a fixed exchange rate. The advantages of a fixed exchange rate, especially for businesses,
are obvious. What is not so obvious is that what is good for business is not necessarily good for a country.
According to Robert Mundell, a Nobel Prize winner in economics, a country does not have the luxury to
simultaneously fix the exchange rate, have free capital moments and low stable interest rates. At best a
country can only have two of these luxuries at a time. If it chooses to have a fixed exchange rate (in this
case the Euro instead of the Dragma) then it has to choose between free capital movements or stable
interest rates. This is what Paul Krugman, another Noble Laurent in economics, calls “the eternal
triangle” and this is where the trouble in the Euro-zoo started.

So why is their trouble in the zoo? A zoo has many kinds of animals that behave differently than others in
the zoo. Thus in the world zoo you will find different CAGEs and in those CAGEs you find, animals with
different Cultural, Administrative (or institutional), Geographic and Economic behaviours (with reference
to Ghemawat’s CAGE framework). For instance you will find, in the South African CAGE, animals that
have different cultural behaviours but with uniform administrative, geographic and economic behaviours.
Across the states of the United States of America you will also find animals whose cultural behaviours
somewhat differ but there administrative, geographic and economic behaviours are fairly uniform across
the states. In the Euro-zoo you have a problem. Here it appears, or seems obvious, that the animals in this
zoo differ in their behaviour on all dimensions. Not the kind of requirement for a single currency to work.
Some like spending and siestas others like saving and long working hours. With the Euro in place the
behaviours of the animals in the different CAGEs must also be aligned for the Euro-zone to work. When
the CAGE frames are removed the Lion will have to change its behaviour because zoo is becoming one

So how does one change the behaviour of the Lion to alleviate the pain of austerity that will happen if you
don’t change the behaviour of the Lion? There are different ways to do this according to Robert Mundell.
One is through what is known; form a first year economic course, the price-specie-flow mechanism. Given
the luxury of the Euro, Greece does not give up the luxury to of free capital movements because for that
you require your own “National/Reserve” Bank and own currency which Greece does not have. Thus, they
have to relinquish their autonomy on fiscal policy and low stable interest rates. Wages and prices will have
to drop in Greece relative to the other countries in the euro-zone to overcome austerity. Although their
economic problems were created by themselves and the Euro; the instruction on how to austere does not
come from themselves because they had to relinquish their autonomy on fiscal policy and low stable
interest rates. What does this mean? It begins with sacking 15000 state workers, drop the minimum wage
by 20%, all and all, it seems a required spending cut of E325 million. The instruction is clear; if we are
going to help you, you should go into a deep austerity. This will not happen overnight – it will be a long
drawn-out and painful process. The plan to bring down the debt to GDP ratio to 120% by 2020 is a good
indication of how long they think austerity will last.

There is another sad story of being part of the Euro. With the relief-debt, as well as higher interest on the
new debt the total debt liability will most probably go up? How will it be possible to bring down the debt
ratio if debt goes up but the income that is supposed to service and reduce that debt is falling at an
alarming rate? If Greece was a company the prediction of this outcome would have been very easy. But a
country is not a company. The “employees” of Greece incorporated will just get poorer, suffer more and
become unhappier. So what are the options given the euro? None at all, except for toughing out austerity.
There is no fiscal space to simulate growth, no monetary space because they don’t have their own
currency, and interest rates will remain high for time to come. Will they get through this with the euro
intact? The answer is un-doubly yes, they will get through this, but it is uncertain if the euro will be intact.
Prices and wages will eventually over the long term drop to levels where Greek goods and services will
again become very attractive for non-Greeks. Exports will begin to increase, factories will hire again and
growth will return, but this is a long, long way off and it will be a very hard struggle.

The second option is to leave the Euro-zone and bring the Dragma back. With the Dragma intact, no
foreigners (or any other eurolites) can command control over Greece’s choice of luxuries. They will
suddenly have a number of new policy options to tackle the austerity problem. First they can allow the
dragma to depreciate. No need for immediate layoffs or 20% cut in pensions or any other drastic fiscal
cuts that will grind growth to a dead halt. The depreciation of the dragma will immediately drop wages of
every Greek, including the rich and famous. Who will take to the streets if you still have a job or your same
monthly pension and minimum wage? There will be no politicians that tell you, you are fired, or you will
get 20% less because others demand this from us. When you go to the market you will simply realise that
you have been fooled to take a hefty indirect pay cut. But, under these circumstances, you can organise
your own life around what you can and cannot afford. Will you be unhappy? Yes but who is to blame. It
happens so fast that there will be no time to organise to take the streets. The upside of all this is exports
will immediately be cheaper for the rest of the world – they will start buying what Greece has to offer and
this stimulus in the economy will ease the austerity pain and the chance of a long deep recession.

Who lose and who gain in all of this? All the Greeks will immediately lose. What about the herd of
international financial managers – will they not exercise their herd behaviour as they have done in nearly
every currency crisis in the past? For sure, but now we have a remedy for that - decree a ban of all capital
flows until the markets stabilises. With the herd behaviour under control you don’t have to resort to much
higher interest rates to contain the herd behaviour as Thailand have tried in 1997, with no success.
Neither do you need high interest rates to protect the depreciation of currency as Dr Stalls did in South
Africa in the 1990s. The counter argument is that if you do this it will be difficult to see capital flowing
back to the country. There is unfortunately no proof of this over the medium term or log term. When
things normalise the herd always returns. What about businesses and executives? Sure they will all lose. If
you have any investment as an outsider in a country whose currency suddenly depreciates you obviously
are worse off because the investment will be worth less in a stronger currency. Whose fault is this? It is
probably your own fault, because you allowed yourself to be fooled by the illusion of a perceived low risk
Euro. Would the decision, at the time of the investment, have been the same if the currency was a Dragma
instead of a Euro? And so the story goes – all the Greeks and everyone else with a finger in the Greek pie
will be losers, but austerity for the Greeks will be much shorter and not as severe. So is the euro good or
bad for those Greeks who did not create it in the first place?

The evil of austerity in Greece will not go away! The question however is; which is the worst of the two
evils – stay in the Euro-zone where austerity will take place internally or opt out and have more policy
options to austere?

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