By Uri Dadush
Stay or leave? Should Greece persist with its extreme austerity plan, or should it abandon the euro? What about Portugal? Spain? In mainstream political discourse, posing the question of euro exit is taboo. When Prime Minister Papandreou of Greece, an ardent European, unexpectedly proposed a national referendum on the matter (one he expected adherents to the euro to win) he was immediately sanctioned by his EU counterparts and threatened with a cutoff of all aid to Greece. He was soon after replaced as leader by his own coalition government.
But the question of euro exit does not go away just because it has been officially outlawed. It is often vented by the political fringe, from the National Front on the Right in France to Basque nationalists in Spain, the Northern League in Italy and many on the Far Left in Greece. These views are easy to dismiss as extreme, irresponsible or simply uninformed. But it is more difficult to ignore prominent experts, such as Wilhem Buiter, a former member of the Bank of England’s monetary-policy committee and now chief economist at Citigroup. In Buiter’s view, there is a 50 percent probability of one or more members leaving the eurozone.
Greece is in its fourth year of crisis; desperately uncompetitive, its output still falling fast. It is the most frequently cited candidate for euro exit, implying a huge devaluation of its (new) currency and default on its debts. Portugal is in only slightly better shape. More recently Spain, a much larger and historically more dynamic economy, where draconian cuts are being implemented in the face of 23 percent unemployment, has come under scrutiny. Another rather more surprising candidate for euro exit is ultracompetitive Germany, on the grounds that it might find it easiest to leave an arrangement many Germans consider dysfunctional.
While Greece’s Papandreou was being fired for, among other things, posing the question of euro exit, the World Bank, International Monetary Fund and UBS, an investment bank, were busy conducting elaborate exercises simulating the effects of euro implosion on the global economy. Their conclusions do not make for pretty reading. Despite the taboo, the question of euro exit is the most important source of uncertainty clouding the outlook for the world economy.
The polar cases of Argentina and Latvia
Quite a bit can be learned about the choice of staying or abandoning the euro by examining the polar cases of Argentina and Latvia, which respectively decided to abandon and to stay with their fixed exchange-rate regime. The comparison reveals that the choice confronting the countries in the euro-zone periphery is much starker than that either Argentina or Latvia had to make.
In the last decade, Argentina and Latvia, like Greece and other countries in the euro-zone periphery, became uncompetitive, struggled with large external debts, and made diametrically opposite choices on whether to stay with or abandon their fixed exchange-rate regime. Their experience holds important lessons for the eurozone, though ones which require careful interpretation.
In 2001, after a long recession that came on the tails of a great boom, Argentina broke its one dollar–one peso convertibility law and massively defaulted on its debt. In contrast, Latvia, which saw an even more gargantuan boom before the global financial crisis hit in 2008, decided to maintain its peg to the euro and remain current on its international obligations with help from the IMF (Latvia, an EU member, is not yet part of the eurozone but is committed to adopting the euro).
What happened next? In both countries, following the sudden stop of foreign credit, domestic demand collapsed and unemployment soared to above 20 percent. Argentina saw a 75 percent devaluation of its peso and defaulted on its debt, paying back only about 25 cents on the dollar. However, it returned to rapid growth within about two years. Latvia, on the other hand, saw a deeper and much more protracted crisis. Even five years after its adjustment began and despite large-scale emigration, its unemployment rate remains near 15 percent. Growth has resumed, though at a snail’s pace. Still, while Latvia’s government now is much smaller and more efficient, and its access to international capital markets has been restored, Argentina remains a pariah and a predatory state a decade after its devaluation and default.
These cases show that there is no easy option for the eurozone. While Argentina recovered much faster than Latvia, it was helped—the argument goes—by a massive commodity boom, and it ignored its continuing structural weaknesses. And while writing down its large debt helped Argentina restore its economy, it permanently impaired its reputation and inflicted great damage on others. In short, if the perspective taken is strictly national, the Argentine course may be the most rational. But if one takes a broader perspective—including the interests of the global economy—and wants to deal with the country’s fundamental weaknesses, then countries should stick it out like Latvia.
Why Europe’s Choice is Starker
But despite similarities in the Argentina and Latvian case studies, the choice for eurozone countries is even starker, with staying in or leaving having more far-reaching consequences.
Unlike the eurozone members, Argentina never gave up its currency, the peso. Reintroducing a new currency quickly and simultaneously redenominating all obligations in the new currency would create an economic nightmare as creditors and depositors found their assets devalued. Myriad legal challenges would ensue. Defaulting on loans from other EU members carries enormous political costs and international treaty complications that Argentina did not have to bear. So would separating from the Eurosystem of Central Banks and liquidating the outstanding liabilities. Even though leaving the eurozone and defaulting would not necessarily mean abandoning the EU, it would nevertheless have profound foreign-policy (and, possibly, security) implications, as in the case of Greece’s ability to marshal allies in disputes with Turkey.
On the other hand, sticking it out like Latvia is likely to result in a more protracted and politically fraught adjustment for the eurozone. How so? To put it bluntly, Latvia had no choice but to adjust immediately as all its external financing dried up—between 2008 and 2009, its current account deficit swung from 13 percent of GDP to a surplus of 9.4 percent—a world-record 22.4 percent of GDP adjustment in one year. In comparison, the adjustment in the periphery of the eurozone has been minuscule. For example, four years into its crisis, Greece’s current account deficit remains near 10 percent of GDP. This is made possible by the automatic working of the Eurosystem of Central Banks, which provides for unlimited supply of euros to any central bank that needs them, as well as by large bailout packages, so that by design there can be no sudden stop of foreign financing comparable to that which hit Latvia.
Eventually, of course, financial markets will refuse to lend to a government or firm whose debts reach alarming levels (government debts in the European periphery are much higher than in Latvia), but that occurs much more gradually and selectively than if markets decide that a whole nation has become insolvent—and there is no lifeline from an official source or from a lender of last resort.
The choice to stay or leave the eurozone is made even starker by the fact that the monetary arrangement itself is being transformed in response to the crisis in ways that go to the heart of national sovereignty. The profound changes needed to make monetary union workable—greater fiscal integration, tighter fiscal rules, better coordination of countercyclical policies, monitoring of competitiveness and consultations on structural reforms, common banking regulations and resolution processes, and establishment of a lender of last resort—require joint decision making that, in democracies, implies much tighter political integration. Electorates will only accept the compromises and costs incurred by the eurozone if they are sure that the monetary arrangement itself is secure, forms part of a broader shared vision and that all its members, in the core and in the periphery, are shouldering the burden of reforms.
The End Game
Given the workings of the monetary union, the adjustment process in the periphery runs the risk of becoming so drawn out as to become politically unmanageable. In such a long and painful process, countries in the eurozone that might have been forced by markets to follow in Latvia’s radical adjustment path could one day find themselves, exhausted by permanent austerity, taking Argentina’s course of default and exit—though at much higher cost to them and their partners.
But the forces at play go beyond short-term politics and economics. In Latvia’s case, servicing debts and maintaining the peg were not seen as a mere choice of monetary arrangement but rather as a decision about what kind of country Latvia wanted to be: a part of Europe, or a small, distant province at the edge of the Baltic Sea, prey to the currents of history.
This imperfect comparison with Argentina and Latvia underscores the fact that leaving the eurozone would not, of itself, remedy the structural weaknesses of countries in the periphery. On the other hand, staying in requires the political will for quick changes, so the population is not exhausted by the process. That desire can only come from within the troubled countries, but it must be reinforced by an equally fierce determination at the core of Europe to make the monetary union work—essentially implying another huge step towards completion of the European project.