Friday, July 10, 2015

There won't be a drachma-induced recovery

I catch both Lars Christensen and Brad DeLong making the claim that an introduction of the drachma will work wonders for Greece. Lars, for instance, says that:
However, Grexit will also remove the monetary straitjacket, which has had caused an enormous amount of economic hardship in Greece since 2008. The removal of this straitjacket will cause a significant easing of Greek monetary conditions, which in my view very likely will cause a sharp rise in nominal GDP in Greece in the coming years.
I hate to rain on the party, but even if a drachma is introduced and it collapses in value there won't necessarily be a drachma-induced recovery. Greece is currently in a straitjacket because its monetary standard -- the system for measuring and conveying economic value -- is a euro standard. Think of the euro as being akin to the metric system, a standard for measuring weights and distances, or dots per inch, a standard for measuring print resolution. An introduction of drachmas banknotes into circulation is simply not a sufficient condition to create the sort of effects that Brad and Lars want. To get their recovery, Brad and Lars need an all out monetary standard switch. But as long a Greek prices continue to be expressed in euros, drachmas will simply swim within the existing euro standard fish bowl. All sorts of mountains must be crossed before the penultimate switch of standards. This isn't "snap of the fingers" territory.

Drachma as another bitcoin

To better understand the destiny of a new drachma, its nice to have an example. Lucky for us, we can find one in the recent emergence of one of the world's newest currencies, bitcoin. Now Lars assumes that a collapse in the drachma will have all sorts of beneficial effects on the Greek economy. But does the world economy roar when bitcoin plunges? No, and here's why.

While merchants accept bitcoin as payment, they haven't accepted it as a standard. Sticker prices continue to be set in units like dollars, yen, pounds, etc., Bitcoin swims within the existing fiat standard. To accommodate those who want to pay in bitcoin, merchants will typically use the last-second bitcoin-to-dollar exchange rate (taken from foreign exchange markets) as the basis for the bitcoin price of their goods. Which means that as bitcoin plunges in value, the amount of bitcoin that retailers ask for their stuff is immediately adjusted upwards by a concomitant amount.

This is important because implicit in Brad and Lars's drachma recovery story is a certain degree of price stickiness. As the fundamental value of the standard unit plunges, sticker prices are slow to adjust upwards. Knowing that sticker prices will at some point start to catch up, people spend their currency now before it loses value, thus stoking an economic boom as merchants' inventories are drawn down. This sticky price effect is entirely lacking in bitcoin. Given a sickening collapse in bitcoin, those who own the stuff have no reason to spend it on before it loses value. After all, the amount of bitcoin that retailers require is adjusted every second, so prices in terms of bitcoin don't stay sticky. A bitcoin collapse therefore has no real effects on the world economy.

Applying this lesson to Greece, there's no guarantee that a decline in the drachma will boost the Greek economy. The appearance in circulation of drachma banknotes needn't mean that sticker prices will be set in drachmas. To determine how many drachmas Greeks must pay for an item, retailers may simply refer to its euro sticker prices and convert that amount into drachma by glancing at the last-second drachma-to-euro exchange rate. If so, then just as bitcoin prices are not sticky, neither will drachma prices. Without the requisite stickiness, a collapse in drachmas will not have the real effects that Lars and Brad want. Only a collapse in the euro, the monetary standard, will harness the sticky price effect the two implicitly invoke. But that effectively means Greece remains in its monetary straitjacket, despite having debuted a drachma.

Hurdles to switching

I've talked about the network externalities involved in switching standards before. Take an incumbent standard and a new standard. Even if the quality gap between the novel standard and the inferior incumbent is quite high, the costs of coordinating everyone onto the new standard may be too onerous for adoption to occur. Hysteresis, or lock in, is the result.

Switching to a drachma standard requires that a strong third party step in to overcome these network externalities. They need to punish, or credibly threaten to punish, those who refuse to comply. The Greek government, which has already demonstrated an inability to execute on basic tasks like tax collection, could very well lack the resources that are necessary to adequately perform the tasks of a third party.

Further militating against a drachma standard is its massive quality gap. A monetary standard should be as nuisance-free as possible. Merchants do not want to be adjusting their prices every day, and customers want to know that the blender they saw on a store's shelves on Tuesday will be worth the same amount when they go back on Wednesday. If sticker prices must be adjusted hourly, or even by the minute, the amount of time and mental space that people must allocate to calculation and measurement will displace other more meaningful activities. Like bitcoin, the drachma would probably be a one of the world's most volatile currencies; the incumbent euro one of its steadiest. So rather than improving on the euro standard, a drachma standard would represent a regression in quality.

Given that a strong government must spend a significant amount of resources getting its population to adopt a better standard, it's hard to imagine that a weak government will ever be able to foist an inferior standard on its population without facing a backlash. So contrary to Lars and Brad, there is no guarantee that issuing drachmas offers an ultimate salvation. In the end, there's probably very little difference between a Greece that introduces a drachma or one that doesn't, since either way the incumbent euro standard will likely stick around.

Note: This is very similar to my previous post on the topic. I've introduced the bitcoin analogy, which I think helps drive home the point, and also brought the quality gap to the forefront. 

Nick Rowe comments here.


  1. "But as long a Greek prices continue to be expressed in euros, drachmas will simply swim within the existing euro standard fish bowl. All sorts of mountains must be crossed before the penultimate switch of standards. This isn't "snap of the fingers" territory."

    Yeah, there will be gradualness to the switch, but in some ways that's a good thing. Exchange will be allowed to continue, even if the drachma is not that widely trusted or available.

    But I think that the drachma would certainly have a lot more value than bitcoins for at least the one big reason any decently functioning government has; you can pay taxes with drachmas. I think as a result, Greece, if they go to the drachma, should really work on their tax enforcement (and decreasing corruption). Plus, no government is going to say that if you don't accept bitcoins for a debt, the debt is erased. And the government can go out and buy things from Greek businesses and say we're paying in drachmas; again, no government is going to say, we're paying in bitcoins, like it or not, and you have to sell to us.

    1. I'm reading your thought provoking post kind of fast, as I have to leave soon, but perhaps a big thing here is that even with the, non-price-stickiness, it's in Euros, thing (which I have to think about). The drachma allows the government a lot of room for fiscal stimulus. They don't need Euros in their coffers that they can't print to go out and buy things. Print drachmas and buy from businesses, even businesses outside of Greece, to some extent, at some rate. That's a level of freedom they just don't have without the drachma.

    2. "The drachma allows the government a lot of room for fiscal stimulus."

      That may be true, but it can get the same fiscal effects by issuing some sort of euro-denominated IOU redeemable in 3 or 4 years. The key point remains... prices will not be sticky in drachma terms, so there won't be a drachma induced recovery. Continued use of the euro probably provides the exact same set of outcomes as the drachma route.

    3. Having a Drachma would be a lot better than IOUs, plus over the long run way better than IOUs.

      But also, thinking about it further, it used to be fairly common for countries to have an official pegged exchange rate for within the country, and capital controls. If Greece did this, until it was through the crisis, and had established its currency, then the prices would stick, at least by this mechanism.

      And eventually, over the long run, you would establish your currency. Otherwise, you never escape the nightmare, at least probably for generations, of sharing a currency with a zone far larger than you, that's very disparate, with little or no fiscal union, and a central bank dominated by inflationaphobes and VSPs, and rightwingers, who want constant recessions and depressions to use as an excuse to dismantle the social safety net.

  2. Monetary standard switch can be very easy, even if all sticker prices remain in euro. It can be done with one stroke of a pen.
    All the greek government needs to do is to declare that by law all contracts (in-country debt contract, wage contract, etc...) and prices of goods denominated in euros are legaly redeemable in the same face value of drachma, so that 1 drachma has to be accepted for redeeming something having the contract- or sticker-price of 1 euro.
    By doing this, the drachma will become a second legal tender.

    This law will of course only apply within the territory of greece, so that the definition of what a euro is will change completely in this single country. In fact then there will be a separation of greece euros and euros of other countries.

    Greshams law teaches us that, as long as enough (i.e.: too much) drachmas are issued, no one inside greece will use euros anymore (except for imports). Prices (denominated in euros, but payed in drachma) will rise.
    Other countries who trade with greece will do so by exchanging their *real* euros in drachmas so as to get a much better deal when paying the euro denominated greece goods.

    This approach has the additional advantage that the greek government can insist that their country is still on the euro standard, while in fact it isn't. From a political standpoint, that might be much better compared to an *explicit* monetary switch. External debt need not to be affected by the legal tender change, so that the debtors should be ok with it.

    Does this idea make any sense?
    I think it is economically somewhat comparable to the greeks illegally printing lots (an inflationary amount) of *real* euro currency, and then are forced by the other euro countries to enact extremely harsh capital controls, so that these euros cannot spil over to other countries. Only without the illegal and capital controls parts.

    1. Ah, and of course this means that all deposits will be automatically also be converted to the new drachma, since their assets (loans) will then as well all be redeemable in drachma.

    2. It's an interesting idea, not sure if you get a drachma induced reflation out of it though.

      "All the greek government needs to do is to declare that by law all contracts..."

      Nice in theory, but my worry is that this would cause a revolution. Does the Greek government have enough resources to enforce this law?

    3. Also, legal tender is only coins and notes, not demand deposits. And there are other ways to enforce contracts without the statist legal system, e.g. with cryptocurrencies.

    4. @Peter Šurda:
      Yes, your are right, but the owner of demand deposits have the right to convert their deposit money into the legal tender coins/notes (in this case drachma), so that doesn't change anything about the economic argument.
      Yes, it does rely on a statist legal system, but so does every legal tender like the current euro. So?

      @JP Koning:
      All legal tender derive their main value from their special legal treatment, namely the fact that their notes and coins must be accepted to redeem contracts denominated in their currency.
      The switch from national currencies to euros about 14 years ago was mainly also just a switch in law, since the new currency was introduced by declaring how every sticker price and contracts is to be converted to euro prices, and by declaring the euro coins and notes to be the new means to redeem them.
      So I don't see how this kind of switch would in any way be heterodox, and why it should cause a revolution.

      About the enforcability:
      While it is true that the greece government is largly unable to enforce laws like value added taxes, this special law is different in that for every contract, there is always one party who has a very strong interest to insist on using the drachma. If the other party doesn't want to accept it, the first party can go to court.
      This is different than (say) the enforcement of a VAT, because in this case, both partys (buyer and seller) have an interest to deceive.

    5. My point is that the attempt to force drachmas onto people may backfire: they would stop using the Greek legal system, further disempowering the government. With respect to the legal tender, this is, in my opinion, less relevant than in the past. There are already limits on how much you can withdraw from your account in general (not even mentioning the 60€ daily limit they have in greece now). Paying taxes or B2B transactions are done by cash less and less, and governments even restrict it to mitigate tax evasion (see If enough Greeks held Euros (for example, Euro-denominated debit accounts in other countries), it would be irrelevant what the legal tender in Greece is, the bank system would convert it using real time exchange rates. In the EU, you can have a bank account in another EU country just with a passport even if you do not reside there (in reality, a proof of income may be necessary too, but in this hypothetical situation this would be present). And if Greeks in this situation needed cash, they would just withdraw a couple of drachams using their foreign ATM card, and spend it quickly.

      And with Bitcoin it would be even easier than with Euros, because you don't need to travel anywhere or ask anyone's permission to get a Bitcoin account.

      This is a double edged-sword, as I like to point out: one branch of the government wants everyone to use its national money, as that gives them seigniorage and the ability to conduct monetary policy. On the other, they want to restrict what they do, in order to conduct fiscal and other policies. These goals are in conflict, and attempt to force one of them may backfire and cause a loss of both goals.

    6. Also regarding enforcement: if the party insisting on paying in Drachmas goes to court, noone will ever sell him anything again. As I said, it's a double edged sword.

    7. Also, with the historical switch TO the Euro, the people in these countries had less choices: everyone was switching, not just one country, and, at least for Greece, it was a switch to a harder currency, so the random citizen had no reason to object.

      The switch TO the Euro was planned for years, accompanied by massive PR and investment in infrastructure, as well as legal framework. The central banks were obligated to exchange the old bank notes at a fixed exchange rate and without fees for at least ten years.

      For arguments' sake, I'll admit that the Drachmaisation is not impossible. It's an empirical issue. But I agree with JP that it does not look like the Greek government can pull it off. They don't have the infrastructure, time or money for that, and being in a quasi-currency-board is not helpful either.

  3. Well, Lars Christensen is probably right that it will cause a sharp rise in nominal GDP. But only if you measure it in drachma.

  4. Won't wages be quoted and paid in drachmas? Ditto rents? And debts? And others that I've not thought of? I have understood much of the argument for going of the Euro as a way to float these 3 sets of prices, and non-traded goods more generally. Traded goods will continue to priced in Euros & then restated in drachmae (? May I use a latinate plural for a Greek word? As a barely mono-lingual American, they're all the same to me), and of course, this is a problem since Greece imports much food and energy, but non-traded goods will fall in value and price, which is one of the reasons for floating exchange rates, no?

    1. "Won't wages be quoted and paid in drachmas? Ditto rents? And debts?"

      Paid in drachmas, not quoted in them. Thus you're not going to be able to float them.

  5. I find your reasoning utterly unconvincing, but your conclusion is probably right on the money (so to speak). So why will a drachma not help Greece? Because the Troika, and the German government and financial sector, wants to destroy Greece as an example. If it starts looking like Greece is recovering, they will bend their resources to ensuring that this does not occur, probably without the slightest hint of shame, nor even the slightest acknowledgement that millions of people might be considered rude.

  6. Hi JP Koning,

    A Greek exit doesn't seem likely. It doesn't seem compatible with a Greek person working across the Border who would still be paid in Euro but has a mortgage or loan in Greece re-denominated in Drachma. It would entail exchange rate risk and conversion costs that were not in the original contract. It was different when a member entered the Euro as joining currency was abolished and so all payments systems were switched over at the same time.

  7. I think you have to keep an eye on what it is you say will improve. As Nick Edmunds says, nominal GDP is likely to rise in terms of new Drachmas. Part of that will be due to inflation part of it due to increase in local output. In that latter sense. I think the added option of fiscal stimulus can help wrt domestic capacity utilisation.

    The problem I see, and which can be observed in many countries with weak / non-reserve currencies, is that you end up with two parallel economies. One, not denominated and conducted purely in reserve currency, for imported and export quality products and another in Drachmas for 2nd rate local produce.

    Seeing as many of the goods that are now in short supply are imported (oil, medication), it is questionable to which extent domestic growth will help solve such real problems. Also, there is the external debt, current and future, denominated in Euros. As I said in a comment to Nick Rowe, keeping exchange rate parity is not enough if nobody accepts your currency in payment. Greece needs to export and I'm not sure how local NGDP growth would help in that respect.

    But this is all tengential to your point about price stickiness, I guess, which I haven't quite grasped yet, I admit.

    1. Or, to put that differently, I'm saying that a boom must not automatically be equated with an export boom as those with quality products would effectively not join the Drachma area and thus not profit from the devaluation, whereas those with 2nd rate products won't find buyers outside Greece no matter what the price and so wouldn't profit on international markets either. To the extent that that makes any sense at all, it may be somewhat congruent to what you're saying?

    2. "But this is all tangential to your point about price stickiness, I guess, which I haven't quite grasped yet, I admit."

      Let's say you know that the dollar in your hand will be worth 10% less next week. Retailers know this too, but rather than adjust their prices up by 10% today, they allow their sticker prices to stay fixed for three more days. What do you do? You spend your dollar now before sticker prices adjust and enjoy . Because everyone will do the same thing that you do, this creates a short term boom.

      Let's say you know that your bitcoin will be worth 10% less next week. Retailers know this too and so they adjust their prices up 10% today. You have no extra incentive to spend your dollar since sticker prices have already adjusted. No boom is created.

      If drachmas are like bitcoin, then a devaluation doesn't create a boom. If they are like dollars, a deval will create a boom.There is a high probability that drachmas will end up being like bitcoin.

    3. So, everybody knows prices will fall, but nobody acts on their knowledge? How do they know then? I say they don't until next week, which is when they change prices.

      My hunch is that price stickiness, apart from a human laziness and a wait and see whether it will take care of itself factor, is mainly a function of debt contracts which are sticky by definition. You certainly don't lower prices until you have absolutely no choice left.

      Bitcoins do not finance any investment so there is no inherent incentive to keep its price in terms of goods and services relatively constant. Bitcoins are however themselves an investment to those who mine them, so there is a strong interest to keep the price of Bitcoins in terms of reserve fiat currencies rising. Why else invest? And it is when that doesn't happen that you see investors running for the trees. That affects the real economy in the same way that a crash in shareprices of any other, non-systemic company does. Not much.

      In that sense, I would put the new Drachma clearly in the category of the Euro, not in that of Bitcoins. It would be credit money. But that isn't to say that the exchange rate witht the Euro would be stable.

      The challenge would be to spread acceptance of the Drachma as quickly and comprehensively as possible to stabilise the exchange rate. It needs to become systemic and not just a marginal phenomenon for gvt. employees and deadbeats and once a year for paying taxes. I'll grant you that that will be difficult, especially since many inputs are imported and therefore conducted in Euros. Same problem here in Switzerland, albeit with reverse signs. But then again that might, after an initial shock, have a stabilising effect - with the downside effect of limiting the boost to international competitiveness.

      I think I'll stick with my first remark and say that Greece under a new Drachma would see two economic spheres that have grown together since the Euro, drifting apart again. A strong, competitive one, denominated and conducted in Euros and a weak, domestic one, denominated in Drachmas. But that's just an uneducated guess.

    4. "Bitcoins do not finance any investment so there is no inherent incentive to keep its price in terms of goods and services relatively constant.."

      Oliver, I'm not following you at all.

      Bitcoin sticker prices fluctuate wildly (just check out because they are generated at the last-second by referring to the USD:BTC exchange rate, which is itself highly volatile. Retailers like Overstock have an incentive to do things this way because if bitcoin falls 30% in five minutes, then a failure to adjust its bitcoin price means it will be offering those who shop with bitcoin an incredible 30% arbitrage opportunity!

    5. I'm coming from a circuit theory / credit theory of money perspective here. Euros and Drachmas are emitted as a byproduct of (more or less) productive investment, either government or private. They have real world counterparts and corresponding debts. Bitcoins, although I cannot claim to have any deeper knowledge of them, seem more like a money derivative to me. Hence the volatility. The confusing part being their function as MOE which they share with 'real' money.

      But that's just my rookie point of view.

      One more question on stickiness: If people expected prices to fall 10% in a week, but didn't adjust prices in a weeks time, what would happen in your opinion? I say nothing, those expectations evaporated.

      Anyway, thanks for engaging.

    6. The key point is the way that real-world bitcoin prices are set, which I don't think is under dispute? If, by analogy, drachma prices were to be set in the same, then drachma prices would not be sticky and there would be no benefits flowing from a drachma devaluation. [If expectations are shattered, as you ask in your last paragraph, then consumers will try to restore their optimal holdings of goods and assets in the next period.]

    7. The key point is the way that real-world bitcoin prices are set, which I don't think is under dispute? If, by analogy, drachma prices were to be set in the same, then drachma prices would not be sticky and there would be no benefits flowing from a drachma devaluation. [If expectations are shattered, as you ask in your last paragraph, then consumers will try to restore their optimal holdings of goods and assets in the next period.]

      No, I'm not disputing your description of the way bitcoin prices are set. I'm saying, Drachmas will (eventually) tend to behave more like Euros because they are fundamentally the same kind of money whereas bitcoin is another creature all together. I say there could be a world with only Drachmas, but no world with only bitcoins.

      Going through the steps:
      Upon introduction of the Drachma, manufacturers will be faced with both local and imported / international inputs. Sticker prices will reflect that in that and will follow Euro prices more closely than the exchange rate itself would suggest. Wages, being in Drachmas would not keep up with Euro infused prices and so there would be a loss in purchasing power, meaning the intended boost would not materialise. I think that is your point? And I agree.

      As a follow up phenomenon, some manufacturers would then begin to substitute Euro inputs for local inputs. That would make sticker prices follow wages / Drachma prices more closely and might lead to a domestic expansion.
      Other manufacturers would specialise in upmarket Euro goods, most notably large brands.
      Unlike now, where local and imported goods are fairly comparable in price and quality, the two would drift apart.

      My third claim is that those new, cheap local goods would not necessarily lead to an export boom, because they aren't export quality. They're cheap but nobody wants them.

      But this is of course all conjecture. And it doesn't apply for example to tourism which would definitely become more attractive, nor I have any idea about the shipping industry. That's probably much more sensitive to taxation than the exchange rate.

    8. My point about bitcoin was that it could not lead an independent life as in steps 2 and 3. But you were only using it to illustrate step 1, which is of course legitimate. I was just a bit slow in untangling my own thoughts.

    9. Not to beat a dead horse, but this post is a very concise description of what I believe money is, and subsequently why bitcoins and the like are not money in that particular sense:

      But I'll stop now (and read your next post)

  8. It the Greek economy after 15 years is very much wedded to the Euro as the unit of measurement for measuring and conveying economic value , then even if sticker prices were quoted in Drachma then it still wouldn't have an effect as retailers and workers would change those Drachma prices and Drachma wage demands in line with the variations in the Euro/Drachma exchange rate.