My take on Greece (Part II: the Euro and the mainstream view)

To most observers it is evident that Greece should never have been admitted to the Euro club, since it falsified its accounts to meet the admission criteria.

However, it is not true at all that only Greece cooked its books. Most forget that Italy, with the help of the Banca d’Italia (under Mario Draghi), falsified its accounts too. Worse, far from being critical, the Economist, in this 2004 article, proclaimed this to be the greatest trade in the history of financial markets,

(…) Think of the various elements of the trade. It was bold and risky. It relied on secrecy. It was brilliantly conceived to solve a specific, and apparently insurmountable, problem. It was executed with great skill. And, for a fee, it gave Italy the opportunity to be part of the euro system, with its incalculable rewards. Part of its appeal is that the profits came not from the counterparty on the trade itself, but from the economic consequences of the trade.

Of course, it was also thoroughly dodgy—had it been done by a company, the management would probably be in prison for cooking the books—though the Italians have always maintained that it exploited weak rules, rather than broke strong ones. But there is no need to be churlish. This was, after all, the greatest trade ever. Bravissimo!(…)

Such were the “incalculable rewards” of Euro-membership that even dodgy practices were justified!

Now these same experts tell us that Greece (and indeed most of southern Europe) with its backward economic structure cannot use the same currency as the more industrial economies to the north. Allegedly, it is far more fitting to the Greek mentality to let their currency depreciate instead on working on productivity gains. More and more economists maintain that the best way forward for Greece would be to exit the Euro zone (“straightjacket”) and start printing Drachma anew. A depreciating exchange rate and the freedom to print money at will for the Greek government will soon bring prosperity, they promise. The alternative is to create a political union with permanent transfer payments from North to South, basically implying that the South is incapable to care for itself.

This, give or take, is basically the establishment view in a nutshell.

Yet, the general view suffers from some inconsistencies.

For instance, it implies that productivity gains and depreciation are interchangeable policy choices that yield similar results, something like: northern countries culturally “prefer” reforms to attain competitiveness via increases in productivity, whereas their southern partners like constant debasement (to achieve the same result). Both of whom will lead to “growth” which, everybody agrees, is what Greece needs. It’s just that the preferences are not compatible therefore “they cannot have the same currency.”

Sounds straightforward!

However, after a closer look at the facts doubts emerge. Isn’t it true that Greece (and the rest of southern Europe) had relatively lower living standards than “hard currency” countries (Germany and the Netherlands) even when they had their own (weak) currencies? Depreciating certainly had not helped them achieve above average prosperity in the past (in the European context). And the gap wasn’t narrowing before the introduction of the Euro or ECU. Historically, debasement to achieve higher living standards has never worked well in practice. Examples abound: just look at Venezuela and Argentina more recently.

In my view, it is questionable whether it is correct to say that the Greek economy even operated on a Drachma standard pre-Euro, since I assume that people were saving and calculating in D-Mark or USD terms. I do not know for sure about Greece, but this is certainly the case in the neighbouring Balkan countries, like the former Yugoslav republics, Bulgaria or Turkey. There the local currency merely serves for official or small, everyday transactions where the citizens are forced to deal in the official government money and have no choice. Saving and capital spending have been conducted in D-Mark, CHF or USD, well, forever. It has not changed much to this day – the D-Mark merely has been replaced with the Euro. Montenegro, doesn’t even pretend to have an own currency and has adopted the Euro a few years back, although obviously not “German in mentality” and without asking the EU for permission. Same for Bosnia and Bulgaria who have currency boards whereas Croatia has had a peg since independence.

Clearly, if we want to understand the problem we have to reconcile all these (and others) little differences and inconsistencies.

Now, let’s take a closer look at the establishment view held by 99 percent of the media and market participants. Where does it come from?

You might be surprised to hear that the mainstream view is the result of a theory. As Keynes correctly observed,

(…) Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back(…)

I think the quote is brilliant.

The theory that is being distilled in our case is the theory of “Optimum Currency Areas (OCA)” by Robert Mundell and is a staple in the economics curriculum. According to the theory, a country that faces the decision whether to give up its own currency or not, has to weigh between the benefits and the “costs” of a shared currency. It is that simple.

Paul Krugman (madman in authority) summed the consensus up nicely a few years back in his “revenge of the currency area,

(…)The disadvantages of a single currency come from loss of flexibility. It’s not just that a currency area is limited to a one-size-fits-all monetary policy; even more important is the loss of a mechanism for adjustment. For it seemed to the creators of OCA, and continues to seem now, that changes in relative prices and wages are much more easily made via currency depreciation than by renegotiating individual contracts. Iceland achieved a 25 percent fall in wages relative to the European core in one fell swoop, via a fall in the krona. Spain probably needs a comparable adjustment, but that adjustment, if it can happen at all, will require years of grinding wage deflation in the face of high unemployment(…)

You see: depreciation and individual wage contracting are interchangeable things and of course a one size fits all depreciation is always preferable (to Mr. Krugman) due to its “lower costs” – in other words: the relative lower costs of depreciation (rising import prices notwithstanding) are a certainty for him.

Usually Milton Friedman, another heavyweight, is thrown in to support the thesis and add flavor,

(…)Europe exemplifies a situation unfavourable to a common currency. It is composed of separate nations, speaking different languages, with different customs, and having citizens feeling far greater loyalty and attachment to their own country than to a common market or to the idea of Europe(…)

Sounds intuitive! And this is why many Americans, peasants and hedge fund managers alike, doubt the viability of the Euro. And even proponents of the Euro (mostly European) do not dispute the theory per se, but merely hope that the benefits outweigh the costs – whatever that means.

In somewhat intellectually lazy fashion people seem to think: if both, Milton Friedman and Paul Krugman – who are supposed to sit at the opposing end of the political spectrum – agree, it must be because it is true.

But is does the theory actually make sense?

For one, it obviously does not explain how the world (not just Europe) successfully operated a quasi-single currency (gold) throughout the 19th century, a period that witnessed an unprecedented increase in living standards – despite all those cultural and language barriers between the nations participating. After all, the gold standard was not abandoned because it did not work well, but rather because it constrained government WWI spending (excellent article here). And I think that even Krugman would concede that this kind of government spending was destructive. Indeed, the world currency had worked so well that most governments sought to return to the gold standard after the war voluntarily. Some (Britain) were even willing to (wrongly) impose tremendous monetary deflation, i.e. a reduction in money supply on its population by forcefully intervening in the market in order to return to the pre-WWI exchange rate.

Why were cultural factors and lack of an “adjustment mechanism” no problem in the 19th century?

It also doesn’t explain why the majority of Greeks want to keep the Euro despite being “different” in many ways and constantly “humiliated” by Berlin. And, by the way, why does Miami, which is culturally as different from New York as is Athens from Berlin, still have the USD and not the peso? What about Ecuador, Panama or Puerto Rico?

I do not know about you, but to me a theory that does not explain things I observe is no good.

Further, from where I stand (Austrian economics) Friedman and Krugman are not necessarily sitting at the opposing end of the spectrum, but are really using the same (faulty) macroeconomic logic.

It is collectivist thinking all over again. For, decisions can only be made by individuals, not by countries and costs and benefits (of using a certain currency) are subjective and marginal. They cannot be aggregated and compared due to the fact that utility is an ordinal, not a cardinal concept. It is absurd and laughably naive to think that the bureaucrats that face the decision to join a currency union are motivated by the (unmeasurable and unquantifiable) “costs” and “benefits” of “their” economy, rather than their own specific benefits and those of the special interest groups they represent. Macro economists, it seems, live in a vacuum, ignoring all insights from public choice theory (or they assume they don’t matter).

But actually, it is not that complicated.

A currency is a medium of exchange that facilitates – better: makes possible – large scale economic exchange and calculation, not more, not less. It works as a common unit of account for the sale of goods and services. Nobody wants to adjust the prices for his produce every day. Nor do buyers want to be forced to speculate whether the goods they buy will adversely change in price or not. Fluctuations impose subjective costs to both parties in a transaction. It follows that currencies that are expected to be relatively more stable are more sought after than others. Clearly, flexibility in monetary policy, an assumed benefit in Mundell’s theory, is not a property that characterizes a good currency from the point of view of Austrian theory – it’s a “bad” really. Once you drop that assumption – the bedrock of Monetarism – the theory and its implications fly out of the window.

Hayek had the following to say about the theory of OCA,

(…) Monetary unification enhances the welfare of individuals only if it springs naturally from the voluntary actions of the money users…In a free market, entrepreneurs will try to respond properly to the demands of their customers, providing goods—including money—of the type, quantity, and quality desired. Therefore, only in a free monetary market would it be possible to discover what is the “optimum” circulation of a certain currency…OCA theory fails to acknowledge this, precisely because it conflates the proper nature of money, focusing exclusively on a single type of money, namely fiat government-produced money(…)

The USD is not the reserve currency because the US is an empire, as many Neocons, conspiracy theorists and leftists believe, but because it has been one of the most stable currencies over the past decades, despite substantial debasement. As a consequence, sellers have been happy to take it as a payment for the goods and services they offer. Think about it: the US military certainly cannot “force” Russian commodity exporters to accept USD for their exports – they accept it voluntarily, regardless of whether “relations” between these countries are good or bad.

Once you accept the Austrian viewpoint, it is much less of a puzzle why we observe people prefer – ideological, historical and cultural differences notwithstanding – to transact in the one currency that is the relatively most stable from their subjective viewpoint.

To sum up: whatever the bureaucrats decide, most Greeks will continue to use the Euro as a standard of value, for a lack of better alternative, no matter whether they hate or love Germans. That is because Greeks, just as everybody else, prefer the relatively most stable subjective standard of value available. They might be forced to use another currency, but they will keep using the Euro as a standard of value for the foreseeable future. It is naïve to think (as does Professor Hans Werner Sinn whose intellectual honesty I much respect and with whom I often agree) that paying workers in debased Drachma instead of cutting wages will be socially more acceptable than wage cuts. It won’t.

Let me be clear: whereas the mainstream view rests on dubious models and simplistic first order thinking the shortcomings of which can easily be shown, I do not want to give the impression that there is no problem with the Euro zone as it currently operates – indeed the problems are huge and complex. And complexity, as I said in the introduction, can only be dealt with using proper theories.

In part III I will look at Greece’s Euro problem using insights from Austrian monetary theory and ABCT. I will also make a real world case study to understand what happens when a country introduces the Euro to answer the question why it is that the south of Europe (not just Greece) seems to suffer disproportionately. This will help us break down the complexity in order to make the problem intelligible and look for possible solutions.



  1. “How much” of the timing of current eurozone stress do you attribute to the nature of the euro and European economic conditions and how much do you think it is influenced by economic and monetary events in America and China?

    Also, the CHF seems to be pretty stable, why didn’t more European countries use it instead of the euro?

  2. Well, obviously these things are connected. One could argue that a loose USD (and a booming China) put additional stress on Europe as it is a net importer of commodities…so some stress comes from that..

    but most of it, I would argue is home-made: labor laws, environmental regulation are just insane, even here in Austria, let alone France, Italy, Greece….
    And the monetary mess is entirely home made, which doesn’t it would not have happened in the US when faced with the same situation. In the next part I wll show what actually happens the Euro is introduced, then a lot should be clearer…

    Most countries adopted the Euro as it was the natural successor od the DMark..A lot of workers from the Balkans (Greece) and CEE sent their DMarks (or Schillings) home and it started circulating there. In communist Yugoslavia they had FX savings account (the regime wantend to encouraged this inflow) circulated more.
    This was also true for CHF, but just to a lesser extent as the absolute number of workers in Switzerland is way lower than in the DMark block. Further, as long as there was the DMark, nobody percieved any currency to be much more stable – even Soros once admitted that back in the days nobody would dare to speculated against the Bundesbank.
    So: not much need for CHF in the past…With the introduction of the Euro this habit was simpliy continued…

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