How might Greece leave the euro area?

Legacy 1000 Drachma Greek banknote

After the bundling of all IMF payments into one "jumbo" payment at the end of the month (June), together with the continued gulf between the Greek government and the "troika" (IMF, EU and ECB) in the negotiations for new measures to be agreed upon to release the bailout funds, the signs have now turned ominous for Greece.  The fact that the Greek government has announced that all banks will remain closed for the whole of this week from Monday (June 29th) and that capital controls are now in place, signifies that indeed Grexit is now a distinct possibility. 

Now Grexit clearly does not imply that a new currency must be formed, but to get any of the longer term benefits from Grexit (such as reclaiming an independent Greek monetary policy), the only way that this can occur is with a new Greek currency.  As an article in the FT today makes clear (see here), this is not a quick or easy process - but nevertheless it is certainly a possible outcome.

Now, as I have repeatedly argued here, Grexit is likely the best long term option for the majority of Greek people (see my paper from the University of Auckland Europe Institute here for the long version, and my previous posts from this blog, which are responses to FT letters for a the shorter version).  But the short term pain in getting back to an independent monetary policy again could be crippling and intense, if not managed properly. 

So what are the possible options for this to occur, given that Greece is probably not going to be in a position to make payments on it's debt, or to keep the euro as it's currency?

So, as I see it, Greece's options are:

i) try and hang on to the euro, despite the fact that Greece might not be in the euro area anymore;
ii) introduce a new currency, and (try and) adopt an orderly/managed exchange rate depreciation;
iii) introduce a new currency, and just let the new currency float on the open market; and
iv) use a new currency, but with a dual exchange rate - a commercial and a financial rate.

So let's deal with each of these options in turn, and try to sort out whether the transition over to any of these options would be more "orderly" or "disorderly", which is the language chosen by economists to signal panic or extremely rapid movements in financial variables (such as the stock market, currency values, or interest rates).

In theory, Greece could try to hang on to the euro as it's national currency, even though it would be no longer part of the euro area. But there has to be some escape valve from the crunch that the country finds itself in, which, if this were a country with a flexible exchange rate, would be depreciation, and if it had a fixed exchange rate, would be devaluation.  The problem here is that Greece is part of a monetary union and therefore only has the option of leaving the euro and massive lowering of the value of its currency.  So continuing to use the euro has none of the advantages of the other options.  Where it does have advantages is in terms of making sure that the debts of the country do not spiral any further out of control, as the majority of the debt is in euros.

The second option, that of the introduction of a new currency is a much more likely scenario.  Now, for arguments sake, let's call this new currency the "New Drachma".  The easiest way to engineer an "orderly" exit from the euro area is to then adopt (and announce in advance) a policy of temporary capital controls and then an initial exchange rate with a commitment to devalue the New Drachma against the euro on a regular basis ( - what economists call a "crawling peg").  This way, "hot" money flows cannot happen, but at the same time, Greece will see a fall in it's currency over time.  This will hopefully help the import sector to adjust to the new reality, and not cause a complete collapse in the import sector.  What would this peg be against?  

The third option, that of the introduction of a new currency that is allowed to float against the euro, with no capital controls, will no doubt lead to a disorderly exit from the euro.  This may well cause an initial over-reaction and see an overshoot from where the currency ideally needs to depreciate to, which may send the economy into further death spirals as importing businesses collapse. On the plus side though, this would lead to an immediate adjustment, from which the Greek economy (given the experience of the central and eastern European countries that tried this in the 1990s), would likely recover after one of maybe two years of drastic re-configuring of the Greek economy.  As a New York Times article recently discussed though (see here), this is likely to be extremely problematic from a debt perspective though, as most of the debt is denominated in euros, so a falling New Drachma would increase the debt load of both the public and private sector considerably.  This is one of the reasons why the Syriza government is anxious to avoid this option.  

The last option, that of some kind of dual exchange rate might be a good option given the struggle that the Greek government will still have to try to make interest payments on existing euro-denominated public debt. If the Greek government used a South African model for the exchange rate, then they would have a financial and a commercial New Drachma rate, where the financial rate would relate only to financial transactions, and all other transactions would occur at the commercial rate.  Note that this would still only require one currency. 

Out of these options, perhaps the best one is the fourth option, but there again, this is a difficult option to implement given that the market will want to see a quick fall in the value of the New Drachma, and yet because of capital controls on the financial side, this will not happen.  It will certainly not instill confidence among foreign investors however, as they will want to see the exchange rate fall to an extremely low level before even thinking of investing in the country.  Further, it will not help importers, and Greece imports a large amount of goods and services for use as intermediate inputs. 

Unfortunately, whatever route is chosen - either staying in the euro and accepting further austerity, or leaving the euro and trying to adjust to a new currency, it is going to be painful.