Inflation Expectations and the Day After

Currently there is an increasing concern regarding the greek  participation in EMU and generally  the foreign exchange status of the troubled European Union north. Among the greatest issue is the foreign exchange status  after Grexit. So far  two main schools of thoughts have been discussed publicly.

The first one is proposed by Tomas  Mayer (ex chief economist of Deutsche bank). This  is related to the  double foreign exchange rate status and  has to do with the simultaneous circulation of two monies. According to this idea floated by Mayer the "geuro" would consist of promissory notes, a form of government debt that can be sold on. It would devaluate sharply against the euro but would allow the government to buy itself some more time to carry out reforms and pass more budget cuts.   The "geuro" would allow Greece to lower its wages and boost exports so as to increase the greek competitiveness. This is for internal affairs. For international trade and any other external activity euro will remains.

The other one is related to an  ERM like status so as to establish target zones—central rates with a rather wide and of permissible variation—among the core currency, as has been  advocated by Williamson (1985) and Bergsten and Henning (1996). In this case the local currency (perhaps Drachma) will float (+- 15%) around an equilibrium rate. A foreign exchange mechanism will intervene in any case the current rate bypass the equilibrium bands.

In both cases there is an Achilles hill and this is called inflation differential between Greece and main trade partners.  At the very beginning it must be noted that the accumulated inflation differential since 2000 (year of Greece’s entrance in EMU) between Greece and the European partners is more than 45%. What that it means? The markets will immediately  seek  to recover this accumulated  difference. Most possible by an  overshooting  exchange rate caused an inflation episode in the greek economy.  So I am afraid that the starting nominal equilibrium rate  will soonly suffer  by depreciated expectations.  Greek economy has no any good record handling  inflation and inflation expectations since market expectations are already fragile.

It is plausible after the initial shock to feed  a death spiral: inflation-depreciation-inflation.  Since the greek external trade is higly integrated withing EU countries and the inflation differential will keep on going at the expense of Greece then the foreign exchange markets  will overshoot the initial equilibrium.

Lets now consider what the proposed schemes have to produce for the greek economy. According to the first scheme (dual rates) increasingly the good money crowd out the good money and this will result in a black market economy. According to the second scheme the band will be bypassed the first months and an any intervention mechanism will be inadequate.