The eurozone crisis is far from the first time that nations in steep decline, saddled with a vastly overvalued currency, have been forced to choose a path to recovery.
It's extremely instructive to study the cases of two countries that in the past decade, confronted with many of the same problems that now haunt euro zone members like Italy and Greece, followed two radically different courses.
Argentina took what we'll called the "Exit route," embracing the brutal shock therapy of suddenly and radically devaluing its currency. Latvia picked the approach that the IMF, EU, and foreign investors universally demand, and that even the stricken EU members themselves swear they'll follow. It's what we'll call the "Toughing-it-out" option: staying in the euro, and taking the painful, grinding road of lowering salaries, slashing government spending, and hopefully, freeing their markets of rigid, productivity-killing work rules.
The results are surprising, especially given the broad consensus that the euro must survive. Argentina rapidly restored its competitiveness, becoming one of the world's most vibrant economies. Latvia, despite enacting heroic reforms, will struggle for years before clawing back to the levels of output it posted in the late 2000s.
The lessons from Argentina and Latvia pose a substantial risk to the euro. If Italy, Greece or Spain considers only its own self-interest, not the damage to Europe's banks or investors that hold its debt or the condemnation of powerful nations, they would clearly choose the "Exit route." As their recessions deepen, and the bailout money is spent, the chances that one nation bolts the euro and then thrives, attracting followers, becomes not just thinkable, but increasingly probable.
In a recent paper, "A Dire Warning from Latvia and Argentina," economists Uri Dadush and Bennett Stancil of the Carnegie Endowment outline the courses the two countries chose, and the results. Both nations effectively pegged their own money to the world's two strongest currencies: Argentina tied the peso to the dollar in the early 1990s, and Latvia yoked its lat to the euro when it joined the EU in 2004. Argentina's collapse came in 2001 and 2002, while Latvia imploded in 2008.
But their rise and busts came for the same reasons. By harnessing their economies to currencies used in countries with low inflation, Argentina and Latvia were able to borrow at extremely favorable rates of interest. Credit exploded in both nations. In the three years before their economies crashed, Argentina grew at nearly 6% a year, and Latvia expanded at almost 11%.
That big growth came not from selling more goods to other nations, but from a boom in real estate and domestic services. The rise in prices and wages pounded their exports, and made imports far cheaper than goods they produced at home. Neither country could devalue to lower the prices of its exports so it could compete on global markets.
In fact, for Argentina, the dollar -- and hence the peso -- kept rising after Brazil devalued in 2001, rendering Argentina hopelessly uncompetitive. For Latvia, it was the global financial crisis that ended the flow of easy money that had made it the fastest-growing developing nation in Europe in the mid-to-late 2000s.
The cycles both countries experienced are extremely similar to the damage wrought by an overvalued currency in Greece, Italy, Spain, Portugal and Ireland.
