Understanding the way forward for Greece requires understanding the cause of its prolonged depression. The argument popular in Greece's creditor countries is that the depression results from prior fiscal profligacy leading to the collapse of an unsustainable debt burden. The argument popular in Greece is that depression results from fiscal austerity forced on it by its external creditors.
These arguments are unsatisfactory and offer little useful guidance for the way forward. An excessive level of debt and the need for fiscal austerity are symptoms or fallout from the underlying root problem. In order to eliminate an unsustainable current account deficit, Greece must undergo depreciation in its internal terms of trade relative to its Eurozone partners. Because Greece is in a currency union with near price stability, I argue that depreciation must occur through Greece having a lower inffation rate than the rest of Europe, which likely means Greece having deflation. The economic disruption from the required deflation has forced austerity on Greece as a consequence of the accompanying deterioration in its fiscal condition. Austerity assures investors of the long-term solvency of the government, which is necessary in order to avoid capital flight and the resulting collapse of the banking system.
Is there any way to avoid the root problem of required deflation? If Greece had never joined the Eurozone but had retained the drachma as its currency, the required depreciation in its terms of trade would have occurred through the depreciation in its currency. Exports would become cheaper to foreigners and imports dearer to Greeks as the drachma price of foreign currencies increased. Lacking that mechanism, the only alternative is for the Greek price level to fall relative to the price level of its Eurozone partners. Deflation uncoordinated by a common set of expectations, however, disrupts the price system and the real economy. Moreover, it causes bankruptcies by raising the ratio of euro-denominated debts relative to the income of debtors.
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