Finance and capital markets
How and why Greece would leave the Euro (part 3)
The pain and mechanics of leaving the Euro. Created by Sal Khan.
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- At7:20, what is "GDP"?(11 votes)
- Gross domestic product (GDP) is the market value of all officially recognized final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living; GDP per capita is not a measure of personal income (See Standard of living and GDP). Under economic theory, GDP per capita exactly equals the gross domestic income (GDI) per capita (See Gross domestic income).GDP is related to national accounts, a subject in macroeconmics(3 votes)
- Sal, could you explain the mechanics why the Entitlements and the Debt is not bound to the inflation rate, but the GDP is? Thanks!(7 votes)
- Think of it this way. You have a mortgage for $250,000 and you make $75,000 working for a magical company that matches your salary with inflation. One morning you wake up and for some crazy reason the cost of all goods doubled overnight, or the world experienced 100% inflation instantly. Thanks to your magical company, you now make $150,000 because they matched the rise in the cost of goods, the inflation. However, do you now owe the bank $500,000? No, because you signed a contract with them saying you owed them $250,000.
For Greece, this magical company that pays you money is called taxes, which will rise with inflation since it comes as a percentage of goods purchased and income made. Similar to their debts, their entitlements, such as retirements and pensions and social security, is for a set amount of money, which is never adjusted to inflation. So if inflation occurs at a rate of 100% overnight, their incomes rise, but their obligations remain the same. This really stinks for the lenders and those receiving entitlements, but that's how it works.(14 votes)
- Has any sovereign nation defaulted before? If so, what were the repercussions and what was the overall outcome?(5 votes)
- Many nations have defaulted. Even the USA has defaulted. You can find a list here: http://en.wikipedia.org/wiki/Sovereign_default
Many things may happen during a default. It mainly depends on wether it's controlled or uncontrolled but the goal will be to reconstruct the debt.
Argentina defaulted in 2001. You could google their debt crisis and see what you find.(7 votes)
- If the conversion to Drachma is a default, as explained at3:40, then why would they still need to inflate their obligations? Wouldn't this setup allow for a full "we're not paying" default, while mostly sidestepping the problems that Sal explained in the previous video?(4 votes)
- You are correct. This would allow them to do a full default (and, historically, it does seem that credit markets are surprisingly forgiving of this after five or ten years). They may still want to inflate away their obligations to their own citizens so they have some chance of spending less of their GDP on entitlements.(3 votes)
- What repercussions for a country does a bank failure have?(3 votes)
- If a bank fails, all its assets will have to be sold to pay its lenders. That means companies and even normal will who have borrowed money from the bank will have to pay back their debt right away. In most cases this means that they have to borrow from another bank to do so but they may not be interested in lending you money (maybe they are in trouble themselves or maybe they don't believe you will be able to pay you debt) thus forcing you to go backupt as well. Banks also lend to each other and so the failure of one bank can lead to failures of more banks.
The end result will be massiv unemployment and bankruptcies though policy makers will do what they can to try and provent it from spreading.(5 votes)
- whats the difference between GDP and GNP(3 votes)
- The two are different ways of calculating the economic value of the goods and services of a country, and is based on largely what you define to be a "country". The GDP is calculated by looking at the total economic activity of a country within its physical borders (including foreigners working within those borders). GNP, on the other hand, is calculated by looking at the total economic activity of the citizens of that country, even if that citizen is overseas.(3 votes)
- Is there a real world example of a country using the inflation method of paying it's debt? What were the political and economic consequences of this?(4 votes)
- You were saying that investors expect their obligations paid back to them in euros, not drachma. Couldn't the Greeks, (regardless of the value of their new currency) print the amount of debt they owe in drachma and as soon as the banking holiday ends use some kind of forex market to convert that amount of money to Euros. I say they'd do this as soon as the holiday ends so that the Drachma's exposure was limited so its value does not decline and the Greeks get a more favourable deal on their end.(3 votes)
- Philip katz, 1:1 or a definite set rate only happens if greece govt and lenders agree( which they obviously wont), otherwise on a free market, rate of 1:1 is practically never possible(2 votes)
- Again on the topic of Central Bank... if they leave the euro and create their own Central Bank, why wouldn
t it rescue the individual banks from a bank run by printing more money - drachmas? I understand why it cant buy back the debt, but why not help the banks be kept from a bank run, as it is said in the last minute of the video?(2 votes)
- A bank run would stem from people withdrawing their euros from Greek banks. No amount of drachmas is going to solve this problem. The banks need euros to pay their liabilities that are denominated in euros. They won't have any initial use for drachmas beyond every day transactions.
They could of course exchange drachmas for euros, but this could end up being a very costly procedure, especially if it is being devalued.(3 votes)
- How would that be worse than the austerity measures? If it would prevent them from paying their debt, then how is a default more damaging than this? Wouldn't other countries not be willing to loan them money after this, just like they wouldn't after a default. And how could this "new drachma" have any sort of value? It sounds like they're just making up new money to try and pay off their debt with money without any value? Like if there were 10 people, and they all used the dollar, and I owed the other 9 a total of $10,000, could I just go and give them a slip of construction paper (my new national currency) for every dollar and pretend like it has any value? They wouldn't lend to me again and my citizens wouldn't want it. It would have no value on an international market, and it seems like it would be harder to recover from than a default.(2 votes)
- You might think that no one would lend to them again, but history shows otherwise. It normally doesn't take too long before new lenders show up who think that the devaluation was a one time event and that they are going to get good returns from here on out.(3 votes)
Now that we have a reasonable understanding of why austerity is very difficult. 1) There probably isn't the political will to do it. And even more, it might drive Greece into a bigger recession. And we also understand why defaulting isn't an option for Greece and we understand what a monetarily independent Greece would have done. We can now get a good sense of what Greece is likely to do, outside any other intervention, outside any help from other Euro Zone members. In future videos, we will talk about why other Euro Zone members do have some incentive to try and stop Greece from doing what I'm about to articulate. So in an ideal world, Greece, if it had its own currency, would just print away and be able to inflate away its obligations. Also, if it had its own currency, and this is not necessarily a good thing to do, because it will undermine investor trust going forward, but even defaulting would be an option, because they would still have access to their own currency and then they could just keep printing and then lending to that government, then the government could continue to pay the nominal obligations, but since they're getting inflated away, in real terms they would become lower and lower. So what Greece, if it doesn't get any help from other Euro Zone members, if it does not get bailed out in some way, what is likely to happen is that Greece leaves the Euro. And the actual mechanics of that, and it will probably go back to a new form of the drachma. And the way that that would actually happen mechanically is that they would declare a banking holiday. And it sounds like a very nice thing like everything which had a world "holiday" in it but a banking holiday is essentially a forced shut down of all of the banks for some period of time, over which they can do transition into the new currency. And so, entering into the banking holiday the Euro was the currency, and the money you had in your bank was denominated in Euro, but exiting the banking holiday the drachma will be the currency, and the money that you have in the bank will be the drachma. And what the government will essentially do is set some type of conversion rate over that banking holiday. They'll maybe say every one Euro you have will be converted into one drachma. And then just the exchange markets will determine what the actual exchange between a euro and a drachma is going forward. And so then everybody would buy and sell in drachma. And the government would also say all of our obligations are now in drachma. Which would essentially be a default because if they told to their debtors that "we no longer owe you....[where is the number?] 356 billion euros", or actually close to 400 billion or whatever the number is, "we do not longer owe you 400 billion euros", they are now going to say "we owe you 400 billion drachma." Or they can even say, we're only going to pay you 200 billion drachma, or a 100 billion drachma. But no matter what they say, even if they say they are going to give you a trillion drachma, that would still be a default on the debt because these debtors, in order to fulfill these obligations, they were expecting euro. And if you give them anything other than euro, if you give them strawberries or bananas or drachma, that is a default. So no matter how many drachma they say they're going to give, this would constitute a default on their debt. But the Greek people could actually then move on with their lives. And there's all sorts of crazy things that would happen, but at least now the government would be able to print its own money and use it to buy government debt, and continue to fund government spending and eventually inflate away its obligations. You could imagine a situation that, right now, its real GDP is, let's say it's the equivalent of 100 drachma. And then by just keep printing drachma, the actual productivity of the economy doesn't change. It actually might improve if money is printed, but you don't get to hyper inflation. Let's say over the next 10 years that the real GDP doesn't change, but the nominal GDP, due to inflation over the next 10 years, becomes 500. Prices in general, ...so inflation, you had 5x inflation. Things become worth 5 times as much, you produce the same goods and services, they are now worth 5x as much. But now, that debt that you have, your taxes are going to grow with inflation because they are a % of your GDP but your actual debt obligations won't change. So in real terms, they'll be 1/5 as much, which all of a sudden, makes them sustainable. Now, as I said, this is not a simple thing to do. And not a painless to do. And we haven't even started talking about the repercussions for the rest of Europe, and why this might be scary, and make other people suspicious of countries like Spain and Italy, etc. And even in Greece this would be painful. Because you can imagine, you can imagine, we're already starting to see this in May of 2012. The government will say every euro in your bank account will now be a drachma, but the people there they know better than just believing that a drachma is going to be worth the same as a euro. They're going to know that as soon as the drachma starts exchanging on foreign exchange markets, that the actual reality is 1 drachma is going to be worth something closer to maybe .6 of a euro. Or .7 of a euro. Let's say it's .7 of a euro. So essentially by this happening, everyone's savings and deposits, in real terms, in terms of their global buying power is going to go down by 30% overnight. And the Greek people are already seeing that. They are seeing the possibility of a banking holiday, and a conversion to the drachma. And so that's why you have people waiting in line before this happens and trying to withdraw their euros. So people are starting to withdraw their euros, and if they have a Swiss bank account they can deposit it there or they can just take the euros and stash in their mattresses. And that by itself is a little bit scary. The bank's deposits are depleted. But remember, they have a fractional reserve banking system. They do not expect everyone to show up on one day and expect all of their deposits to be accessible. So this is essentially going to lead to a run on banks. And you're already starting to see this in Greece, and it is actually rational behaviour. If you think that 30% of your savings is about to swiped away because of this thing right here, I'm going to give you .7 of a euro for every euro you have, you would rationally go to the bank and get your deposit back. But because everyone is going to start doing that, the banks won't have their reserves. The Greeks don't have their own central bank that can back up the banking system there. So this might lead to massive bank failures. And essentially, the entire Greek banking sector could go down because of this. And they don't have an independent central bank, independent of the European central bank, to kind of fight the fires the way that the Fed would in the US. So this is not a clean situation; it is not a painless situation. But, outside any help, it seems like the only option that Greece has at this point.