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Time for Greece to Bring Back the Drachma?

By Desmond Lachman, resident fellow at the American Enterprise Institute

Albert Einstein famously observed that a sure sign of insanity was the endless repetition of the same experiment in the hope of obtaining a different result. Yet that appears to be exactly what the troika is now doing in Greece. It is doing so by imposing on that country the very same policy mix of draconian fiscal policy adjustment and structural reform within a euro straitjacket that got the Greek economy into its present dreadful economic and social pass. And it is doing so in the expectation that this time those policies will lead to a stabilization of the Greek economy as a prelude to renewed economic growth, despite their patent failure at having done so in the past.

Five years into an economic depression of epic proportions, one would have thought that the Greek government should be raising serious doubts as to whether the oft-repeated troika recipe of severe fiscal austerity is going to produce any different economic results this time around. And one would also have thought that the time has long since passed for the Greek government to start seriously exploring alternatives to a policy approach that offers the country the bleakest of prospects of many more years of a deepening economic depression and extraordinarily high unemployment.

The U.S. Example

Normally, in the midst of a deep economic slump, countries follow countercyclical policies to extricate themselves from the slump and to avoid a downward deflationary economic spiral. They do so by some combination of fiscal policy stimulus, interest rate reduction, and exchange rate depreciation. This was certainly the path followed by the United States at the onset of the Great Economic Recession in 2008-2009.

Among the first orders of business of the Obama Administration in early 2009 was the enactment of the largest peace time U.S. fiscal stimulus on record, which involved a fiscal stimulus equivalent to two percentage points of GDP a year for three years. And that fiscal policy stimulus was fully supported by an aggressive Federal Reserve policy of interest rate reduction and quantitative easing.

More of the Same Is Not the Solution

The policies now being imposed upon Greece by the troika in the midst of its economic depression could not be more different from those policies pursued by the United States in its slump of 2008-2009. Whereas the U.S. adopted massive countercyclical fiscal and monetary policies, the troika is insisting that Greece reduce public spending by over EUR 11-1/2 billion in 2013 and 2014, or the equivalent of more than 5-1/2 percentage points of GDP. And Greece is expected to do so at the same time that its banks keep cutting back on credit in a pro-cyclical manner in response to an ever deepening economic depression. It is difficult to see how such a pro-cyclical policy approach is not going to lead to a further large decline in output in a country that has already seen its GDP decline by more than 20 percent from its pre-crisis peak.

Sadly, Greece's still highly compromised public finances leave it no room for a fiscal policy stimulus. However, despite the chorus of "nay" saying from the troika, Greece still does have the option of unbinding itself from its euro straitjacket and introducing its own currency. Such a course of action, if properly executed, would afford Greece the opportunity to use exchange rate policy as the means to secure a large real devaluation of its currency. That devaluation could in turn serve as the means to promote Greece's tourism and export sectors as a vital offset to the negative effect on output of the large amount of budget adjustment that Greece still needs to undertake.

Time to Reintroduce the Drachma?

In considering such an option, the Greek government might usefully take a look at Sweden's highly successful adjustment program in 1992-1993. At that time, the size of the imbalances in the Swedish economy was on the order of those in Greece. Yet Sweden managed to cure those imbalances by extricating itself from its ERM arrangement and by letting its currency depreciate by over 25 percent as the means to promote its export sector. And through the pursuit of prudent macroeconomic policies it managed to do so without reigniting domestic inflation.

To be sure, there are very real risks that the reintroduction of the drachma might not be supported by the appropriate domestic fiscal and monetary policies or by the international financial support that would be needed to make the new currency succeed. However, those risks need to be carefully weighed against the certainty that remaining in the euro and hewing to the policy line of the troika will plunge Greece ever deeper into depression for many more years to come. In that light, it would seem that despite the risks, there is little downside to Greece embarking on a different policy path than the one on which it is presently embarked and which has failure written all over it.

American Enterprise Institute (AEI) resident fellow Desmond Lachman previously served as director in the International Monetary Fund's Policy Development and Review Department. He was also a managing director and chief emerging market economic strategist at Salomon Smith Barney.