Friday, October 28, 2011

The Argentinian Euro Deal

. Friday, October 28, 2011

Markets seemed to like it yesterday, not so much today. You can find news and discussion of the plan everywhere. I liked Salmon's takes here and here.

Like many others I'm skeptical that it will work. Interestingly enough I'm currently reading Paul Blustein's very good And the Money Kept Rolling In (and Out) about the IMF's relationship with Argentina around the turn of the millenium. The parallels between Argentina and Greece are striking -- I'm not the first to notice this -- but the parallels between the IMF and EU actions are also notable. Let's run down some of them.

1. At the time Argentina was on a convertibility system with the peso was pegged one-to-one to the US dollar. This is functionally very similar to the European common currency, where "Greek" euros are pegged one-to-one with "German" euros. Both systems were adopted for similar reasons: national authorities were not able to credibly commit to stable monetary policy, which led to a lot of economic volatility, investment risk, and concomitant slow growth. In both cases macroeconomic adjustment is impossible through the exchange rate, which leaves internal devaluation (i.e. austerity) and/or debt default as the only remaining options.

2. Both policies worked well for about a decade. Because of that, the Argentine and Greek governments were able to borrow at low interest rates. And because of that, governments were fairly casual about fiscal probity. While public deficits were not extreme, they were politically entrenched. When growth began to slow lower tax revenues led to a growing debt burden. Interest rate spreads widened as investors began to believe that both economies would not be able to grow fast enough to manage their debt. This, of course, can become a self-fulfilling prophecy. Both governments were voted out of office, both new governments instituted fiscal reforms. In both cases these were insufficient to close the budget gap. In both cases the cost of incurring new debt, or of servicing old debt, became prohibitive.

3. In Argentina, the IMF began disbursing relatively small amounts of money in the hope that external financing would reassure bond markets. In other words, the IMF hoped that it was a liquidity crunch, not a solvency crisis. In that situation a tie-over loan can buy time for the economy to get some growth back. The EU did the same thing with the introduction of the EFSF. But the underlying economic numbers didn't improve, and bond markets continued to believe that issue was over solvency, not liquidity.

4. Politics intervenes. In Argentina, the US (and other key IMF members) were hesitant to offer additional financing as they had done during the Tequila Crisis. In particular, John Taylor -- then at the Treasury Department -- didn't want to throw US funds into the pot. Neither did Glenn Hubbard of the CEA or Paul O'Neill, the Treasury Secretary. In Europe, many members were reticent to commit more funds. In both cases policymakers tried to figure out how to leverage already-appropriated funds to have a greater effect, but nobody bought it in either case. (Ken Rogoff, at the IMF during the Argentina crisis, quipped "After one strips out all the window dressing, there is no way to make $6 billion of liquidity worth more than $6 billion in liquidity. But there are many creative ways to make it less.")

5. Then come the "voluntary" private sector haircuts, coupled with additional public funds. These are intended to do a few things: extend the timeframe that indebted countries have to consolidate fiscally, reestablish growth, force the private sector to bear some of the costs of bailouts, and thus prevent default in a politically palatable way. In both cases the initial market reaction was positive, but in Argentina the effect was short-lived and I expect that to be the case with Greece as well. Barry Eichengreen described the Argentina situation thus: "The realization had dawned that the IMF package offered no magic formula for getting growth going again. And without growth, it is hard to see how political support for paying the foreign debt can be sustained." This sounds a lot like Greece, no?

6. A corollary of the private sector haircuts, as well as extended financing from international institutions, is that the country actually becomes more indebted rather than less. This happens in two ways. The private sector demands some form of compensation in exchange for voluntarily altering the terms of their debt contracts; and the new financing from international institutions also tacks onto the principle. Additionally, it's more difficult to default on IMF/EFSF loans than private sector loans. Given that the optimistic scenario is that this deal will reduce Greece's debt load to 120% of GDP, and the fact that the fundamental problems -- low growth + high debt in a fixed-currency system -- have not been resolved, there is little reason to be optimistic about the outcome.

Ultimately Argentina's internal adjustment plans were undermined by domestic politics. Voters simply got sick of extreme austerity and revolted. That meant a debt default and the abandonment of the convertibility system. It's hard not to imagine a similar scenario playing out in Greece in the coming months.

Even if it doesn't, there's still Spain and Italy looming over the horizon.



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The Argentinian Euro Deal
 
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