0

Will Greece Make It?

CAMBRIDGE – Greece has bought some time with a new package of financial support, but the country is not out of the woods yet. It remains to be seen whether the souped-up austerity policies that Prime Minister George Papandreou’s government has promised will prove to be politically acceptable and sustainable.

History suggests some grounds for skepticism. In a democracy, when the demands of financial markets and foreign creditors clash with those of domestic workers, pensioners, and the middle class, it is usually the locals who have the last say.

Britain’s exit from the Gold Standard in 1931 remains the historical landmark. Having made the mistake of restoring parity with gold at a level that left the economy desperately uncompetitive, Britain struggled for several years with deflation and rising unemployment. Industries such as coal, steel, and shipbuilding were hit hard, and labor strife became rampant. Even as unemployment reached 20%, the Bank of England was obliged to maintain high interest rates in order to prevent a massive outflow of gold. Eventually, increasing financial-market pressure pushed the country off gold in September 1931.

It wasn’t the first time that financial probity had required the real economy to suffer under the Gold Standard. What was different was that Britain had become a more democratic society: the working class had become unionized, the political franchise had expanded fourfold since the end of World War I, mass media publicized ordinary people’s economic plight, and a socialist movement was waiting in the wings. Despite their own instincts, central bankers and their political masters understood that they could no longer remain aloof from the consequences of economic recession and high unemployment.

Even more importantly, investors understood this, too. As soon as financial markets begin to question the credibility of a government’s commitment to a fixed exchange rate, they become a force for instability. At the slightest hint of things going awry, investors and depositors pull up stakes and move capital out of the country, thereby precipitating the collapse of the currency.

This movie was replayed in Argentina in the late 1990’s. The linchpin of Argentina’s economic strategy after 1991 was the Convertibility Law, which legally anchored the peso to the US dollar at a one-to-one exchange rate and prohibited restrictions on capital flows.

Argentine Economy Minister Domingo Cavallo envisioned the Convertibility Law as both a harness and an engine for the economy. The strategy worked well initially by bringing much-needed price stability. But, by the end of the decade, the Argentine nightmare had returned with a vengeance.

The Asian financial crisis and the Brazilian devaluation in early 1999 left the Argentinean peso looking decidedly overvalued. Doubts about Argentina’s ability to service its external debt multiplied, confidence collapsed, and before too long, Argentina’s creditworthiness slid below that of some African countries.

Ultimately, what sealed Argentina’s fate was not its leaders’ lack of political will, but rather their inability to impose ever-more costly policies on their domestic constituents. In fact, the Argentine government was willing to abrogate contracts with virtually all domestic constituencies – public employees, pensioners, provincial governments, and bank depositors – in order to meet its obligations to foreign creditors. 

But investors grew increasingly skeptical that the Argentine congress, provinces, and ordinary people would tolerate the austerity policies needed to continue servicing foreign debt. As mass protests spread, they were proved right. When globalization collides with domestic politics, the smart money bets on the home team.

Perhaps there is another path. Consider Latvia, which recently found itself experiencing economic difficulties similar to those of Argentina a decade ago. Latvia had grown rapidly since joining the European Union in 2004, on the back of large-scale external borrowing and a domestic property bubble. It had run up a current-account deficit and a foreign-debt burden that were literally of Greek proportions.

Predictably, the global financial crisis and abrupt reversal in capital flows in 2008 left the Latvian economy in dire straits. As lending and property prices collapsed, unemployment rose to 20% and GDP declined by 18% in 2009. In January 2009, the country had its worst riots since the collapse of the Soviet Union.

Latvia had a fixed exchange rate and free capital flows, just like Argentina. Its currency has been pegged to the euro since 2005. Unlike Argentina, however, the country’s politicians managed to tough it out without devaluing the currency and introducing capital controls.

What seems to have changed the balance of political costs and benefits was the prospect of reaching the promised land of eventual membership in the eurozone, which compelled Latvian policymakers to foreclose any options that would endanger that objective. That, in turn, increased the credibility of their actions – despite those actions’ very high economic and political costs.       

Will Greece be an Argentina or a Latvia? The economics is not encouraging. Unless the Greek economy recovers, taking on new debt is a temporary palliative that will require even more austerity down the line. And, as long as domestic demand remains depressed, structural reforms – privatization and liberalization of labor markets and professional services – are unlikely to deliver the needed growth.

As the experiences of interwar Britain – and, more recently, of Argentina and Latvia – show, it is the politics that ultimately determines the outcome. For the Greek program to have any chance, the Papandreou government must mount a monumental effort to convince its domestic constituents that economic pain is the price they are paying for a brighter future – and not just a means to satisfy external creditors.