Frenkel Cycle: The Inconvenient Truth About Monetary Unions and the Greek Crisis

Let's go back to the basics of economics and consider what happens when large monetary areas are created, uniting different economies without compensation tools and thinking that money is enough to unify the various countries. The explanation linked to the Frenkel Cycle comes to our aid.

The “ Frenkel Cycle ” in economics is a theory that describes a boom and bust process that occurs when a less economically developed country (the “periphery”) is pegged to a stronger currency area (the “center”) , losing its monetary sovereignty and adopting a fixed exchange rate regime. This cycle was expressed by the Argentine economist Roberto Frenkel and is sometimes referred to as the “ Frenkel-Neftçi Cycle ” because of its first mention in literature. Unfortunately, Frenkel will not win the Nobel Prize, because his discovery is too inconvenient.

What is the Frenkel Cycle: The Dramatic Phases

The Frenkel cycle is typically divided into seven phases , characterized by an economic dynamic that takes the periphery from a phase of apparent prosperity to a deep crisis. Let's look at them in detail, with a focus on the most dramatic aspects:

1. Accession and Liberalization Phase (The Dangerous Embrace): The peripheral country decides to enter a monetary union, adopting a fixed exchange rate with the currency of the center and liberalizing capital movements and financial markets. This move, often presented as a step toward modernization, exposes the periphery to unimaginable risks.
2. Massive Capital Inflow (The Illusionist): The core countries, benefiting from the stability of the fixed exchange rate, flood the periphery with capital. This happens because interest rates in the periphery are often higher, and exchange risk is eliminated. It seems like a golden opportunity, but it is a prelude to disaster.
3. GDP Boom and Public Debt Reduction (The Brief Euphoria): The inflow of foreign capital fuels domestic demand, leading to an apparent growth of GDP and, paradoxically, to a temporary decrease in public debt, thanks to the increase in tax revenue. The periphery experiences an illusory phase of prosperity.
4. Rising Inflation and Private Debt (The Silent Snake): Growth fueled by foreign capital leads to rising inflation in the periphery. At the same time, private debt is growing at an alarming rate, far exceeding public debt. Prosperity is unsustainable and rests on fragile foundations.
5. Shock and Burst of the Private Debt Bubble (The Inevitable Fall): A traumatic event, internal or external (such as a global financial crisis), forces creditors in the center to withdraw capital from the periphery. The private debt bubble bursts with devastating effects.
6. Recessive Vicious Circle and Worsening Public Debt (The Spiral of Pain): The lack of foreign liquidity triggers a deep recession in the periphery. GDP collapses, consumption and investment disappear, and previously contained public debt explodes due to lost tax revenues and (often imposed) bailout measures. Austerity policies, aimed at reassuring creditors, further aggravate the situation, trapping the country in a vicious circle.
7. Abandoning the Fixed Exchange Rate (The Last Resort): The situation becomes unsustainable. The periphery is forced to abandon the fixed exchange rate regime and devalue its currency in an attempt to regain competitiveness, even if this entails enormous social costs and a further deterioration of living conditions.

Implications for the Economy

The implications of the Frenkel Cycle for the economy are profound and often devastating, especially for peripheral countries:

• Loss of Monetary Sovereignty: The peripheral country loses the ability to use monetary policy as a tool to stabilize its economy. It cannot devalue its currency to increase export competitiveness or stimulate domestic demand.
• Vulnerability to External Shocks: The economy of the periphery becomes extremely vulnerable to external shocks and decisions taken in the center, such as the withdrawal of capital. What happened to Greece and, to a lesser extent, Italy, is an example.
• Austerity and Economic Contraction: Austerity policies imposed to “reassure markets” and foreign creditors lead to drastic cuts in public spending, increased taxes, and a consequent economic contraction, increased unemployment and worsening social welfare.
• Increase in Public Debt: Despite austerity measures, public debt tends to increase as a proportion of GDP due to the collapse of production and the recession.
• Social Deterioration: The economic crisis leads to a dramatic increase in unemployment, poverty and social inequalities, with serious internal tensions.
• Economic Dependence: The cycle highlights a strong economic dependence of peripheral countries on the capital and policies of central countries, limiting their prospects for autonomous and sustainable development.

The Frenkel Cycle, in particular, has often been invoked to explain the dynamics of financial crises in emerging countries and, with different interpretations and debates, to analyse the Eurozone crisis , where some member countries (the “periphery”) found themselves facing similar dynamics, albeit in the context of a monetary union.

Greece and the Frenkel Cycle

The Greek debt crisis was not a bolt from the blue, but a striking manifestation of the Frenkel Cycle , a model that describes how “peripheral” countries that tie themselves to a strong currency area can end up in a boom-bust spiral. Let’s look at how Greece lived through these seven dramatic phases.

1. The Euro's Fatal Embrace: Accession and Liberalization

In 2001 , Greece joined the eurozone, adopting the single currency and integrating into European financial markets. This move, seen as a step toward stability and modernity, eliminated exchange rate risk for foreign investors, paving the way for future capital flows. The country gave up its monetary sovereignty, a decision that would prove crucial.

2. The Illusion of Easy Wealth: Massive Influx of Capital

After joining the Euro, Greece was flooded with foreign capital. European banks lent huge sums to the Greek government and private sector, attracted by interest rates aligned with those of Germany and the perception of zero risk thanks to the Euro. This wave of liquidity fueled a false sense of well-being.

3. The Brief, Deceptive Euphoria: GDP Boom and Apparently Controlled Debt

The next few years saw robust growth in Greek GDP, fueled by borrowed consumption and investment. Tax revenues increased, giving the illusion that public debt, though high, was under control. It was a period of apparent prosperity, but its foundations were made of sand, not real productivity.

4. The Silent Poison: Inflation and Exploding Private Debt

Capital inflows and domestic demand overheated the Greek economy. Prices and wages rose faster than in the rest of the Eurozone, eroding the country's competitiveness. At the same time, households and businesses took on massive debt, inflating a giant bubble of private debt that, invisible on the surface, far exceeded public debt.

5. The Shock That Triggers Catastrophe: Shock and Bubble Burst

The 2008 global financial crisis acted as a catalyst. Investors, suddenly aware of Greece’s fragilities and hidden structural deficits, began to withdraw their capital. Rates on Greek government bonds skyrocketed, making it impossible for Athens to refinance itself. The private debt bubble burst, paralyzing the financial system.

6. The Spiral of Ruin: Review and Public Debt Out of Control

The Greek economy plunged into a devastating recession . GDP collapsed, unemployment skyrocketed, and already precarious public debt became unsustainable due to economic contraction and lost tax revenues. International “bailouts” were granted only in exchange for brutal austerity policies that further strangled the economy, trapping Greece in a vicious cycle of mounting debt and contraction.

7. The Last, Desperate Option: Internal Devaluation (Instead of Fixed Exchange Rate)

Since leaving the Euro (Grexit) was considered too risky, Greece was forced to undertake an “internal devaluation”. This meant draconian cuts in wages, pensions and services, an attempt to restore competitiveness by lowering costs without being able to devalue the currency. The price was deep social suffering, mass emigration and a prostrate economy, mirroring the final phase of the Frenkel Cycle.

These are the pleasures of having created a single currency without having created a real, single, market and without having adequate compensation systems, that is, a common guarantee for the debt or targeted transfers that compensate for peaks and collapses of the cycle in its phases, which perhaps slowed down excessive growth, but compensated with transfers during the collapse. Instead, natural selection was expected to operate, even if this caused suffering and poverty to a people whose only fault was to believe in the promises of their leaders. Who then paid a minimal amount for their mistakes.

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The article Frenkel Cycle: The Inconvenient Truth About Monetary Unions and the Greek Crisis comes from Scenari Economici .

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This is a machine translation of a post published on Scenari Economici at the URL https://scenarieconomici.it/ciclo-frenkel-crisi-grecia-unioni-monetarie/ on Sat, 05 Jul 2025 13:36:14 +0000.