The Main Policy Lesson from the Greek Crisis

A main conclusion to be drawn from the Greek crisis is that an external currency regime is no cure for lax budget policies, writes Megan McArdle in a Bloomberg post today. On the contrary, I would add, an external currency can be a main cause of disequilibrium in public finances since a disequilibrium exchange rate stifling growth effect is likely to incite a government to recourse to more public spending and budget deficits in the hope of compensating for the deflationary monetary policy effect.

Here is a quote from her post:

“It's easy to moralize Greece's feckless borrowing, weak tax collection and long history of default, and hey, go ahead; I won't stop you. But whatever the nation's moral failures, what we're witnessing now shows the dangers of trying to cure the problems of weak fiscal discipline with some sort of externally imposed currency regime. Greek creditors and Brussels were not the only people to joyously embrace the belief that the euro would finally force Greece to keep its financial house in order; you hear the same arguments right here at home from American gold bugs. During the ardent height of Ron Paul's popularity, I tried to explain why this doesn't work: "You don't get anything out of a gold standard that you didn't bring with you. If your government is a credible steward of the money supply, you don't need it; and if it isn't, it won't be able to stay on it long anyway."

This goes double for fiscal discipline. Moving to a fixed exchange rate protects bondholders from one specific sort of risk: the possibility that inflation will erode the real value of your bonds. But that doesn't remove the risk. It just transforms it. Now that the government can't inflate away its debt, you instead face the risk that they are going to run out of money to pay their bills and suddenly default. That's exactly what happened to Argentina, and many other nations on various other currency regimes, from the gold standard to a currency peg. The ability to inflate the currency had gone away, but the currency regime didn't fix any of the underlying institutional problems that previous governments had solved with inflation. So bondholders protected themselves from inflation, and instead took a catastrophic haircut.

In financial markets, it is easy to move risk around and change who is bearing it. On the other hand, it's very hard to actually get rid of the risk. The biggest problems come when we think we have -- when we mistake risk transformation for risk avoidance. That's what happened in 2008, and that's what happened with Greece: Creditors acted like the risk that Greece wouldn't be able to pay its bills had somehow been eliminated once it moved to a harder currency. When everyone starts pretending that we've suddenly stumbled onto a sure thing, the safest bet is that we're in for a lot of drama.”

To contact the author on this story:

Megan McArdle at mmcardle3@bloomberg.net