Cochrane doesn't believe in the consensus view that a Greek default means a Greek euro-exit. He thinks Greece can default and stay in the Euro. He also makes the good point that Eurobonds already exist... in the form of Target2 transfers. His last post illustrates how difficult it would be to create a new drachma. I am sympathetic to many of his views.
I had an interesting debate in the comments section of his last post on the difficulties of creating a new drachma.
Someone pointed out that Gresham's law dictates that bad drachmas will easily drive out good euros. Therefore, drachmas will quickly gain currency. This is a mistaken view of how Gresham's law works:
Gresham's law only applies when there are two circulating currencies and the authorities successfully enforce a peg such that one currency is artificially overvalued. The undervalued currency disappears from circulation as people either hoard it or send it overseas where it has more purchasing power, leaving only the overvalued (the "bad") currency to circulate.
But in Greece, the authorities lack the authority and power to even set a peg to begin with. Rather than being expelled, already existing paper Euros will continue to circulate while new drachmas fall to a deep discount. Anticipating this fall, why would people even rationally accept drachmas to begin with? New drachmas will be valueless as good money drives out bad.With regards to what might anchor a new drachma's value, someone pointed out that the "market will anticipate the exchange rate to which new drachmas would eventually fall (once equilibrium was reached), so they would trade at this exchange rate from the start." Incidentally, this idea of an "anticipated equilibrium" derives directly from Don Patinkin's equilibrium theory of fiat money, which he deployed to rebut Ludwig von Mises's regression theory of fiat money (see more below).
It need not be the case that the market successfully anticipates a new drachma's equilibrium price:
...you are assuming that the process of introducing a new fiat drachma always results in a monetary equilibrium (say 1:3). This sort of monetary equilibrium in turn assumes that communication among economic players is unlimited so that it allows them in advance to agree upon some positive initial exchange value for a would-be-drachma.
But a non-monetary equilibrium in which the drachma is capable of purchasing 0 euros is also a possible solution.
Given the inherent frictions in the real-world, a non-monetary "corner solution" is not only possible, but highly probable, especially given the rather dubious credibility of the Greek state. Far safer for a shop keeper to not accept drachmas at all and require euros than to accept drachmas at a huge discount. Outside of equilibrium models, real world shop keepers simply cannot pre-calculate the would-be equilibrium value for the soon-to-be drachma, and will assume it to be 0.
A potential monetary equilibrium requires some sort of institutional process for generating positive expectations sufficient to achieve drachma acceptability; I doubt there is such a process I would trust if I was in Greece right now. Setting a peg to the euro would be one option for generating positive expectations, but this only works in normal situations. Right now, no one would believe a drachma peg.The above argument is somewhat cribbed from George Selgin's On Ensuring the Acceptability of a New Fiat Money, which is one of my favorite papers.
Don Patinkin held that a new fiat money need not have had a specific prior purchasing power before gaining currency. Rather, individuals could formulate a demand for money balances at all possible prices for that new money (the "individual experiment"). Prior to the market for the new currency opening, these individual demand curves would be amalgamated and processed by the Walrasian auctioneer to form the overall market's demand, who from there would compute the new money's purchasing power (the "market experiment"). Then, when the market reopened, the new money would have a pre-determined market price and all individual demands for money will be satisfied at that price. The rebuttal to Patinkin is the one above: in the real world, traders do not have the resources to mimic the Walrasian auctioneer.
Lastly, another commenter pointed out that the Greek government's imposition of taxes and legal tender requirements would be sufficient to provide the drachma with a positive value. This is the chartal theory of fiat money:
The tax-drives money theory makes sense. A government sets an obligation on its population which can only be discharged by payment of fiat money, say drachmas, therefore creating a demand for drachmas such that they have a positive value.
But you are implicitly assuming that the Greek government has the ability to impose an obligation on its population. There is no guarantee that this obligation could be credibly imposed, especially given the mass financial and social chaos that would follow an attempted euro-exit. Why buy drachmas to pay for taxes if you don't have to pay those taxes to begin with?A potential debut of the drachma will serve as a real-world experiment of how new fiat currencies come (or do not come) into existence. I'm betting that the drachma will not be re-introduced because would-be architects of such a scheme realize how difficult it will be. If they do give it a shot, I think there are decent odds the drachma will be competed out of existence by already-circulating euros.
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