Paradigm Lost: The Euro in Crisis

Greece has been profligate and fiscally irresponsible. Still, the contrasting experiences of Argentina and Latvia in dealing with excessive spending and currency overvaluation—problems that now plague Greece—hold a warning for Europe: leaving the Euro area and defaulting—while almost unthinkable now—could become the best of very bad options for Greece, though it would have disastrous implications for both the European Union (EU) and the world. The EU must support Greece with all available means to prevent this from happening.

Inflation has been higher in Greece than in its northern Euro area neighbors for years, and wage increases in excess of productivity have impaired Greece’s ability to compete. As the table below shows, this problem is shared to different degrees by Ireland, Italy, Portugal, and Spain. Together, the affected countries represented 35 percent of the Euro area’s GDP in 2009 and constitute an economy over 30 percent larger than that of Germany.

Wages Rising Much Faster Than Productivity
Percent increase in unit labor cost in euros

Q1 2001 to Q3 2009
Greece 33%
Italy 30%
Spain 28%
Ireland 27%
Germany 6%
United States -27%
Source: OECD, IMF.

Common features of currency overvaluation include an inability to grow without creating excessive current account deficits, rising debt burdens, and a gradual loss of investor confidence. There are only two ways to address the problem. The first is to devalue. For countries in the Euro area, this would require the radical step of abandoning the euro and returning to a national currency, leading to default as debt burdens soar relative to incomes. The other course of action is austerity and structural adjustment—reducing government spending, cutting wages, and undertaking reforms that raise productivity.

Devaluation: The Best of Bad Options?

Examination of two polar cases of resolving overvaluation—Argentina, which was forced to break out of its currency board in January of 2002 and devalue, and Latvia, which had to resort to IMF help in December of 2008, has decided to tough it out and maintain its peg to the euro—suggests that the output losses associated with the latter can be even higher than those associated with devaluation and default.

In the three years prior to the onset of each country’s respective crisis, GDP in that country grew rapidly: 5.8 percent per year in Argentina and 10.9 percent per year in Latvia. Meanwhile, the real effective exchange rate appreciated by 12 percent in Argentina and by 24 percent in Latvia; the current account deficit exceeded 20 percent of GDP in Latvia in 2006 and 2007, and nearly  5 percent in Argentina in 1998—its highest level since before 1980.


As investors lost confidence and exports slowed, both countries eventually entered recession. Brazilian devaluation and the mild global recession in 2001 were precipitating factors in Argentina, while the onset of the global financial crisis triggered the Latvian crisis. In both countries, debts were denominated in foreign currency and debt burdens rose sharply in the years preceding crisis, though private debt dominated in Latvia, whereas both private and public debt were large in Argentina. 

Argentina was forced to devalue, and the peso declined by nearly 70 percent against the dollar, while Latvia—despite its much larger external deficit—elected to maintain its peg and adjust with the help of massive support (43 percent of GDP) from the IMF and the EU.

Though they adopted widely different courses, both countries saw a massive fall in output and employment. From peak to trough, GDP fell by 18.4 percent in Argentina and 21 percent in Latvia, and forecasters predict further declines in Latvia. Unemployment in both countries surpassed 20 percent.

Greece’s vulnerabilities have been building for years, and are in some respects as or more pronounced than those of Argentina and Latvia.

In Argentina, the massive devaluation led to widespread disruption and outright default on 75 percent of its $100 billion (today’s prices) foreign debt. In the seven years following devaluation, the total cost of default to foreigners, including the direct cost of lost principal and interest and the indirect losses in equity values, has been estimated to be nearly twice as large as the initial value of the debt in default. Thus, Argentina was able to make its creditors share the cost of the crisis. However, eight years later, Argentina has yet to recover the confidence of investors, its access to capital markets remains restricted, and its S&P rating is seventh worst among 123 countries.

Though Argentina paid a heavy price for devaluing and defaulting, its competitiveness was quickly restored and a rapid recovery—helped by favorable global conditions—ensued. Its exports grew by 15 percent in 2003 and 17 percent in 2004, while its GDP grew 8.8 percent in 2003 and 9.0 percent in 2004, regaining its pre-crisis peak within about ten quarters.

In contrast, though Latvia’s current account balance has swung to surplus, this has come on the back of demand containment rather than export growth: since the end of 2007, imports have fallen 41 percent compared to a 14 percent decline in exports. Latvia remains mired in recession, with the IMF forecasting that GDP will contract by 4 percent in 2010, followed by anemic growth of 1.5 percent in 2011. In addition to its large outstanding private debt, it now has a large foreign public debt burden to repay to the IMF and the EU.   

How Do Greece and Others Compare?

Greece’s vulnerabilities have been building for years, and are in some respects as or more pronounced than those of Argentina and Latvia. From 2002 to 2007, domestic demand grew by an average of 4.2 percent, compared to growth of 1.8 percent in the Euro area. Foreign borrowing helped to finance this relatively rapid growth, and higher inflation in Greece resulted in a 17 percent appreciation of the real effective exchange rate over the past four years, less than various estimates for Argentina and Latvia. The current account deficit increased from 5.8 percent of GDP in 2004 to 14.4 percent in 2008, much larger than Argentina’s increase but smaller than Latvia’s. Greece’s public debt has reached an estimated 112 percent of GDP, almost double Argentina’s debt of 63 percent of GDP prior to devaluation, and about 6 times larger than Latvia’s pre-crisis levels.

It is in Europe’s and the international community’s vital interest to support Greece and facilitate its adjustment.

It is unlikely that a deepening crisis in Greece will be confined to that country. In Spain, the current account deficit exceeded 10 percent of GDP in 2007, and the recession has already pushed unemployment above 20 percent. Though Italy’s current account deficit—2.5 percent of GDP in 2009—remains moderate, this has come at the expense of growth underperforming its Euro area partners by an average of 1.2 percent over the last five years. With Italian government debt rising to 116 percent of GDP, a crisis in Greece and Spain could quickly become a crisis in Italy. 

What is the Best Policy Response?

Four simple policy messages emerge from this comparison: first, regardless of how Greece adjusts to excess demand growth and overvaluation, the effect on incomes and employment will be large, and likely much larger than current forecasts suggest.

Second, abandonment of the euro and default, though an extraordinarily painful course, may eventually prove to be a less costly option for Greece if its adjustment does not succeed and help is not forthcoming. Devaluation and default would shift some of the burden onto foreign creditors, avoid further debt buildup in the bailout, and establish conditions for resumed growth much more rapidly than policies of austerity and adjustment.

Abandonment of the euro and default may eventually prove to be a less costly option for Greece if help is not forthcoming.

Third, what may be a less costly course for Greece may be much worse for its Euro area partners. Devaluation and default would lead to further impairment of banks, unpredictable contagion effects on other countries, and a hit below the waterline on the euro project. There would also be global implications. Assuming the cost of default is proportionally just half of that of Argentina, devaluation in Greece and Spain—which hold an estimated $370 billion and $770 billion in debt respectively—would cost foreign investors 2 percent of global GDP; default in Italy alone would cost over twice this sum. 

Fourth, it follows that it is in Europe’s and the international community’s vital interest to support Greece and facilitate its adjustment. This should involve not only direct loans but also increased aid if necessary (as happens when social safety nets operate to support depressed regions in the United States). Additionally, expansionary fiscal policies in Germany and other countries that can afford it and more expansionary monetary policy in the Euro area over several years should be considered. Recourse to the IMF should remain a live option not only because of its resources and expertise, but also because it creates the sorely lacking political space for providing finance and administering tough conditions. Whatever course is adopted, a likely result of the crisis will be a lower euro, which would also work to facilitate adjustment in Greece and other vulnerable countries and create more space in Germany and other external surplus countries to help.

Uri Dadush is a senior associate in and the director of Carnegie’s International Economics Program. Bennett Stancil is a junior fellow in Carnegie’s International Economics Program.