Currency crisis and collapse in interwar Greece: predicament or policy failure?

TLDR: Greece in 1928 viewed the anchoring to the Gold Exchange Standard as the imperative choice of the time in order to implant financial credibility and carry over an ambitious plan of reforms to modernise the economy.

Abstract: Greece in 1928 viewed the anchoring to the Gold Exchange Standard as the imperative choice of the time in order to implant financial credibility and carry over an ambitious plan of reforms to modernise the economy. But after the pound sterling exited the system in 1931, Greece, instead of following suit, chose a defence that drove interest rates at high levels, squeezed the real economy and exhausted foreign reserves. Unable to borrow from abroad, it quitted the system in 1932 and the Drachma was heavily devalued. Despite a rise in competitiveness, the erosion of real incomes cut domestic demand, unemployment continued to rise and the country entered a period of acute social and political instability. The lessons are perhaps relevant today for the costs that Greece would face by exiting the Eurozone. A model of Balance of Payments crises with partial capital controls is employed to analyze the response of currency pegs to external shocks and examine under which circumstances the regime collapses. Its main predictions are found to be in agreement with the actual outcomes in 1932.

Figures

Figure 8. Greek sovereign yields quoted in London and in Athens. The yield quoted in Greece is calculated as the simple average of monthly reported yields on Greek bonds issued at 1881,1884,1887,1889, 1890, 1902, 1907, 1910 and 1914.

Figure 7. Number of unemployed.

Figure 10. Correlation between yield spreads and foreign reserves for the period before the regime collapsing, 1928:05-1932:03.

Figure 9. Foreign reserves in million of LMU Drachmas

Figure 15. The response of foreign exchange reserves. Actual profile shown in Figure 9.

Figure 1. Public debt of Central Government, in million LMU Drachmas.

Full text

All views expressed in this paper are those of the authors and do not
necessarily represent the views of the Hellenic Observatory or the LSE
© Nicos Christodoulakis
Currency crisis and collapse
in interwar Greece:
Predicament or Policy Failure?
Nicos Christodoulakis
GreeSE Paper No.60
Hellenic Observatory Papers on Greece and Southeast Europe
JULY 2012

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TABLE OF CONTENTS
ABSTRACT __________________________________________________________ iii
1. Introduction _______________________________________________________ 1
2. The quest for stability in Greece _______________________________________ 6
3. Sliding on the golden edge: fight, flight and failure _______________________ 11
4. Modeling the currency crisis _________________________________________ 17
5. Conclusions _______________________________________________________ 27
Appendix A. Graphs __________________________________________________ 31
Appendix B. Modelling the currency peg __________________________________ 39
Appendix C. Data analysis _____________________________________________ 41
References _________________________________________________________ 42
Acknowledgements
I am thankful to N. Pittis and Olga Christodoulaki (no relation) for valuable suggestions, and
also to participants at a seminar in the University of Cyprus, and in the Conference on
‘Interwar Economic Leadership in Small Countries’ organized by the Venizelos Foundation for
helpful comments on an earlier version. Help by Sofia Lazaretou on the recently compiled
data series of the Bank of Greece is gratefully acknowledged. The usual disclaimer applies.

iii
Currency crisis and collapse
in interwar Greece:
Predicament or Policy Failure?
Nicos Christodoulakis
#
ABSTRACT
Greece in 1928 viewed the anchoring to the Gold Exchange Standard as
the imperative choice of the time in order to implant financial credibility
and carry over an ambitious plan of reforms to modernise the economy.
But after the pound sterling exited the system in 1931, Greece, instead
of following suit, chose a defence that drove interest rates at high levels,
squeezed the real economy and exhausted foreign reserves. Unable to
borrow from abroad, it quitted the system in 1932 and the Drachma was
heavily devalued. Despite a rise in competitiveness, the erosion of real
incomes cut domestic demand, unemployment continued to rise and the
country entered a period of acute social and political instability. The
lessons are perhaps relevant today for the costs that Greece would face
by exiting the Eurozone.
A model of Balance of Payments crises with partial capital controls is
employed to analyze the response of currency pegs to external shocks
and examine under which circumstances the regime collapses. Its main
predictions are found to be in agreement with the actual outcomes in
1932
JEL classification: N14, N24, F32.
Keywords: Gold Exchange Standard, reserves, exchange rate.
#
Athens University of Economics and Business (AUEB), 76, Patission Street, Athens GR 10434

1
Currency crisis and collapse
in interwar Greece:
Predicament or Policy Failure?
1. Introduction
A byproduct of the current Greek debt crisis is a thriving literature based
on the intellectual speculation – sometimes on a market one as well –
that Greece is bound to fail the stabilization process and, therefore, exit
the Eurozone and default. The argument goes that under the present
fiscal austerity and currency fixity, recession will deepen destroying jobs
and igniting social unrest; see Roubini (2011). After abandoning the
Euro, Greece is assumed to become master of its fate so that she prints
her own money, rebukes the austerity program, and – of course -
devalues, perhaps heavily. 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; see Feldstein
(2011). But, the argument continues, this is an affordable cost as the
economy soon will assume a growth path, with competitiveness and
employment restored, and reforms advancing; see Azariadis (2011).
If not convincing enough, the above arguments are enriched by historical
clichés, according to which Greece will fail because under similar
circumstances it has also failed in the past. Hartwich (2011) argues that
one such episode was the country leaving the Latin Monetary Union
(LMU) in 1908 and concludes that “Greece is a basket case”. However,

Frequently asked questions

Q1. What are the contributions in "Currency crisis and collapse in interwar greece: predicament or policy failure?" ?

Christodoulakis et al. this paper analyzed the causes and consequences of the crisis in the 1930s and the present paper sets to analyze three points: 

Q2. Why did the Greeks try to restructure their relations in key sectors?

In the 1930s, Greek economic policy was trying to restructure parochial relations in key sectors ranging from banking to agriculture, to build productive infrastructure in order to close the gap of regional inequalities, and at the same time to become an equal partner in shaping European politics. 

Q3. What is the determinant of the transition matrix in (10)?

In complete form, expression (10) implies in continuous time the dynamics of spreads:0 1 2 3s s Q Qα α α α= + − −(19)The resulting system is now three-dimensional in [ Q x s] , and using (6) and (8) the transition matrix is obtained as:_1 2_2 3 3 1 2 1 3( )0 (1 )( ) ( ) ( )r 

Q4. What evidence does Obstfeld and Taylor (2003) have?

Recent econometric evidence by Obstfeld and Taylor (2003) on interwar markets suggests that the return to the Gold Standard after the Great War did confer lower sovereign spreads to participants on servicing their debt. 

Q5. What was the effect of the devaluation of the GES on the Greek economy?

the appetite of London investors for Greek bonds declined en masse and, as result, the Greek economy was suffering both from credit shortage and capital flights abroad that were further exacerbating domestic contraction. 

Q6. What is the main argument for a repudiation of obligations?

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; see Feldstein (2011). 

Q7. Why did the Greeks choose to fix the exchange rate to another country?

The choice of fixing the exchange rate to another country’s currency,with which Greek trade was limited, made the Drachma uncompetitive towards other economies and soon after the country experienced large external deficits. 

Q8. How does the approach by Hellwig et al. (2006) work?

In the approach by Hellwig et al. (2006), investors take into account the risk of default, thus the gap between demand and supply of domestic bonds closes by offering satisfactorily high spreads over the foreign yield. 

Q9. Why was joining the Gold Standard a precondition for Greece?

In such an environment, joining the Gold Standard was rightly seen as a precondition to facilitate the influx of foreign capital essential for economic growth. 

Q10. How did the unemployment in Greece decline in the second half of the decade?

Unemployment in Greece declined only in the second half of the decade after major political changes have taken place that brutally destroyed trade unions and sent their representatives in exile. 

Q11. How did the Greek Government react to the devaluation of the GES?

The Greek Government was taken by sheer surprise when the UK abandoned the GES in September 1931 and devalued by 35% to the US Dollar. 

Q12. What is the reason why a run-away may be triggered?

In other cases a run-away may be triggered simply when investors are risk-averse and adopt stop-loss schemes to limit their exposure. 

Q13. What was the reason for the abandonment of the regime?

Whatever the motivation, the result of further credit expansion was that foreign exchange reserves were depleted fast as shown in Figure 9, precipitating the abandonment of the regime as analyzed in the next section. 

Q14. What was the key decision to anchor to Gold?

Authorities viewed the anchoring to Gold as the unique choice to implant financial credibility and carry over an ambitious plan for the modernisation of the economy. 

Q15. Why did the Bank of Greece suspend the Stock Exchange?

The decision to suspend the Stock Exchange in September 1931 in order to avoid sell-out hysteria fuelled more fears that the Government is in a precarious situation and may not succeed for long in keeping with the GES.