Devaluation – last option to save the euro

As debate about a Greek exit from the euro grows, the European crisis is reaching boiling point. There are three sources for the problems of Greece and other peripheral European nations.

The first and most immediate is the fear that Greek banks will convert euro deposits into a new Greek currency. This has prompted withdrawals from not only Greek, but also Spanish and Portuguese banks and sent money flowing to German banks and German government bonds. The second is the unsustainable budget and current account deficits of many of the peripheral countries.

The third, and ultimately most important and intractable source of the crisis, is that labour costs in the peripheral countries are too high and uncompetitive with the northern European countries, particularly Germany. Historically, overpriced labour markets have been cured, albeit painfully, by currency devaluation – an option which is not open to euro-based economies.

If Greece does exit the euro and establish a new currency, investors fear that Greek deposits and Greek debt will be converted into a new currency which will sell at a steep discount to the euro. If Greece took this action, it would cause bank runs in Portugal, Spain, and even Italy as depositors fear their governments will do the same.

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