European leaders fear disaster if they allow the Greek government to renege on its debt and drop the euro. But that outcome may not be as bad as it seems. The experience of Russia suggests that what looks like catastrophe before the event can be something very different after it.
After three years of crisis, rising unemployment and falling living standards in Greece and other strapped nations, the European Union and the International Monetary Fund are demanding more austerity in return for emergency loans. The logic: The pain wrought by a default and an exit from the euro would be so catastrophic that it is better to force governments to slash spending in the depths of a recession.
Neither austerity nor loans, though, are likely to solve the fundamental problem. For Greece -- as for Portugal, Ireland and Spain -- the value of the euro against other currencies is too high. As a result, their economies aren’t competitive, making it difficult for them to generate enough money to pay their debts. Meanwhile, the burden of interest payments renders them unable to stimulate the economic growth that could make their obligations more manageable.
Greece’s predicament is familiar to many governments in emerging markets, and particularly to Russia. Back in the mid-1990s, Russia anchored its currency to the dollar, a move with similar economics to joining a monetary union. Inflation slowed and interest rates fell, but Russia quickly developed a competitiveness disadvantage. The ruble’s strong value against the dollar made Russia uncompetitive. Imports replaced domestic production, and the economy was unable to generate growth. Investors lost faith in Russia’s creditworthiness, pushing borrowing costs higher.
Fear of Default
As in Greece, the IMF, governments and holders of Russian debt saw default and devaluation as akin to Armageddon. After the Asian financial crisis in 1997, Russia was the line in the sand. It was simply too big to fail. The government was told repeatedly that default would mean that Russia wouldn’t be able to access the credit markets for a generation and that foreign money would never dare return.
In late 1997 and early 1998, Russia received huge (for the time) loans from Germany, Japan, the U.S., the IMF and the World Bank to compensate for the market’s reluctance to lend. But the loans didn’t address the underlying issue. Ultimately, on Aug. 17, 1998, Russia gave in to market pressure and did the unthinkable: The central bank allowed the value of the ruble to slide, and the government defaulted on billions of dollars in debt. But the catastrophe didn’t happen.
The pain lasted only about six months, followed by a decade-long boom during which the dollar value of Russian economic output increased 10-fold and the stock market rose 20-fold. The private sector reacted in textbook fashion to the boost to competitiveness provided by the devaluation -- and also by rising oil prices -- and started to recover for the first time since the breakup of the Soviet Union. Global investors were back lending to Russia within 12 months, and the government ultimately paid a large portion of its debts in full, often ahead of schedule or at a premium.
As far removed as it may seem from Europe’s situation, Russia’s experience may hold some important lessons. Currently, default and, in particular, removal from the euro zone seem like they would amount to failure. Governments are afraid of caving in on obligations and losing credibility in the eyes of voters and markets.
Certainly the political capital invested in the euro is greater than anything seen in emerging markets. But the economics are remarkably similar.
Coming out of the 2008 global crisis, with growth anemic and banks unwilling or unable to lend, Greece and other peripheral European countries need to stimulate their economies. They can’t do so by lowering interest rates because the European Central Bank runs monetary policy for the entire euro area. They also can’t do so by increasing government spending because international lending agencies are demanding fiscal austerity.
As a result, they are left with the all but impossible task of restoring competitiveness by lowering wages and cutting costs -- an approach that means pain for the majority of voters.
Russia’s experience doesn’t bode well for the ability of international lenders to contain Greece’s problems. The only result of the foreign loans to Russia was to allow the private sector to get out of their holdings of government debt and offload their credit mistakes onto international agencies.
Throughout peripheral Europe, the first steps toward austerity have resulted in the opposite of what was intended. The cost of debt is rising and the credibility of governments is falling. National solidarity wasn’t achieved. Instead, regional governments, companies and households are doing what is rational and finding ways to avoid their obligations. Protesters are out in the streets and politicians are being voted out. The economic and political costs of resisting market pressure are rising.
By contrast, if Greece and other countries defaulted and left the euro, they would have the leeway to stimulate their economies, and their currencies could find the level needed to restore competitiveness. Moreover, the first country to jump would benefit most.
The lesson from Russia in 1998 is how quickly the unthinkable can become the inevitable, precisely because it is the beneficial.
(Roland Nash is chief investment strategist at Verno Capital, manager of the Russia-focused Verno Capital Growth Fund. The opinions expressed are his own.)
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