What risks face the Greeks if they return to the drachma?


By Anne-Laure Delatte (associate researcher of the Forecasting Department)

The debate about whether the Greeks will stay in the euro zone is intensifying. Christine Lagarde, head of the IMF, has lamblasted the Greek government. The German Finance Minister, Wolfgang Schäuble, believes that the euro zone can now deal with a Greek exit, and that the Greeks no longer have a choice. What would be the risks for the Greeks of a return to the drachma? Would this inevitably plunge the country into chaos? Argentina’s experience with returning to the peso in 2002 provides some insight.

In Argentina, the peso/dollar parity was set at one peso per dollar by law in 1991. The dollar could be used freely in domestic exchange. The result was that dollars began to be used for everyday transactions, including the denomination of financial assets. In practice, in the 1990s, on average more than 70% of bank deposits and two-thirds of private sector lending were denominated in dollars. These figures peaked in the last quarter of 2001, just before the system was abandoned, when 75% of private deposits and 80% of all loans were denominated in dollars.

The average Argentinean’s strong commitment to the dollar was propped up during the 1990s by the promises of all the presidential candidates to continue the system. Moreover, the abandon of the dollar in January 2002 took place in an especially dramatic context, after five presidents in a row had resigned and amidst a period of popular revolt that was felt beyond the country’s borders. The peso was devalued by more than 70% against the dollar, and a massive amount of domestic savings fled the country into foreign banks. While the barter economy remained marginal, the provinces and the central State began to issue their own currency to pay civil servants and government suppliers. According to the country’s central bank, in 2002 these parallel currencies accounted for an average of 30% of all bills in circulation.

The context in which Argentina returned to its national currency in 2002 therefore bears some resemblance to the current situation in Greece: widespread political confusion, a serious recession, and above all a national currency with no credibility.

Against all expectations, despite the serious crisis, the social and political disorder and monetary disintegration, which led to predictions that it would take 10 years for Argentina’s GDP to return to its pre-crisis level, an economic recovery began to take hold by the second half of 2002. With nominal annual growth of 9% and controlled inflation, Argentina ultimately restored its pre-crisis level by 2004. How did the country manage to leave the dollar with such results?

The default on 90 billion dollars in public debt, followed by a fiscal pact between the provinces and the central State, along with budget controls, led to a recovery in public finances. But the unique feature of Argentina’s experience was the monetary reform carried out in January 2002.

The devaluation of the peso rocked the country’s financial equilibrium. With 80% of lending contracted in dollars, most consumers and businesses saw the value of their debt virtually quadrupled! After the devaluation, in 2002 the amount of private debt came to 120 billion dollars, whereas the country’s GDP was only 106 billion dollars. To avoid bankrupting the entire private sector, the national authorities came up with a rule for the reimbursement of debt.

The logic was that, to avoid bankruptcy, business revenue should be denominated in the same currency as the debt. Hence on 4 February 2002, the government issued decree 214/02, which imposed the “peso-fication” of the entire economy: all prices and all contracts in the real and financial sectors, all salaries and debts, were converted into pesos at a rate of one peso per dollar, whereas the market rate was almost four pesos per dollar. Contracts in the financial sector were also converted: deposits that did not exceed thirty-thousand dollars were converted at a rate of 1.4 pesos for 1 dollar [1]. How could such a rule be imposed in light of the disastrous wealth effects on creditors?

The conversion at a rate of one for one (or 1.4 for 1) imposed by the authorities resulted in a settlement of conflicts over debt in favour of debtors, and to the detriment of national and foreign creditors. However, the main debtor in the economy is the productive sector, that is, businesses. By offering them a protected way out of the crisis, the new monetary rules neutralized balance sheet effects and permitted the devaluation to have the expansionary impact one would conventionally expect. In effect, trade began to run a surplus and the country’s economy was able to benefit from the booming global economy in the early 2000s. Exports rose from 10% to 25% of GDP, and by 2004 GDP was 2% higher than the average for the 1990s. In short, the government’s monetary rule led to a return to growth and employment, which explains why it won the support of the majority of the population.

In actuality, the Argentines, like the Greeks today, were caught in a trap: with contracts denominated in dollars, the return to the peso, following the devaluation, was leading towards a generalized bankruptcy of the private sector. If the Greeks were to leave the euro right now, the entire country would go bankrupt. If the drachma were devalued by 50%, as certain forecasts currently predict, private debt would double. With revenue denominated in drachmas and debt in euros, businesses and consumers would be incapable of repaying their lenders. This was the same kind of trap that paralyzed Argentina’s leaders before 2002.

Argentina’s experience thus provides several lessons. First, the main risk for Greece of leaving the euro is that the entire private sector would go bankrupt. Given that the public sector has already restructured 50% of its debt, all else being equal, a return to the drachma would lead to financial conflicts between private creditors and debtors that would paralyze the entire system of payments. Secondly, the State has to play a key role as arbitrator in order to resolve the crisis. In conditions like these, the nature of the rules adopted is not neutral. A number of solutions exist, and these reflect different policy orientations and have different economic consequences. In Argentina, the decision to favour national debtors ran counter to the interests of the holders of capital and foreign investors. Furthermore, contrary to the assertions of Wolfgang Schäuble, the Greek government does have choices. This is the third lesson. The resolution of the Greek crisis is not simply an economic matter, and the options being offered to the Greek people involve political choices. The choice made will have a more favourable result for some economic groups (such as European creditors, Greek employees, holders of capital, etc.).

Depending on the nature of the political order, the State could seek to maintain the existing balance of forces, or, on the contrary, disrupt them. A reform could lead to a rupture, and provide an opportunity to establish a new balance of forces. The option pursued up to now has consisted of spreading the cost of resolving the Greek crisis over creditors, on the one hand, by restructuring the public debt, and over debtors, on the other hand, by means of structural efforts (cuts in wages \and social transfers), along with an increase in the tax burden. In contrast, a withdrawal from the euro zone accompanied by an Argentina-style restructuring of private and public debt would place the burden of the crisis resolution more on the shoulders of creditors, mainly the rest of Europe. This explains the renewed pressure seen in the discourse of some European creditor countries with respect to Greece, as well as the confusion that typifies the debate in Europe today: in the absence of an optimal solution with a neutral impact, each party is defending its own interests — at the risk of destroying the euro.


[1] Deposits of greater amounts could be either converted under the same conditions or transformed into dollar-denominated Treasury bonds.