What Latin America Can Teach Europe About Crisis Resolution
Readers may recall that in June a senior IMF official sent a resignation letter to the IMF Board complaining of “European bias”, failures to act, and “risk aversion”. Two days later a Wall Street Journal blog reported:
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“Many economists say the IMF hasn’t treated Europe with the same tenacity and aggressive policy prognosis as it has emerging markets, such as in Asian and Latin American financial crises in previous decades. For example, some economists believe the IMF should have urged a restructuring of Greek debt much earlier, but acquiesced in the face of strong opposition within EU’s power circles. If Greek debt had been restructured at an earlier stage, those economists say, Europe may have been able to stem its crisis.”
It was evident from the start of the Eurozone crisis that the IMF under Dominique Strauss-Kahn had greatly softened loan “conditionality”. When the morally-challenged Strauss-Kahn was forced to resign and make way for a new chief, Europe pushed hard for another European at the helm. The appointment of Christine Lagarde left the IMF open to charges, at least initially, that IMF resistance to debt restructuring in Greece reflected the desire of European politicians to avoid forcing haircuts on European banks and investors.
“What European leaders may want most from the Fund are easy loans and strong rhetorical support. But what Europe really needs is the kind of honest assessment and tough love that the Fund has traditionally offered to its other, less politically influential, clients … The Fund is doing Europe’s people no favor by failing to push aggressively for a realistic solution, including dramatic debt write-downs”.
In 2002, while still at the IMF, Rogoff -- again it was at Project Syndicate -- offered a useful common sense explanation of IMF conditionality. Many years earlier he had lent his brother Hal some money to tide him over a difficult stage when he was starting a family and renovating an apartment.
“Did my brother blame me for the period of belt-tightening austerity his family had to face? No, obviously not ... I did not ask Hal what, exactly, he planned to do with my money ... When the IMF comes in, it typically applies some degree of conditionality, as would any other lender, to ensure that its loan is eventually repaid, and used for its intended purpose. Unlike my loan to Hal, the IMF usually does ask government officials to show how they plan to put their country back on its feet. Indeed, it is this planning dialogue that does more than anything else to help stabilise the economy and restore a viable balance of payments.”
That was also the lesson of IMF programs in Latin America in the 1980s and 1990s. Though far from perfect, and never without controversy, conditional assistance during the Latin American debt crises was essential to robust recovery in those countries which most closely complied with the letter of IMF agreements.
Another former chief economist of the IMF -- Simon Johnson -- last month co-authored an article titled “Introducing The Latin Euro”, which argued that the decision of the European Central Bank to purchase unlimited national debt in the troubled periphery (with only vague promises of conditionality attached) was a sign that “powerful interests” had won their battle for “easy credit” and been strengthened in the process.
“It may be difficult to imagine that wealthy European nations could follow the tragic path to inflation and defaults seen for so long in Latin America, yet with each ‘step forward’ in this euro crisis, Europe moves further along that same route.”
Which brings me to the enlightening new research just published by two economists at the Inter-American Development Bank -- Eduardo Cavallo and Eduardo Fernandez-Arias.
“To the extent that a sudden stop in a country is underpinned by structural factors … external resources alone are no solution. Unconditional external financial assistance would only serve the purpose of delaying otherwise unavoidable adjustment in the economy to a permanently tighter financing constraint. Countercyclical policies financed with external financial assistance can allow time for economies to adjust, but they are no substitute for structural reforms aimed at reducing the underlying vulnerabilities and restoring long-term growth … If domestic political economy factors impede needed change or repayment enforcement is doubtful, implementing structural reforms should be a condition for continued financial support … Where debt restructuring is needed, multilateral support conditional on an appropriate policy framework appears to be instrumental to ensuring that debt reduction is a solid base for recovery.”
The authors now have an article at Vox summarising the conclusions. I summarise tweet-size:
Here are the lessons which Latin America’s long experience with the resolution of sovereign and banking debt crises can teach Europe:
Lesson 1: Moral hazard was not a problem in external financial rescues because strict conditionality was enforced.
Lesson 2: If underlying fundamental problems are at the root of distress, protracted external liquidity support is no cure.
Lesson 3: Don't worry, the markets will continue to invest while you go about cutting public debt as a top priority.
Lesson 4: Bank crisis resolution must minimise sovereign debt fiscal liabilities; consider privatising and/or liquidating rather than simply recapitalising banks.
Lesson 5: External official support to troubled economies allows a country time, but is no substitute for structural reforms.
Lesson 6: Prompt currency depreciation was key in Latin America, so the authors suggest how Europe could substitute “regional cooperation” alternatives for currency devaluation.
And, to underline the main message of this post once again:
“The continued failure of liquidity support to European 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.”
I was pleased also to see that Cavallo and Fernandez-Arias make the point I made in a previous post, namely that crisis is the best and perhaps the only time for structural reform.
They say: “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.”