Should Greece leave the euro?

The Greek crisis has led to calls for the country to leave the euro and adopt a new drachma. This, though, is no solution.

If this were to happen, then - obviously - the new drachma would fall very sharply against the euro. This would mean that Greece would be even less able to repay its euro-denominated debt. In this sense, the move would have to be accompanied by a default. The alternative would be for the debt to be redenominated into drachmas. But this would be a default in all but name, as foreign holders of Greek debt would be repaid in a devalued currency.

Faced with huge losses on their loans, investors would be loath to lend to the Greek government and would - for a few years at least - do so only at exorbitant interest rates, to compensate them for the risk of further falls in the drachma. To reduce such punitive borrowing costs, Greece would still have to run budget surpluses.

But wouldn't a devaluation make it easier to achieve such surpluses? With the drachma cheap, Greek exports would be competitive again and foreigners will flock to the country for cheap holidays. Greece could then grow its way out of debt.

Only for a short period. If workers get higher wages to compensate for higher import prices, then competitiveness doesn't change: what exporters gain from the cheap currency is lost through higher wage costs. History shows that this is exactly what happened to Greece when it had the old drachma. Between 1987 and 2000 - when Greece joined the euro - the drachma halved relative to the Deutschemark. But during this time, Greek relative unit labour costs rose by 35.5 per cent compared to a rise of just 3.6 per cent in Germany. Greece actually lost price competitiveness, because wages rose to offset the cheaper exchange rate. Remember, Greece joined the euro in part precisely because the devaluation-inflation-devaluation cycle had failed to improve the country's fortunes.

Of course, devaluation might work if wages stayed low. But to achieve this would require fiscal austerity to reduce workers' bargaining power. And it would impose a large real wage cut upon workers who would face soaring import prices. In this sense, devaluation is not an alternative to austerity, but a complement to it.

Leaving the euro, then, would not solve Greece's problem. It would, though, add to the woes of other peripheral nations. Having seen one country leave the euro, investors would believe that there would be a risk of others following. They would therefore require a currency risk premium to hold the bonds of Portugal and Ireland, and possibly Spain. These countries would thus face higher borrowing costs.

Worse still, insofar as the Greek devaluation does give the Greek economy a short-term boost, it will do so at the expense of these nations: tourists will go on holiday to Greece rather than Spain or Portugal.

For these reasons, the desire to keep the euro intact has a solid economic foundation. It's not just down to politicians' vain desire to keep the "European project" alive.

Of course, just because something would have nasty consequences does not mean it won't happen. It could. But let's be clear. Greece leaving the euro is no solution. There's no happy ending to this story.

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