Should Greece ditch the euro?

Some think that Greece and other weak euro area countries would benefit from ditching the euro and introducing devalued national currencies. Are they right?

By , Guest blogger

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    Pedestrians pass a plaque portraying a Greek one-drachma coin, which was replaced by the euro in 2002, outside Athens City Hall, on Monday, May 14, 2012. Some argue that cash strapped European countries like Greece should get rid of the euro and go back to a devalued national currency.
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Aside from Argentina, that I've discussed here, the most popular empirical example used to argue that Greece and other weak euro area countries would benefit from ditching the euro and introduce devalued national currencies, is the experience of the 1930.
Though there are differences between the euro and the gold standard, they are similar in the sense that both means fixed exchange rates and the inability to devalue/depreciate the currency.

And the empirical record of the 1930s is pretty clear. The faster countries got off the gold standard the faster they recovered. Britain and Sweden that devalued first recovered first, the United States devalued somewhat later and recovered somewhat later, while France and Belgium that held on to the gold standard the longest recovered latest of all countries.

This strong correlation was in fact mostly causal. The reason was that bank panics had caused wide scale collapses of fractional reserve banks creating in turn what Hayek called secondary deflation in very high doses, often as high as 10% per year, something that given the inability of nominal interest rates to go below zero meant that real interest rates was as high as 10%-far above the natural interest rate, causing not only malinvestments but also fundamentally sound investments to be liquidated. And when other countries devalued this helped aggravate this secondary deflation.

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When those unnaturally high real interest rates were dramatically lowered after the gold standard was abandoned, this caused the economies to recover.
However, in the euro area today we see no secondary deflation. Price inflation is well above 2.5% in the euro area, and even in Greece it is still 1.5%. That is why we can't expect a similar development if Greece or others re-introduce their currencies. Eventually at some point during the coming years they will almost certainly see some form of recovery, but that will happen regardless whether they stay in the euro are or not.

The baltic countries have seen their economies recover strongly ( Estonia's GDP have increased a cumulative 13.9%, Latvia's by 10.5% during the last two years), albeit from a very depressed level, despite not devaluing while Britain and Iceland failed to see any recovery following the dramatic drop in the value of their currencies in 2008, illustrating that devaluations only work if it is made in the context of secondary deflation.

The Christian Science Monitor has assembled a diverse group of the best economy-related bloggers out there. Our guest bloggers are not employed or directed by the Monitor and the views expressed are the bloggers' own, as is responsibility for the content of their blogs. To contact us about a blogger, click here. This post originally ran on stefanmikarlsson.blogspot.com.

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