Why Greeks Might Accept More Austerity in Sunday's Vote

ATHENS, GREECE - JUNE 30: Demonstrators during a rally organized by supporters of the 'Yes' vote for the upcoming referendum
ATHENS, GREECE - JUNE 30: Demonstrators during a rally organized by supporters of the 'Yes' vote for the upcoming referendum in front of the Greek Parliament on June 30, 2015 in Athens, Greece. Greek voters will decide in a referendum next Sunday on whether their government should accept an economic reform package put forth by Greece's creditors. Greece has imposed capital controls with the banks being closed until the referendum and a daily limit of 60 euros has been placed on cash withdrawals from ATMs. (Photo by Milos Bicanski/Getty Images)

BRUSSELS -- Countries plagued by a history of large deficits, high inflation and economic stagnation often look for external anchors. Pegging the exchange rate to the currency of a stable partner is one way to do it. But experience has shown that these "hard pegs" can quickly become a source of trouble when they are no longer credible.

About 15 years ago, the Greek people thought they could do something even better: instead of just pegging the exchange rate, they decided to throw away their inflationary currency and adopt the euro instead. This seemed to work wonders initially. For almost 10 years the country prospered as never before. Large borrowing from abroad allowed huge increases in consumption and wages. But when the music stopped, the country had a serious debt problem, which has not been solved until today. This should not have come as a surprise.

"This feeling of belonging to Europe might make the difference."

Almost exactly a decade before Greece entered Europe's "Economic and Monetary Union," another country had also thought it had discovered a foolproof way to get financial stability. The year was 1991, and Argentina introduced a new currency that was pegged by law "irrevocably" one-to-one to the U.S. dollar.

Initially, the new arrangement worked very well. Growth returned, and confidence among foreign investors was such that large inflows of foreign capital arrived. But, after about 10 years, the success story turned bitter. Argentina's dominant trading partner devalued, the U.S. dollar appreciated and the prices for the main export products fell. The country thus had problems exporting. It developed external deficits and growth slowed.

Moreover, fiscal policy had not been kept under control, resulting in increasing public debt. International investors were initially quite willing to finance the government, but risk premia started to increase when the deficits became chronic. At this point the "irrevocable" currency peg started losing credibility and risk premia became unbearable. Argentina had to turn to the International Monetary Fund and some friendly countries (like the U.S.) for financial support.

"The one key difference between Argentina then and Greece today is political: in Argentina the hard peg to the dollar was a project of the elite, which had never been popular."

The first rescue package envisaged a resumption of growth, a decline in the fiscal deficit and structural reforms. None of this was achieved, as the economy deteriorated under the impact of the tight fiscal measures, which were not offset by a surge in exports, because the export base was too narrow and wages did not fall much. One year later, a second bailout package had to be put together, followed by a large "voluntary" debt rescheduling.

But none of this was enough to restore the confidence of international investors, who were not convinced that the government could service its debt in the face of mounting social resistance and an economy that continued to contract. Even worse, the country's savers lost trust in their own government, and started to withdraw their deposits. The government imposed capital controls, but then the economy went into a tailspin and social tensions exploded. The government fell, and one of its fleeting successors announced a cessation of payments to foreign bondholders and an end to the currency peg.

Argentina took about 10 years to move from its hard exchange rate peg to the dollar to its messy default at the turn of 2001-02.

Is Greece a Replay of Argentina?

The Greek experience until 2011-2012 looked like a replay of the Argentine drama. During the first decade of the euro the government had overspent massively and the country lost competitiveness relative to Germany, just as Argentina had lost competitiveness to Brazil. Greece also had to ask its private creditors to forego part of their claims. But once this was done in 2012, the situation stabilized -- also thanks to financial support on an unprecedented scale.

But even after 2012, the economic situation did not improve despite relative financial stability. The export sector had always been small in Greece (just like in Argentina) and the country is exporting few competitive products whose sales could be increased by lower wage costs. The election of an "anti austerity" government this year then reignited the vicious cycle of political uncertainty and deposit flight. When Prime Minister Tsipras broke off negotiations with the creditors last week and called for a referendum, he had hoped for continuing support from the European Central Bank. When that was not forthcoming, a bank holiday and capital controls were inevitable.

What's Next?

What next? The experience of the last months of the hard currency regime in Argentina is instructive: it took only 36 days from the imposition of capital controls to the end. Law and order broke down as people saw their savings disappearing. When nobody paid taxes anymore, the government could no longer function. In the end, a newly elected president had to be rescued by helicopter from his residence.

What could help Greece avoid the experience of Argentina? The best solution would of course be a new agreement which would allow for the banks to reopen soon with only mild controls on capital exports. However, this is unlikely despite the flurry of new proposals coming from Athens, which betray the increasing nervousness of the Syriza government.

The one key difference between Argentina then and Greece today is political: in Argentina the hard peg to the dollar was a project of the elite, which had never been popular. By contrast, in Greece, it seems that support for euro area membership, even if the price is austerity, is stronger among the population than the present government. The electorate feels vaguely that returning to the Drachma means somehow leaving Europe. Legally this is not correct. The country could default on its European partners, possibly even go back to the Drachma, without formally losing its EU membership. But, in reality, Greece might be relegated to a, de facto, second class membership if it turned its back on the euro.

This feeling of belonging to Europe might make the difference. It might lead a majority of Greeks to accept another austerity program, and prevent Greece from repeating Argentina's tragedy.

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