The excellent Kindred Winecoff considers the troubled periphery of the Eurozone:
[A]usterity must occur. It’s only a matter of how it occurs. The alternative to an internal devaluation through wage cuts, tax increases, and reduction of social services is external devaluation (exit from euro) and default. Call it the Iceland Alternative (Iceland was never in the euro, but it did devalue/default, which is what we’re talking about). In that scenario, the new drachma and Irish pound will collapse in value and the government will be unable to borrow from international capital markets. This is austerity too. The government budget will have to be balanced almost immediately, and unless there’s a full default will likely need to run a primary surplus for many years.
Moreover, small open economies like Greece and Ireland are heavily reliant on imports to maintain standards of living. Ireland imported about 40% of its GDP in 2009; Greece about 1/3. For comparison, the U.S. imported about 14% of its GDP. If the post-euro currencies drop 50% in those countries (as Iceland’s did, and it was never attached to the euro), then those imports become 100% more expensive. That’s a big price increase. True, there will be some substitution into domestically-produced goods, but such a large adjustment will take time and cause pain. These are not large, diversified economies and there’s a reason domestic production wasn’t being consumed before; overall standards of living will have to drop if there’s a currency devaluation. And while exporting industries may benefit from a cheaper currency, boosting employment in those sectors, the importing industries will suffer, contracting employment in those sectors. Even if overall employment goes up, it will be at much lower relative wages. This is why Iceland is applying for EU membership, including adoption of the currency, despite the sacrifice of policymaking autonomy that entails.
In other words, there will be austerity. The only question is how it’s distributed.
Winecoff makes an important point, but I think he needs to cut his analysis a bit more finely. Economies run two very different kinds of deficits, a government fiscal deficit and an international current account deficit. Although the two deficits are related, there is no mechanical connection between the two. They do not reliably move together.
A country that defaults on its international debt will find its paper shunned international capital markets for a while. In countries that have grown accustomed to running current account deficits — that is, countries whose citizens have grown used to consuming more imports than they pay for with exports — a forced return to international balance will undoubtedly be perceived as a form of austerity.
But Winecoff is wrong to claim that “[t]he government budget will have to be balanced almost immediately, and unless there’s a full default will likely need to run a primary surplus for many years”. As long as the country, post-default, issues its own currency, and as long as the country’s citizenry is interested in accumulating domestic currency and debt, the government can run a budget deficit after the restructuring. The capacity of a country to run budget deficits post-crisis will depend largely on the citizenry’s confidence in domestic institutions after the fall. (Countries can also employ controls to prevent capital flight and support domestic currency. But in cosmopolitan, habitually integrated Europe, I suspect that won’t work unless people have some measure of confidence in the project. Wise governments would implement technocratically credible monetary institutions and simultaneously encourage patriotic enthusiasm for the country’s newly independent scrip.)
Winecoff’s example of Iceland is a great case in point. Following its collapse and quasi-default in 2008, the Iceland ran a budget deficit of 9.3% of GDP in 2009 (a primary deficit of 6.6%), and has continued to run deficits since, gently drifting towards balance. Iceland has also been able to sustain large current account deficits as well for a while after the crisis, which helps to cushion the adjustment. Iceland received loans from the IMF and several European countries, which partially financed its continuing international deficit. Also, private citizens of Iceland may have had foreign asset holdings which they could pledge or sell to finance imports while the economy shifted towards international balance.
Iceland’s circumstances were, perhaps, unusually benign. Other crises (Argentina in 2002, Russia in 1998) proceeded much as Winecoff describes, with sharp, simultaneous moves towards fiscal balance and current account surplus. But would crises in the Eurozone look more Argentina or like Iceland? I don’t know, but I can make a strong case for Iceland. Savers in the Eurozone periphery inhabit a world of open financial borders, and have already been diversifying out of home-country bank deposits. (Importantly, this forces governments and the ECB to cover financing gaps left by fleeing depositors.) Argentine savers perceived dedollarization as expropriation, which was corrosive to the legitimacy of domestic institutions. Citizens of the Eurozone periphery, on the other hand, might support their governments’ bid to escape impossible foreign debt. The drawn out, slow motion nature of the Euro crisis has made it easy for private citizens to prepare for Euro exit by sending funds abroad. This practice shifts the costs of default to governments, who in turn can shift costs to external creditors. If domestic publics support the move and believe Euro exit to be a one-off event rather than the start of recurrent devaluation cycles, governments may well be able to run deficits and use Keynesian fiscal policy to smooth the aftershocks of Euro exit.
There may be important differences of institutional credibility between Greece and, say, Ireland or Spain. An Irish exit might be more Icelandic, while a Greek exit might be more Argentine. (It’s worth pointing out that, a decade later, Argentina’s default seems to have worked out very well.) As in Iceland, the (growing) foreign savings of private citizens might cushion the shift from international deficit. (Euro drop-outs could not expect the post-crisis IMF support that Iceland enjoyed, though.) There is a hazard that the furious Eurozone core would try to hold the private wealth of citizens of the periphery as security against the defaulted debt of sovereigns. But that would be a stronger violation of current norms than sovereign default.
Suppose that it will be possible for a drop-out to run a fiscal deficit, but as Winecoff predicts, a sharp shift to international balance proves inescapable. Winecoff is absolutely right to point out that
small open economies… are heavily reliant on imports to maintain standards of living… If the post-euro currencies drop 50% in those countries (as Iceland’s did…), then those imports become 100% more expensive. That’s a big price increase… [S]uch a large adjustment will take time and cause pain. These are not large, diversified economies
Undoubtedly, ending an era of persistent current account deficits will prove painful to consumers accustomed to cheap imports. However, that is not ultimately an incremental cost of leaving the Euro. After all, the purpose of staying and suffering austerity would be to pay down indebtedness, which is more costly than a shift to balance. Contrite borrowers have to pay interest on past debt and run (primary) surpluses. Deadbeats just need to pay for what they buy now. Quantities matter. Staying within the Eurozone offers the palliative of stretching the pain out over time, but increases the ultimate burden of the adjustment. Exiting front-loads costs, but reduces their size, as much of the work is done by the act of default. Undoubtedly, jilted creditors would punish “Euro deadbeats”, and exact non-financial costs, so the benefits of debt write-offs would be counterbalanced, at least in part, by new costs. There’d have to be some cost-benefit analysis. But the options are not, as Winecoff suggests, a zero-sum shift in how countries take their lumps. Countries may find they have a lot fewer lumps to take if they repudiate their debt than if they don’t.
Losing the capacity to run a current account deficit and losing the capacity to run a fiscal deficit have very different implications. Shifting international accounts from deficit to balance harms citizens in their role of consumers, but serves them in their roles as workers and savers. If you view the current crisis as driven by the challenge of maintaining consumers’ standard of living measured in tradable goods, then losing the ability to run current account deficits seems harsh. But if you view the crisis as driven by frustration within countries over insufficient opportunity and employment, then shifting to international balance or even to surplus helps. Losing the capacity to run a fiscal deficit has the opposite effect. Where current account austerity increases labor demand, fiscal austerity reduces it. So if you think that underemployment is the pressing problem in the Europeriphery, current account austerity plus continued fiscal deficit is a golden combination.
Lots of countries, obviously emerging Asia but also Germany, seem to prefer the social goods that come with full employment and financial security to the consumer purchasing power gains that accompany current account deficits. The countries of the Eurozone periphery have so far “chosen” the path of excess consumption, but it’s not clear whether that represents a genuine preference or a historical accident. This isn’t to minimize the pain and disruption that would undoubtedly attend import scarcity. Changing human habits hurts. But, as Joni Mitchell might say, something’s lost but something’s gained. This would not be a novel sort of transition. It would be a reprise of the aftermath of the Asian financial crisis.
Leaving the Euro would not be all bows and flows of angel’s hair. But it would not necessarily be catastrophe, and there is no fixed quantity of austerity that Europeriphery countries have to face one way or some other. These countries have difficult choices before them, and should think carefully about the tradeoffs and just what sort of outcomes they hope to engineer.
Note: I have very mixed feelings about any break-up of the Eurozone. This piece was not intended as advocacy of that. I do think the European core is being foolish and shortsighted in its dealings with the periphery. In a better world, the core countries would equitize their claims against the periphery by, for example, adopting some variation of Warren Mosler’s frequent suggestion that the ECB issue per capita grants to all member states, that surplus nations would use as they see fit but debtor states would use to reduce indebtedness.