By Xavier Cirera
The debt crisis is quickly spreading from Greece to Spain and Italy. Neil McCulloch asked in a previous entry what would happen if Greece defaulted and left the Euro. I would like to ask the opposite question what would happen if these countries do not leave the euro. Assuming that the EU is able to agree in a fiscal package to calm financial markets – this is a strong assumption given the very low political willingness for fiscal federalism in Europe, how are these countries going to get back to growth?
If the European Central Bank (ECB) intervenes to take on the Spanish and Italian debt, it will do so on exchange of a very large fiscal adjustment. The experience of developing countries tells us that adjustment programmes are associated with large recessions that depend on the fall on the exchange rate and how this stimulates exports to support growth. The difference in this case is to apply fiscal adjustment without being able to use the exchange rate. Even worse with an exchange rate that, despite the crisis, remains fixed with your main trade partners and stable with the main industrialised markets.
The lesson from previous cases in developing countries shows that crises are painful, and often have long lived impacts, especially on the poor. The case of Argentina with the collapse of the currency board shows that people take a large hit when the exchange rate collapses, but at the same time the boost of the exchange rate collapse on the export sector can be large and enhance the sources of economic growth. This is because the exchange rate is an incredible mechanism for adjustment.
By staying in the euro some countries of the euro zone seem to be entering a large period of painful adjustment and low growth. The decision for policy makers seems to be one of a painful default and abandoning the euro, but more flexibility for recovery or a long process of real adjustment with low growth. I think politicians will try to stick to the latter while it is still remotely feasible, but I fear that in the long run this may be the most painful solution.
P.S. Imagine if an African government had not been able to reach an agreement on the fiscal plan due to political rivalry and was walking towards a default, saved in the last minute with an agreement that is not sustainable. Would the government bonds ratings downgraded?