Currency crisis and collapse in interwar Greece: Predicament or Policy Failure?
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.
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