Many peripheral Eurozone countries are suffering from financial and competitiveness problems reminiscent of previous Latin American challenges. The analogy has been noticed many times.
In a recent paper (Cavallo and Fernandez-Arias 2012), we focus on selected areas in which the Latin American experience with crisis and recovery offers useful lessons for today’s European concerns, namely high public debt risk premium, distress in the banking system, sudden stops of capital flows, and low growth and competitiveness.
Some Latin American answers
Here are some lessons from a region with a long history of financial crisis and difficult intertwining of economics and politics.
- Do not be paralysed by the fear of moral hazard.
The Latin American experience demonstrates the need to provide swift and ample external liquidity support to mitigate financial stress and prevent it from festering into full-blown crises. Moral hazard has not been a problem in Latin America’s external financial rescues because countries repaid their obligations under strict enforcement arrangements, and therefore internalised all the costs and benefits from external official assistance without benefiting from opportunistic behaviour. Arguably, too little external support was behind the depth of Latin America’s great collapses. Moral hazard has been an issue only in domestic bailouts of subnational entities by the federal government.
- Treat sick fundamentals, not symptoms.
Financial lifelines are necessary but not sufficient to solve financial crises. The failed Latin American experience with the Baker plan for debt restructuring in the 1980s shows that if underlying fundamental problems are at the root of financial distress, protracted external liquidity support alone is no cure. It even becomes counterproductive over time because it allows the rot to deepen and embroils official liquidity providers in credit risk, leading to official financial support fatigue. The continued failure of liquidity support to European crisis countries to cure their financial distress is an indication that the policy debate ought to refocus on fundamentals: structural reform for growth and, where needed, restructuring to resolve banking crises and the debt overhang. Implementing needed adjustment and policy reform should be a condition for continued financial support if domestic political economy factors impede it or repayment enforcement is doubtful.
A public debt overhang is deleterious to growth because it acts as an implicit tax on investment, especially in the absence of clear rules for its resolution. Fiscal contraction may easily fail to reduce the debt overhang to the extent that it depresses economic activity, possibly leading to output collapses. The recognition that debt reduction is in order tends to be delayed, leading to a protracted state of recession, and sometimes social unrest or political instability. The Latin American experience with the Brady plan in the 1990s shows that orderly debt reduction in the right economic environment for growth can be the solution to growth recovery and renewed capital inflows. Where debt restructuring is needed, multilateral support conditional on an appropriate policy framework is useful to ensure that debt reduction is a solid base for recovery. Concerns about market reluctance to invest after a debt restructuring have generally not been borne out by experience in Latin America.
- Encapsulate banking risks.
Another relevant lesson from Latin America is that entangling banking crisis risks with sovereign debt crisis risks is a recipe for disaster because they feed on each other. If bank troubles require injecting more capital into banks, banking crisis resolution must be implemented with an eye toward minimising emerging fiscal liabilities. In the Latin American experience, some of the methods employed to this end were: the privatisation of troubled public banks; the liquidation rather than the recapitalisation of some banks; and a minimalist approach to only address problem banks and target assistance to preserve key functions of the banking system, such as the payment system.
- Change the bad habits after rehab.
Apart from cleaning up the mess, successful crisis resolution requires restoring economic growth to reduce high debt burdens, improve bank assets and reduce the probability of political backlash. External official support to troubled economies can provide time for economies to adjust, but is no substitute for reforms aimed at reducing structural vulnerabilities and restoring long-term growth. The experience in Latin America shows that it is more likely that growth-enhancing reforms will be implemented in the aftermath of crises, especially in supportive institutional environments.
- Beware of currency redenomination.
A discrete real exchange rate depreciation to promptly regain competitiveness so prevalent in the Latin American recovery experience would require the reintroduction of local currencies in the case of Eurozone countries. Of the cases reviewed, the Argentina crisis of 2001-2002 is perhaps closest to the current European crises in peripheral countries in terms of the difficulties associated with currency rigidity. The Argentinean meltdown of 2002 – when the collapse of the currency board led to 'pesofication' of dollar contracts and controls on financial dollarisation – offers a reminder of the great risks associated with uprooting exchange rate arrangements. In the case of Europe, compounding factors suggest that the potential cost of such uprooting under pressure would be catastrophic. Some of these factors include: the larger scope of the currency conversions; the deeper domestic and international financial integration, which complicates the process of breaking up contracts; and the higher investment in institutions that would be wasted. Moreover, courts in Europe – where the rule of law is stronger – would likely give due course to legitimate complaints by those adversely affected by currency conversions leading to protracted litigation. Finally, the likely spillovers of a euro exit crisis would likely threaten financial stability in the core countries.
Some open European questions
Eurozone crisis countries bound by the euro are caught between a rock and a hard place when it comes to competitiveness going forward and, therefore, their outlook for recovery. The normal policy prescription of nominal devaluation would require abandoning the euro, which in our estimation would be catastrophic for the country attempting to re-introduce its local currency – so costly that it should not be considered an option if it can be avoided. In fact, it is in the interest of all parties to exhaust all alternatives to a euro exit.
At the same time, the natural market adjustment towards effective real exchange rate depreciation via lower domestic inflation is slow and recessionary, especially with rigid wages. Alternative competitiveness policies via fiscal devaluation exploiting the non-uniform incidence of different taxes are worth exploring, but they are presumably slow to act and may be insufficient in scope1.
On the other hand, the existence of EU creates possibilities that were not available in Latin America. The scope for regional cooperation is much larger. Supranational institutions, such as the ECB, are resourceful and ready to complement national policies dealing with sovereign debt, the banking system, and general balance-of-payments support. Debt restructuring can be coordinated by regional bankruptcy-like arrangements, as tested in the Greek case. The regional banking union under study could encapsulate and contain bank risk. None of these conditions of regional cooperation was available to Latin American countries.
In particular, European cooperation may go a long way toward helping Eurozone crisis countries regain competitiveness. While currency devaluation is not an option, cooperation could enlarge the scope of alternative competitiveness policies, such as complementing fiscal devaluation in less competitive economies with fiscal revaluation in core countries in the Eurozone, and buy time for these policies to work gradually. As mentioned, market forces push for recession in crisis countries via price deflation and sticky real wages above full employment. Cooperation by core countries could temper this process by allowing higher euro inflation, which would provide more space to open a healthy inflation gap in peripheral countries. In turn, this moderate level of domestic inflation in periphery countries would facilitate downward real wage adjustment as it has traditionally done in Latin America (without risking the runaway inflation sometimes experienced). Finally, cooperation also has a role to play if the break-up of the euro becomes ultimately unavoidable because the external adjustment in peripheral countries is unmanageable without larger and more rapid real exchange rate depreciation than what the system allows. The Latin American experience suggests that it would be better for all sides for the exit to occur in a context in which peripheral countries continue receiving financial support in a spirit of full cooperation to facilitate necessary adjustments in order to avoid catastrophic outcomes.
More tools to address the problems does not guarantee success. In contrast to Latin America’s experience, generous European cooperation with lax repayment enforcement, by design in the case of pari-passu lending, would open the door for moral hazard concerns that need to be managed. Controlling moral hazard may require permanent monitoring.
The Eurozone is navigating through uncharted waters; determining the correct course of action for policymakers in crisis and core countries alike is difficult and requires innovation. Furthermore, democratic governance in European countries may limit the policy space of national governments trying to find a cooperative solution. If available tools of cooperation are not used effectively, crisis countries in Europe may fare worse than those in Latin America.
Cavallo, E A and E Fernandez-Arias (2012). “Coping with Financial Crises: Latin American Answers to European Questions.” Policy Brief No. IDB-PB-176. Inter-American Development Bank, Washington, DC, October.
Cavallo, D and J Cottani (2010), “For Greece, a ‘Fiscal Devaluation’ Is a Better Solution Than a ‘Temporary Holiday’ from the Eurozone”, VoxEU.org, 22 February.
Cavallo, D (2011), "Looking at Greece in the Argentinean mirror", VoxEU.org, 15 July.
De Mooij R A and M Keen (2012), “Fiscal Devaluation and Fiscal Consolidation: The VAT in Troubled Times.” In: A Alesina and F Giavazzi (editors), Fiscal Policy after the Crisis, Cambridge, US: National Bureau of Economic Research.
Farhi, E, G Gopinath and O Itskhoki (2011), “Fiscal Devaluations.” NBER Working Paper 17662. Cambridge, US: National Bureau of Economic Research.
Fernández-Arias, E and E Talvi (1999) “Devaluation or Deflation? Adjustment under Liability Dollarization.” Paper presented at the XIV Meeting of the Latin American Network of Central Banks and Finance Ministries, Inter-American Development Bank, Washington, D.C.
IMF (International Monetary Fund) (2011), Fiscal Devaluation: What Is It and Does It Work? Fiscal Monitor, Appendix 1, Washington, DC, US: IMF.
1 Fahri, Gopinath and Itskhoki (2011) define fiscal devaluation as a set of unilateral fiscal policies that implements the same real allocation as under a nominal devaluation, but holding the nominal exchange rate fixed. For discussions about fiscal devaluation in Latin America see Fernández-Arias and Talvi (1999) and in the Eurozone, see Cavallo and Cottani (2010); de Mooij and Keen (2012); IMF (2011).