Because the European crisis is both financial and real, any solution that focuses solely on debt restructuring (either through a bailout or a default) is likely to be insufficient if it is not complemented with a plan to recover price competitiveness. An “internal devaluation” (a big wage cut) looks politically unfeasible and economically self-defeating. Hence, the growing debate over a euro exit that promises to boost external demand while avoiding painful nominal cuts.
There is an inevitable comparison to Argentina’s experience during its economic crisis of the late 1990s and early 2000s. Many economists point to Argentina’s swift recovery and systematic outperformance— even relative to its South American neighbors that benefitted by historically high terms of trade— and attribute the results to the newly-gained competitiveness from a depreciated exchange rate. But was the devaluation effect really about competitiveness or was it just debt reduction in a different guise? I believe the competitiveness interpretation of the Argentine devaluation has been vastly exaggerated.
It is true that the devaluation of the Argentine peso brought a mild boost import substitution and nontraditional exports and that its pass-through to inflation lowered real wages, favoring labor intensive activities while avoiding unpopular wage cuts. But its real kick came from its contribution to the debt dilution and wealth transfers that are typical of all “successful” currency collapses.
The math is simple. Take an Argentinean company that owed $10 million to the bank at the end of 2001; twelve months later, with domestic liabilities “pesified” (converted to the local currency at the one-to-one parity prevalent in 2001) and the exchange rate at four pesos to the dollar, the same corporate debtor saw its dollar debt reduced to $2.5 million (a 75 percent haircut). External obligations that could not be pesified under Argentine law were restructured under the umbrella of the sovereign default and the imposition of capital controls that restricted debt service abroad.
The resulting debt dilution in a context of depressed wages and subsidized utility prices provided the internal funds needed to fuel investment in a credit-less economy. Private investment was not driven by external demand but rather by extraordinarily high corporate profits.
Moreover, while Argentina’s corporations were short dollars at the time of the crisis, their owners were mostly long, owning large and largely underreported stock of foreign assets. It was these dollar savings that provided the ammunition for bargain hunting in the aftermath of the devaluation and help explain the swift rebound of real estate prices and residential construction, one of the drivers of the Argentinean recovery.
If these type of wealth transfers to the corporate sector and the rich (i.e., those with a greater propensity to save and invest) are not unusual in post-crisis recoveries, Argentina’s devaluation-pesification combo turbo charged the dilution machine, and its propelljng effect.
What does all this tell us about the current situation in Europe?
If we leave out the Eurobond solution (which rules out a euro exit by definition), most analysts would agree that a “de-euroization” would almost immediately trigger a debt default since the local currency needed to pay euro debts would increase with the devaluation, exceeding the increase in local currency revenue even in the rosiest scenario.
But what about the converse? Would a debt default within the euro, if possible, be enough to sort things out or does it require an exit to a new currency to solve the real half of the predicament?
In this regard, Argentina´s lessons are far from trivial. On the one hand, take away the commodity boom and evidence suggests that the exit from the peg failed to lead to an export-led boom. On the other hand, in the Argentine experience, debt default was not enough. The conversion to a depreciating peso was an essential part of the process to clean the balance sheets of indebted corporations and re-stimulate the economy.
Judging by this single episode, one would conclude that a new currency by itself is unlikely to improve exports or trigger foreign investment to the point of reigniting growth in peripheral Europe. This is particularly the case given the current unfavorable global economic conditions. But the conversion of financial contracts to the new currency at a one-to-one parity — the only way to avoid an outright default — would render corporations and households miraculously free from the euro debt overhang and ready to spend.
Is this a free lunch? Not at all. In principle, euro creditors that are at the other side of the contracts would be deprived of considerable gains. A devaluation without a currency conversion would make a euro depositor unexpectedly rich; a conversion to the new currency takes that away from him. Indeed, the fact that it is a transfer of contingent rents rather than actual wealth that is at play makes the whole process easier to engineer.
Based on the Argentine experience, a euro exit is unlikely to revive growth in debt-laden peripheral Europe. However, if a European fiscal union does not materialize, the conversion of euro debts into a new depreciated national currency appears to be an unorthodox but effective last resort to bring the European periphery back to life.