What happens when a country faces forced austerity, a banking crisis, a risk of sovereign default, and pressure to abandon a currency peg it has has sworn to be eternal and unbreakable? Several European countries are in this position today, but there is nothing really new about it. It's all happened before, most recently in Argentina in the winter of 2001-02. So what became of Argentina? Are there any lessons there for today's Europe?
Argentina introduced what it called its "convertibility plan" in April 1991 as a way of stopping its latest episode of recurrent hyperinflation. Rather than opting for outright dollarization, as Ecuador would do a few years later, Argentina introduced a new version of its own currency, the peso, and pegged it to the U.S. dollar at a 1-to-1 rate. The peg was underpinned by a currency board arrangement, which required the central bank to hold sufficient dollar reserves to back the entire monetary base (paper currency in circulation plus bank reserves) and to exchange pesos freely for dollars.
At first it worked. A fixed exchange rate can be a powerful tool to stop run-away inflation. As inflation came down, Argentina experienced a few years of good growth. However, it was not long before the fixed exchange rate showed its negative side: inflexibility in the face of external shocks. The Mexican "tequila crisis" and a devaluation of the Brazilian real, among other things, left Argentina with an overvalued currency, a big trade deficit, and excessive dependence on foreign borrowing. In addition, Argentina had a hard time mustering the fiscal discipline needed to live with a fixed exchange rate. By the end of the 1990s, Argentina was again in crisis. With IMF encouragement, it first tried fiscal austerity, and when that did not work, more radical measures, including a freeze on withdrawals of bank deposits. "This buries whatever hypothesis may exist that we will devalue," said Finance Minister Domingo Cavallo, speaking, in December 2001, of the banking freeze. But just a month later devalue they did, and they defaulted too.
What happened next is very interesting. Devaluation and default did not bring the end of the world. Hyperinflation did not return. The peso, when floated, did not go into free fall, but instead settled into a range between 3 and 4 to the dollar, where it remains to this day. Most importantly, the real economy recovered strongly. Since 2003, Argentina has grown more rapidly even than neighboring Brazil, widely touted as a developing-world success story. One of my students dubbed Argentina's recovery the "Nike effect" because of the resemblance between a graph of Argentine GDP growth and the shoe company's famous "swoosh" logo.
Does Argentina's Nike effect hold a lesson for embattled euro area countries like Ireland, Greece, Spain and Portugal, or for those like Latvia, Lithuania, and Bulgaria, whose currencies are pegged to the euro with currency boards or similar policies? Could devaluation and even default be a better path to recovery than forced austerity?
The first lesson is that fixed exchange rates work best when all partners in a currency area have similar exposure to shocks. In the case of Argentina, probably the greatest problem lay in pegging the peso to the currency of the United States, a country with which it carried on only about 8 percent of its trade. Shocks like the Mexican crisis and the Brazilian devaluation, which hit Argentina hard, were hardly noticed in the U.S. With regard to trade in goods and services, the euro area makes much more sense than did the Argentine currency board. Intra-euro trade shares run in the 60 to 70 percent range. However, asymmetrical financial shocks remain a problem for the euro. Germany and a few other countries with persistent trade surpluses are sources of financial outflows. During the boom of the mid-2000s, countries like Ireland, Spain, and Latvia were in the opposite position, with large current-account deficits and huge financial inflows. When the global financial crisis exposed the fragility of the asset values that had attracted the inflows, those countries were left high and dry.
The second lesson is that a fixed nominal exchange rate does not protect countries from real exchange rate misalignment. A 22 percent real appreciation of the Argentine peso from 1998 through 2001 contributed to the problems of the convertibility policy by undermining the country's competitiveness and adding to its current account deficit. Similarly, as the following chart shows, some of the most distressed EU members experienced real currency appreciation in the years leading up to the crisis, both relative to the rest of the world, and relative to Germany, the anchor economy of the euro. Since Ireland, Spain and Germany all use the euro, and Latvia's lats has been pegged to the euro since 2005, nominal exchange rate changes account for none of differences in the evolution of real exchange rates. Instead, most of the real appreciation in the peripheral euro countries was caused by higher inflation than in Germany, and the inflation, in turn, was largely fueled by financial inflows chasing real estate bubbles.
The third lesson is that when all options are bad, the unthinkable may become the least bad. The orthodox recovery path for a currency-area member is "internal devaluation," that is, real devaluation through deflation of wages and prices rather than through nominal devaluation. Tax increases plus public sector wage and spending cuts are used to bring the budget back into balance. High unemployment, perhaps supplemented by labor market reforms, is used to force down private sector wages and prices. Once prices fall enough and creditor confidence is restored, growth can resume again. The IMF has traditionally favored this set of policies when giving assistance to countries like Argentina, Greece, and Latvia, in part because they protect foreign creditors, who tend to include the most influential IMF members. But it is a slow path to recovery, and one that is socially and politically painful for the patient.
(Click to enlarge)
The alternative to austerity and internal devaluation is to abandon the fixed exchange rate. That option, too, is not free of pain. For one thing, in an attempt to make the fixed exchange rate maximally credible, it will often have been locked in by constitutional amendment or treaty or some other mechanism above the reach of mere administrative authority. In addition, it may not be possible to devalue without triggering both public and private defaults on borrowing denominated in foreign currencies. If banking problems have not already been a trigger of the crisis, as in Ireland, devaluation is likely to bring about a banking collapse, as it did in Argentina. Despite all those drawbacks, however, devaluation can open the door to a more rapid recovery than is possible under internal devaluation - -a Nike effect.
The Bottom Line: Life in a fixed-rate currency area is not for everyone. Some countries are structurally unsuited for a fixed exchange rate because of their patterns of trade, their exposure to external shocks, or their inflexible labor markets. Others may be structurally suited but lack the needed fiscal or financial discipline. A country locked into a currency union for which it is not suited is like a spouse locked in a bad marriage. Sticking to one's vows and blaming one's own failures for all the problems of the relationship is certainly one alternative. But the option of divorce should not be too hastily taken off the table.