Greece should follow Argentina into default and devaluation

European policymakers want to avoid Greek default and keep Greece in the eurozone. However, Argentina?s decision to devalue its currency and default was the right one. It was the only step that offered a way out of the crisis facing the country. Greece should do the same.

By Juan F. Navarro-Staicos / April 2, 2012

In 2002, Argentina devalued its currency and defaulted on its debt. An already severe recession worsened to the point where 1 in 2 people were poor.

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This outcome is what European policymakers want to avoid as they attempt to keep Greece in the eurozone. However, Argentina?s decision to devalue and default was the right one. It was the only step that offered a way out of the crisis facing the country.

Last month, Greece pulled off a massive restructuring of debt held by private investors ? offering bondholders new debt with less than half the face value. Guess what? Most private investors accepted the painful deal and the world did not fall apart. Greece should proceed to a restructuring of its remaining debt. And like Argentina, it should also free its currency.

Consider the parallels between the two countries:

From 1998 to 2001, Argentina experienced a severe recession. It attempted several rounds of fiscal austerity that only had the effect of further slowing the economy. The country had a fixed and overvalued exchange rate, a large trade deficit, and a shrinking economy.

Its austerity plan, directed by the International Monetary Fund, included cuts in government spending, tax increases, and structural reforms to make markets more flexible. The IMF and international lenders dogmatically insisted on debt repayment and maintenance of the currency peg to the US dollar. They hoped reductions in wages and prices would make Argentina competitive in global markets.

Greece today is experiencing many of the same symptoms as pre-default Argentina. For Greece, the euro is too strong. Greek goods are uncompetitive in global markets, reflected in a large trade deficit. The economy is stagnant, with unemployment at record levels. Over the past several years, the European Union and the IMF have insisted on increased austerity and structural reform in exchange for funds used to service the country?s debt.

The history of both countries on the way down is also similar. Argentina tied its currency to the dollar in 1991 as a way to control rampant hyperinflation. Inflation was dramatically reduced, but the currency peg left the government with little freedom to control its money supply and smooth economic shocks.

This lack of flexibility worked during a time of large capital flows from abroad that helped finance investment. But with the Asian financial crisis, the Russian default, and the Brazilian devaluation in the late 1990s, capital stopped flowing to Argentina and the economy slowed.

Creditors became worried that Argentina would not be able to repay its debts. The government cut spending and raised taxes, but these actions only further decreased growth and required additional austerity to ensure the country could pay its bills.

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