A Greek tragedy – Quo vadis? (40 points) The ongoing Debt Crisis has been shakin

Question

A Greek tragedy – Quo vadis? (40 points)

The ongoing Debt Crisis has been shaking up Europe for several years now. In particular, the infamous “PIIGS” countries (Portugal, Ireland, Italy, Greece, Spain) have been worrisome. Among those, Greece certainly gave people the strongest headaches. Even though they received a major “haircut” in 2011 (i.e. partial debt relief), its debt still amounts to almost 200% of GDP.

Economists, politicians, and investors have been discussing for years how to solve its economic problems. Greece’s problems are aggravated by the fact that it is part of the Eurozone, i.e. it does not have its own currency, thereby not allowing it to conduct independent monetary policy. One argument has been frequently brought up, namely for Greece to discard the EURO and readopt its former currency – the Greek drachma.

For the following questions let’s do a hypothetical. Assuming that Greece would indeed discard the EURO, which would also imply that it had to withdraw from the EU, discuss the following challenges it had to face.

Explain the “Impossible trinity”. In particular address the following issues:

i. Do some research and provide one example for each of the three scenarios.

ii. Which of the 3 features would you be most willing to give up if you had to advise the Greek government. Make sure to justify your answer as usual.

Explanation / Answer

Impossible Trinity:

The ‘impossible trinity’ is a concept in economics which shows the limited options available to countries in adopting its own monetary policy. The idea sets a relationship between monetary policy, exchange rate & capital flow. It states that a central bank must choose between maintaining fixed exchange rates or allow free capital movement. If a central bank adopts expansionary monetary policy it won’t be able to maintain foreign exchange value of its currency. Either it can adopt its own monetary policy & maintain fixed exchange rate or allow free capital flow.

Thus, according to ‘Impossible trinity’ a country cannot have sovereign monetary policy, fixed exchange rate & allow free capital flow at the same time. Now we will evaluate this theory in the context of Greek crisis in Eurozone. As Greece doesn’t have its own currency & being a member of Eurozone uses ‘Euro’ as its currency. It means Greece’s exchange rate is fixed as it uses Euro & it also doesn’t have its own central bank.

If Greece adopts its own monetary policy by abandoning Euro & reinstating its own currency, it can get away with the austerity measures & convert Euro based debt to own currency. It can print more money & lower its exchange rate boosting economic growth. But it is not as simple as it looks. Foreign owners of Greek debt will suffer huge losses as the repayment value will be less in their own currency. European banks will be hit hard as most of the debt is own by them. Some can even go bankrupt.

Since Greece is a major importer which imports more than 40% of its food & pharmaceuticals & 80% of energy. Devaluing currency will trigger hyperinflation as the cost of imports will increase. The country won’t be able to attract new foreign direct investments again putting the country into debt crisis. Capital flow will be restricted. Thus it will be very difficult for Greece to have all three at the same time.

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