Given the debt crisis in Greece, I have been shocked to see no one in the media talking about the effects of currencies on a nation and how that fits into the idea of Grexit. So let’s fix that with a game of “what if”. There are a dozen reasons why economists avoid playing “what if” games but here I think it will help to explain the situation. With that said, give me a bit of leeway with the detail. What if Detroit seceded from the union in late 1960’s?

So in our alternative history, Detroit along with some of the adjoining area (specifically those including the MSA data area) leaves both the US and the State of Michigan in an organized manner starting in 1966 and finished their transition in 1968. They are on good terms with Canada and America helps with the transition to ensure everything happens smoothly. Detroit even launches their own currency, the Seger, named for the musician who plays at the bar where the open market committee meets. The Seger is pegged at 1 Dollar to 1 Seger during the transition. The Nation of Detroit continues to export cars to America and import, well, most other things.

This continues for a few years with the value of the Seger fluctuating from .9 to 1.1 of a Dollar but roughly staying near the original 1 to 1 rate. The people of Detroit will remain in roughly the same economic shape as Americans in neighboring areas. But in 1973 the oil crisis hits and things change. American customers start to favor smaller foreign vehicles, which are not built in Detroit. This lowers the demand for the larger style cars made in Detroit. With exports down, the value of the Seger drops to 1 Seger = 75 US cents. This has two effects. All those imports that Detroit buys just got a lot more expensive. This means the living standards of a Detroiter just got lowered. However this also makes all those heavy cars that are for export much cheaper for American buyers.

And this is where history really splits. This currency adjustment cushions the hit that automakers actual took in the mid 70’s, however it does so at the cost of a drop in buying power for everyone else in Detroit. Over the next decade, more factories stay open and less of the industrial base of Detroit is gutted, but each of these adjustments happens both via a drop in the value of the currency and in the buying power of those in the community. Economics is a double edged sword and with a floating currency there is a relationship between exports and currency value that acts as two steps backwards and one step forward in this crisis.

Of course this Detroit is a “what if” scenario. No massive currency adjustment happened and Detroit did lose a lot of its industrial base and the buying power of those living in Detroit is not fundamentally different from those elsewhere in the US. But for fun, let’s apply the same analysis to Greece.

There are many problems in the Greek economy, but let’s focus on of the core ones. The cost of labor is higher than the productivity of that labor. To those who do not study economics, please do not read this statement as a personal or racist insult to the Greek people. It is not. It is a calculation and that calculation is affected by many elements including technological sophistication, the maturity of the industrial base, the role of automation, and availability to capital to only name a few. It is not a critique of culture.

Now, if a country has its own currency and its labor to productivity rate is too expensive there are a few options. First, the nation can become more productive and thus worth the price that labor is charged. Second, the labor prices could drop to match their productivity levels. Third, and the focus of this blog post, is the value of the currency could drop. This last option would naturally happen over time if neither of the other two options happen. However Greece is not Greece, it is Europe and on the Euro. So does Europe’s labor price match its productivity? Yes, yes it does and thus a long term drop in the value of the Euro is not likely.

A quick note on scale and GDP: the US is $16.8 trillion and Detroit is currently $225 billion. The EU is $18.5 trillion and Greece is currently $242 billion. As you can see I did not pick Detroit at random. Much as we did not spin-off Detroit, a “Dexit” one would assume, neither was Greece forced out of the EU… thus far. But we also can’t expect the result to be much different. As Detroit suffered from their high labor costs as factories moved to the South or oversees, do not expect Greece to dodge that fate as long as their labor to productivity ratio remains high.

Would Detroit have been better as a spin-off nation of the US? In purely economic terms, it would have been a mixed result. Would Greece be better in or out of the EU? Once again there are no good answers and the result would be mixed…. but with one caveat: the transition.

In our “what if” the US helped Detroit transition. When Greece joined the Euro it did so via an orderly transition. The danger is not in the long term result, but in the short-term transition. Both enlightened experts and even the markets themselves can get this transition wrong, at least in the short term. Pegging the right price to a new currency will dramatically affect Greece. And yes, the Drachma will be a new currency even if it has an old name. In 2008, Greece exported $17 billion and imported $61 billion. By 2011, after the start of their crisis, those levels have adjusted to exports of $27 billion and imports of $48 billion. This means 31% of their economy is directly linked to trade and thus that currency evaluation rate. Another 18% of Greece GDP is based on travel and tourism, processes that are greatly simplified by a single currency.

I have heard many, many economists and politically savvy individuals point out that Greece should not Grexit and the recent bailout deal is wrong. Greece should instead focus on growing their economy via a Keynesian approach by increasing deficit spending to increase consumption and thus create economic growth. I understand that desire and I personally agree with large swaths of Keynesianism. However I do have a problem with it in this case. In the US from 1932 to 1936, the worst years of the Great Depression, budget deficits were equal to 4.8% of GDP on average. Since 2008, the start of the Greek Crisis, budget deficits have been equal to 10.2% of GDP on average. Greece is not running a New Deal, they are running two of them in terms of deficits and they have ran them for more than twice a long! I understand why some many have suggested this, but if this policy was going to have an effect it would have happen already.

There are some problems you can grow out of and there are some problems that just keep spawning more problems until something fundamentally changes. I’m afraid Greece is the second form in which case the reforms are still a poison pill but one correctly prescribed. The real question is if they go far enough. If they do, then and only then can I see some form of targeted deficit spending becoming a functional policy option. Until that day, deficit spending in Greece under the current conditions is just doing the same thing again and again expecting a different result.