09 01 2011

PIIGS, Argentina and the cost of being an outcast

International investors are panicking. The EU and IMF have bailed out Greece, then Ireland and everybody's guess is that Portugal or maybe even Spain may be next. After the bail-out, these countries are in for a long and tough period of austerity and low growth. Is the Argentinian default a decade ago a better alternative?

During the recent bail-out of Greece, many North European commentators praised Ireland. It was said that unlike the unreliable Greeks, who had delivered fake statistics so they could get into the Euro undeservingly in the first place, and after that had failed to achieve a balance between public spending and taxes, the Irish had acted rapidly and responsibly showing their iron-fisted will to cut the public sector and thus bring order in their house.

How different the situation is now, where Ireland is in the process of being bailed out by the EU and more and more voices are doubting that they will ever be able to pay their debt.

If we look at the so-called PIIGS countries (Portugal, Ireland, Italy, Greece and Spain), three of which are on the periphery of the EU, they are suffering from several problems very much like the rest of the developed countries.

  • The first is the bursting of a housing and property bubble compounded by the bursting of a consumer credit bubble, bringing millions of households who have overpaid for their housing and over-indebted themselves into deep trouble.
  • As a result of these bursting bubbles, the financial sector has gone into crisis.
  • And furthermore, many of these countries have become uncompetitive as a result of their adoption of the Euro. This lack of competitiveness could be hidden when cheap credits flowed softly, financing the housing and consumption bubbles. It seemed as if the countries could simply spend their way into development.
  • During this process the governments have become increasingly indebted, as demand falls and the governments have to pick up both the social costs of the crisis and the cost of saving the financial sector. It is suddenly not very clear to the creditors that these governments will ever be able to pay their debt back.
  • These four problems have affected all of the countries to a different degree. In Greece the fall in property prices is minimal, and there is no banking crisis, but the problems are principally related to a lack of competitiveness as it is reflected in a persistent deficit on the current account, high unemployment and the very high level of public debt (expected to reach almost 150% of GDP in 2013), implying that a heavy part of the government revenue will go to simply service the debt.

    Ireland is a different case. Primarily due to the real estate boom, the government finances were actually quite good before the crisis, but once the property boom burst, government revenues have dropped and there is a huge budget deficit. Worst for the Irish is that the bursting of the property bubble took the banking system down with it, and as the government stepped in practically taking over the debt, the public sector is now heavily indebted. The Irish economy also suffers from a lack of competitivity, but as a Portuguese worker stated in a recent TV interview: “the Irish are better of than we are, for at least they have some industry left over, while we have nothing”

    This brings us to the case of Portugal, widely expected to be the next failure on the list. Portugal has not experienced a property bubble, so the fall in property prices has been modest and the banks are therefore not particularly troubled. Government debt is not particularly high (76% of GDP), but as a result of the general fall in demand, the public budget deficit was of almost US and UK dimensions in 2009 (9% of GDP) and is expected to be over 7% this year. So if interest rates continues to go up, the debt service can become too onerous. Portugal's main problem, however, is its lack of competitiveness, exacerbated by its adoption of the Euro, so it has been experiencing low growth for many years.

    When a debt crisis looms, a vicious spiral starts, which is difficult to stop. Creditors think the risk is high, so they charge a higher interest rate, which makes it more difficult to service the debt, and hence the risks continues to rise, and so on. Until it becomes unsustainable. Both Greece and Ireland have been through this vicious cycle, and it is starting to hurt also in Portugal and Spain.

    Countries that issue the debt in their own currency are in a more comfortable situation. They can let their currency devalue, and thus force the creditors to take on part of the cost. But countries, which issue their bonds in a currency they do not control, as the EU zone countries and most developing countries, do not have this possibility. Worst off are the countries that have adopted fixed exchange rate regimes or simply have adopted another country's currency (Argentina in the nineties, Ecuador, El Salvador, Panama) – getting out of this situation is extremely painful as the Argentinians found out a decade ago.

    The populations of Greece and Ireland will suffer for the coming decade. The austerity packages put into place by both countries are tough. Demand will be depressed, unemployment high, growth negative or low for the coming 5-10 years - unless there is a boom in the neighbouring countries that can pull them out of the hole. People are of course protesting, and even if until now a majority has accepted the belt tightening, lower salaries etc., this may not continue, particularly when new austerity packages have to be implemented as government revenues falter because of the recessions caused by the previous austerity packages – not an unlikely scenario.

    Are there any alternatives?

    There is an alternative for countries like Ireland or Iceland, where the banks are the main problem, and that is simply to let the banks go bust. A lot can be said in favour or against, but this alternative has never really been tried, as the governments have jumped in very early to guarantee the bank deposits and even interbank loans, hoping – in vain - in this way to avoid the problem.

    This leaves two other alternatives. One is a redistribution of the burden. In the case of Ireland, many people have got rich during the property boom – e.g. constructors, bankers and property owners, who got out when prices were still high. So a way to go after the people who benefited is a wealth tax. And in general to strengthen taxes on the people who have the means, e.g. on luxury items as expensive houses, cars, yachts etc. This will have a less negative effect on overall demand, but will probably not be enough to close the hole in the public finances. So in general, taxes will have to go up and public expenditures will have to be cut also. This will deepen the recession, but there is no way avoiding it.

    The other alternative is default. That is, the government will declare that the debt is impossible to pay, so there will have to be a restructuring, where part of the debt will be written off, terms will be made longer and interest rates lowered. This is considered an anathema by most bankers, politicians and economists.

    The most recent experience, Argentina in 2002, gives on example of how it works when a country defies the IMF and the international bond-markets and declares a default. Argentina's problems in 2002 were not much different from the PIIGS countries, and the result of some of the same policies: adoption of a foreign currency (by pegging the peso to the dollar), liberalization of the capital flows leading to a rapid inflow of cheap and volatile capital, resulting in an overvalued currency, booming consumption and property markets, and an uncompetitive and depressed productive sector.

    The cost of the crisis and the default was high. Production dropped with around 20% from 1999 to 2002, and unemployment and poverty soared. The default resulted in around two thirds of the debt being written off. But contrary to de predictions, Argentina came relatively quickly out of the crisis despite being excluded from the international capital markets as a punishment. Economic growth resumed in 2003 with almost 9% and continued over 8 percent the years after – it is expected to reach almost 10% this year. So sometimes it pays to be an outcast.

    And by the way: Argentina expects to make the final agreements with its remaining debtors in the coming months, which should pave the way for its re-entry in the international capital markets. And the total public debt is at present a manageable 32% of GDP.

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    Thorbjorn Waagstein

    Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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