The Economist: When Greece exits the euro

For months we’ve been bombarded with endless articles on the crisis in Europe, the mounting problems in Greece, questions on the survivability of the euro and predictions that Armageddon will ensue if the euro disappears. Don’t misunderstand me – the situation in Europe is extremely serious and is hampering the U.S. recovery. But whatever the ultimate resolution, I’m pretty sure the sun will come up the next morning.

The problem faced by several of the nations in the European Union – and to some extent here in the U.S. – is huge federal budget deficits adding to an outsized federal debt. The solution that has been imposed on Greece is austerity – cut wages, cut spending, raise taxes. In theory that sounds like an obvious solution.

The problem is that the more austerity is imposed, the more economic activity contracts. Tax revenues fall and demands on the social safety net rise, increasing the deficit and the debt rather than reducing it. As the government imposes still more austerity, social unrest increases.

As much as I am in favor of low taxes and limited government, I don’t believe it is possible to shrink your way to prosperity. There is a time for government to intervene, as ours did during the Great Recession, thus avoiding a repeat of the 1930s.

What will happen when the Greek government accedes to the reality that the current policy is not working? The usual way to increase economic activity, and thus jobs and tax revenues, is to print money, thus devaluing your currency and increasing exports. But Greece, as a member of the euro, has no currency of its own to devalue.

So, the obvious solution is to abandon the euro and return to the drachma. There is no question that the transitional costs would be huge. Contracts would have to be redenominated; the banking sector would likely be wiped out; chaos would reign for a year or more.

Then what? Contagion, with country after country following Greece’s footsteps? The end of the euro? A much smaller euro-zone close to its original size? The breakup of the European Union? A return to the devastating wars of the early 20th century?

Financial Times columnist Samuel Britten suggests an interesting alternative, a Europe of competing currencies. The euro might survive, particularly in shipping and finance, while local currencies would be used for tourism and exports. Horrors! Back to trying to figure out how much a meal that costs hundreds of thousands of lira is really taking out of my travel budget.

It’s been done before. In the early days of the United States, banks issued their own paper money. Hundreds of different currencies circulated side by side. Not surprisingly, currency from a bank that was far away was discounted substantially. How would someone in New Jersey collect the gold backing of a note from the Bank of Denver back in 1893? How could you still know the Bank of Denver really existed? I still have a Civil War note backed by bales of cotton on the dock in Memphis. Assuming it is still there (which, of course, it isn’t), what would I do with cotton if I collected?

But today, currencies are backed by faith in the country that issues them, not precious metal. The countries in Europe are only a few hours apart and communication between them is instantaneous. Even today, many large hotels and department stores there will accept payment in euros or pounds or Swiss francs. Dollars, at least until recently, were as easy to spend in Moscow as rubles.

Europe faces three choices. 1) An almost endless stream of money can flow from the wealthy countries in the north to the struggling countries in the south, along with debt forgiveness and other concessions. 2) The EU members can accept a true political union, with a permanent transfer of sovereignty from Athens and Bonn and Paris to Brussels. 3) Plans can be developed quickly that allow for an amicable divorce.

If you believe Germany will support alternative 1 or 2, I have a bridge to sell you, along with some cheap oceanfront property in Flordi. Stay tuned. It won’t be Armageddon, but it is sure to be interesting.