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Currency crisis and collapse
in interwar Greece:
Predicament or Policy Failure?
Nicos Christodoulakis
October 2012
Is Greece doomed to leave the Eurozone?
Roubini (2011): Under the present fiscal austerity and currency
fixity, recession will deepen destroying jobs and igniting social
unrest.
After abandoning the Euro, Greece becomes master of its fate,
prints her own money, rebukes the austerity program, and – of
course - devalues, perhaps heavily.
Feldstein (2011): (after abandoning the Euro) … a concomitant
option would be to repudiate obligations since all public debt is
presently denominated in Euro and a steep devaluation would
make its servicing intolerable.
Azariadis (2011) argues that this is an affordable cost as the
economy soon will assume a growth path, with competitiveness
and employment restored, and reforms advancing.
Predicament theories
Now, the country is thought my many to be doomed
to leave the Eurozone … because
Hartwich (2011): “Greece is a basket case”
and will fail because, under similar circumstances,
it has also failed in the past.
Corroborating precedents:
1. The country leaving the Latin Monetary Union (LMU) in 1908
2.The second incident took place in 1932
when Greece abandoned the interwar Gold Exchange Standard
(GES) and subsequently repudiated its debt.
Bloomberg
History Offers an Ugly Precedent for a Greek Euro Exit
By Sean Vanatta Jun 1, 2012 10:30 PM GMT+0300
http://www.bloomberg.com/news/2012-06-01/history-offers-ugly-precedent-for-greek-euro-exit.html
Things were not exactly so!
1908.
1.Greece successfully managed to stay in LMU for forty years
(since 1868).
2.It was only after the war in 1897 that Greece became unable to
service the debt and pay retributions to Ottoman Turkey.
3.In any case Greece joined back in 1910,
1932.
1.Main reason of Greek collapse was the UK collapse!
2. In contrast to conventional wisdom, the postcollapse regime did NOT manage to cure the economic
and social problems.
Sources:
1.Bank of Greece, 1978, The first fifty years, Athens.
2.Mazower M., 2002,
Greece and the Interwar Economic Crisis, MIET, Athens.
3.Data series newly issued by the Bank of Greece
4.Global Financial data
Debt multiplied in the 1920s
Total debt service, %GDP,lhs
12 Domestic Debt, mio DRS, rhs
7,000
10
6,000
8
5,000
Default
6
4,000
3,000
4
2,000
1,000
0
0
1918
1919
1920
1921
1922
1923
1924
1925
1926
1927
1928
1929
1930
1931
1932
1933
1934
1935
1936
1937
1938
2
Inflation and yields in the 1920s
Annual inlation rate
100%
80%
60%
40%
20%
0%
-20%
1918 1919 1920 1921 1922 1923 1924 1925 1926 1927
30
25
Bond yield (%)
20
15
10
5
1927
1928
1925
1926
1923
1924
1922
1920
1921
1918
1919
1916
1917
1914
1915
1912
1913
1910
1911
1908
1909
1907
1905
1906
1903
1904
1901
1902
0
90
80
450
400
DRS per USD
Exchange rate
70
350
60
300
50
250
In 10 years, lost more
40
200
than 9/10 of its value
30
depreciating fast
150
DRS per BPS
20
100
10
50
0
0
1918 1919 1920 1921 1922 1923 1924 1925 1926 1927
Trade balance, mio USD
0
But, despite this,
-20
Trade balance, in deficit
-40
-60
-80
-100
1925
1926
1927
1928
Main episodes
April 1928: Establishment of Central Bank
May 1928: Joining the Gold Exchange Standard
Parity 375 Drs per BPS (i.e. 77 Drs per Dollar)
Some major reforms were advanced:
• Banking system consolidation
• Reforming agricultural sector
• Industrial policy (many new firms established)
• Increase in state Revenues
Oct 1929: The Great Crash
……
Shortcomings of the Greek decision:
•Pegging unilaterally to the UK at prevailing rate
(appreciated after a recent foreign loan)
•UK pegged at pre-war rate to USD
Keynes: The barbarous relic: 4.866 BPS per USD
•Most of reserves kept in pounds: No currency risk assumed.
• Fiscal policy was expansionary
Shortcomings of the system:
1. No central coordination
2. No credit provision mechanism
3. No concern on recession and unemployment
Inflation and yields during GES
16%
12%
8%
4%
Inflation fell
0%
from 15% to zero!
-4%
-8%
Inlation rate
-12%
-16%
1926
1927
1928
1929
1930
1931
Bond Yield %
10
8
Bond yields fell
6
from 10% to 6%
4
2
0
1927
1928
1929
1930
1931
Exchange Rate Market Pressure (EMP) eased substantially
Eichengreen, Rose and Wyplosz (1995)
EMP = [Exchange rate volatility] + [Spreads] + [Losses in Reserves]
Exchange Market Pressure
Nov 1931
6
5
4
3
2
1
Marc.
Jan.1932
Nov.
Sept.1931
July
May
Marc.
Jan. 1931
Nov.
Sept.
July
May
Marc.
Jan. 1930
Nov.
Sept.
July
May
Marc.
Jan. 1929
Nov.
Sept.
July
May
Marc.
-1
Jan. 1928
0
Fiscal position did not improve under GES
Public revenues
Public spending
Budget balance
40
36
32
P erce n t o f G D P , %
28
24
20
16
12
8
4
0
-4
-8
-12
1923/24
1924/25
1925/26
1926/27
1927/28
1928/29
1929/30
1930/31
1931/32
1932/33
1933/34
1934/35
1935/36
Revenues rose by 4% of GDP
… but Spending increased even more!
Greece entered GES to facilitate spending, not to cut it!
1936/37
The capital flows
Private
Capital flight
International
markets
sector
Domestic
Foreign
debt A
debt F
Credit
Reserves
Government
Profits
Central Bank
Money
The trade flows
USA
Z = Pound/$
UK and the
rest of GES
X = Drs / $
X/Z = Drs/Pound
Greece
World Demand (W)
+ Drachma exchange rate
Net Exports
-
Pound exchange rate
+ World Demand
-
Domestic demand
J = β0 + β1 ⋅ x + β2 ⋅ (x − z) + β3 ⋅ w − β4 ⋅Y
The dynamics of currency and Foreign Reserves
Dornbusch (J. Development Economics, 1987):
“Expectations of market agents on the transition from fixed to floating
regime are influenced by reserves behaviour and devaluation pressure”.
The dynamics of Foreign Reserves:
( Change in Foreign Exchange Reserves ) =
(return on previous stock) + (net exports) – (foreign debt service)
The dynamics in the Forex Market:
(expected depreciation) =
[with capital controls]
= (sustainability gap)
[without capital controls] = (interest rate spreads & Reserves)
= [capital controls]*(fundamental rate – current rate )
- [1- capital controls]*( Foreign Reserves)
Solving the model, in the face of shocks
Unique and stable equilibrium, approach on a saddle-path
If permanent shocks hit the system,
new path shift upwards:
Exchange
Rate (x)
Equilibrium possible if either:
• higher exchange rate (depreciation)
• higher reserves to beat expectations
E1
x1
New
path
Equilibrium
path
E0
x0
Reserves (Q)
Q0
Q1
Crisis in Sept 1931: UK leaves GES
Greece appreciates vs the Pound and
shifts to US at the OLD parity of 77 Drs per Dollar
Capital flight and imposition of capital controls
Stock Market shuts
Interest rates rise sharply
Loosing foreign reserves
Jan
1932: Greece seeking assistance from League of Nations
Fiscal cuts intensified
Mar
1932: Assistance denied
Recession deepens
… and collapse in Apr 1932: Greece abandons GES
The shocks for Greece in 1931 were
British pound was devalued by 35%
World trade was contracted by 25% relative to 1929
A new equilibrium is needed: Question is how we get there?
1. Let the system to adjust, as if it were free
2. Cancel the consequences of the shocks by applying
equivalent measures
3. Sacrifice Reserves for defending the system, until …
Alternatives to face the shocks - 1
Exchange
rate
Option 1:
Follow the British action:
Move immediately to E1
Other Empire countries
e.g. Canada
E1
x1
path1
adjust
E0
x0
reserves
Q0
Supporters in Greece: Varvaressos, Niemeyer
Venizelos strongly denied the option
Alternatives to face the shocks - 2
Option 2:
Exchange
rate
Debt forgiveness to compensate
for the losses in trade balance.
Debt
cut
E1
Go back to the OLD path,
“annulling” the shocks
path1
E0
x0
Publicly proposed by D. Maximos
Later, the option was
partly endorsed by Venizelos.
But after long debates, rejected
by the League of Nations
reserves
Q0
Evaluating the Alternatives
Devaluation required:
1
dx * =
[ β 2 ⋅ dz − β 3 ⋅ dw ]
β1 + β 2
Plausible values: β3 = 0.20 and β1 + β 2 ≈ 0.25
Compatible with depreciation dx = 34%
“Haircut” required:
1
dF* = −
⋅ [β2 ⋅ dz − β3 ⋅ dw] = −0.70
r +σ
In 1932 debt repudiation was 70%
Option 3: Stay in the system and fight, alone
Use Reserves for Defending the system
(BoG, Commercial banks, Government)
Exchange
rate
E2
x2
Float &
accumulate
E1
x1
New path
Consequences
exit
E0
x0
Defend
& deplete
QMIN
reserves
Q0
1.
2.
3.
4.
5.
6.
7.
Spreads rise
Capital flight
Reserves deplete
Deep recession
Abandonment
Overshooting
Free-float
x2
adjustment
The exchange Rate
x1
exit
x0
defense
0
t
t exit
160
700
DR/USD (left hand scale)
140
600
DR/BPS (right hand scale)
120
500
100
400
80
300
60
200
40
100
20
0
0
1918
1919
1920
1921
1922
1923
1924
1925
1926
1927
1928
1929
1930
1931
1932
1933
1934
1935
1936
1937
J(t)
adjustment
The external Balance
J1
J0
exit
defense
t exit
t
20
0
Trade Balance, mio $
Current Account
-20
-40
-60
-80
-100
1925
1926
1927
1928
1929
1930
1931
1932
1933
1934
1000
J a n -2 8
M a r- 2 8
M a y -2 8
J u l-2 8
S ep-28
N o v -2 8
J a n -2 9
M a r- 2 9
M a y -2 9
J u l-2 9
S ep-29
N o v -2 9
J a n -3 0
M a r- 3 0
M a y -3 0
J u l-3 0
S ep-30
N o v -3 0
J a n -3 1
M a r- 3 1
M a y -3 1
J u l-3 1
S ep-31
N o v -3 1
J a n -3 2
M a r- 3 2
M a y -3 2
J u l-3 2
S ep-32
N o v -3 2
J a n -3 3
M a r- 3 3
M a y -3 3
J u l-3 3
S ep-33
N o v -3 3
J a n -3 4
M a r- 3 4
M a y -3 4
J u l-3 4
S ep-34
N o v -3 4
Q(t)
Q0
Foreign exchange Reserves
defense
QMIN
0
5000
accumulation
exit
t
t exit
4500
4000
3500
3000
2500
2000
1500
Total Reserves, mio LMU Drs
500
0
What happened after the collapse
Prices rose again,
Cutting real wages
110
105
Real wage index
100
95
90
85
1927
1928
1929
1930
1931
1932
1933
1934
1935
1936
1937
Production increased in industry,
Not so in agriculture
160
160
150
150
INDUSTRY INDEX
140
140
130
130
120
120
110
110
100
100
90
TOTAL ACTIVITY INDEX
EXPORTABLE
AGRICULTURE
80
90
80
70
70
60
60
1924
1925
1926
1927
1928
1929
1930
1931
1932
1933
1934
1935
1936
After the collapse: Employment hysteresis
10
110
8
105
6
100
4
95
2
90
0
Employment Index
Growth rate %
85
-2
80
-4
1926
1927
1928
1929
1930
1931
1932
1933
1934
1935
1936
Number of unemployed
250,000
The number of
unemployed raised
200,000
150,000
(Hysteresis effect)
100,000
50,000
0
1928
1929
1930
1931
1932
1933
8,000
4,000
Trade balance
improved, BUT
due to less imports,
not to more exports
0
EXPORTS
IMPORTS
-4,000
-8,000
-12,000
1931
1932
1933
1934
The Athens Stock Exchange revived,
but did not exceed the post-1929 crash level
11/30/1934
09/30/1934
07/31/1934
05/31/1934
03/31/1934
01/31/1934
11/30/1933
09/30/1933
07/31/1933
05/31/1933
03/31/1933
01/31/1933
11/30/1932
09/30/1932
07/31/1932
05/31/1932
03/31/1932
01/31/1932
11/30/1931
09/30/1931
07/31/1931
05/31/1931
03/31/1931
01/31/1931
11/30/1930
09/30/1930
07/31/1930
05/31/1930
03/31/1930
01/31/1930
11/30/1929
09/30/1929
07/31/1929
12/31/1928
Athens Stock Exchange Index
140
120
100
80
60
40
20
Sovereign bond yields, quoted in London and Athens
Athens: New series from the BoG, yield average of bonds issued at
1881,1884,1887,1889, 1890, 1902, 1907, 1910 and 1914.
London: Global Financial Data, GFD
40
30
25
20
Percent %
35
crisis
Athens
quote
15
London
quote
10
5
1928
1929
1930
1931
1932
1933
1934
In fact, Greece returned to the international bonds market only in 1998!
Exchange Market Pressure continued long after the collapse
EMP =
6
5
4
3
2
% depreciation
% spread
% ∆ Reserves(t-1)
+
−
STD
STD ( spread )
STD ( Losses )
Exchange Market Pressure
Jan. 1928
April
July
Oct.
Jan. 1929
April
July
Oct.
Jan. 1930
April
July
Oct.
Jan. 1931
April
July
Oct.
Jan.1 932
April
July
Oct.
Jan. 1933
April
July
Oct.
Jan.1 934
April
July
Oct.
Jan.1 935
1
0
-1
-2
-3
-4
Why Greece failed after the collapse?
•
No export-led growth
Industry: few comparative advantages
Agriculture: few exportables
Protectionism on the rise everywhere
• Peripheral economy: Thin domestic market
•
Strong employment hysteresis
•
No loan facilitation: Credit remained stagnant
•
Weak institutions led to social unraveling
and political fragmentation
The political fall-out was dramatic:
Within four years after the collapse:
•Four elections (1932, 1933, 1935 and 1936)
•one election boycott
•one assassination attempt against ex Prime Minister
•a (allegedly rigged) referendum on Monarchy
•four military coup d’ etats
1933, 1935:
1935:
1936:
Party of Liberals, executions of the 3
Royalists
dictatorship
Greece, after 1936: Economy improved,
but at a huge socio-political cost
• Trade unions bashed, militants in domestic exile
•
Labour corps, working on low wage rates
•
Protectionism and foreign trade clearing
•
Intensive defense procurement
During 1932-36, Greek economy did not follow the
prevailing view that abandoning exchange rate stability
was automatically resulting to recovery and more
employment.
Keynes: the currency liberation from the golden fetters
This happened in core economies, not in the periphery.
Perhaps in Greece after 1936, it was
the imposition of the “iron fetters”
that made unemployment to decline and output to grow
.
Georg Hegel
"What experience and history teach is this –
that people and Governments
Governments
never have learned anything from history,
or acted on principles deduced from it."
… Refutations welcome!