Extend and pretend

Debt crisis lessons from Latin America

By John Paul Rathbone

It is only vanity that makes anyone believe they are special or “different”. Asia didn’t think Latin America’s long history of financial crises held many useful lessons in 1997; it did. The same is true of Europe. It risks falling victim to the same vanity today.

Take UK Prime Minister David Cameron’s much touted “big bazooka”. In 1980s Latin America, such comprehensive packages were simply known as “el paquete”. Of course, “el paquete” is only the beginning of the end of a crisis. The real challenge is implementation. This requires leadership.

Technocratic governments (like in Italy and Greece) can work. Fernando Henrique Cardoso, for example, was an academic before he became Brazil’s finance minister and twice president. But bear in mind that Mr Cardoso had a popular mandate. Without that, any government is just a caretaker.

Argentina is a case in point. In 2001, it ran through a series of governments before triggering the world’s then-biggest default ($100bn; so small compared to Italy’s €1.9tn bond market). Even the brilliant economist Domingo Cavallo failed to turn the tide. To restore competitiveness without breaking Argentina’s euro-like currency peg, he engineered a “synthetic devaluation”. Across-the-board export subsidies and import duties came straight out of the textbooks, but didn’t work. Just as they often do in Europe today, investors saw the country’s debt dynamics still working against it.

Default fears led to higher bond yields, which led to lower growth and smaller government revenues. This made default more likely in a process that soon became self-fulfilling. After three years of recession, much of southern Europe may already be at this point.

Even loan support from a multilateral – be that the International Monetary Fund or the European Central Bank – can make matters worse. Why? Because one condition of their help is seniority in a sovereign’s debt structure. This converts private investors into “junior bond holders”. Large official interventions can thus produce the opposite of what they mean to do: an investor rush for the exit.

The next stage is all too familiar. Citizens also withdraw their savings before they are converted into devalued pesos, drachmas or liras. A bank run ensues. To prevent a collapse of the payments system, the government announces a devaluation – often over a long weekend. The next day, all hell breaks loose.

These scenes are not out of the question in Europe, and to prevent them, a workable plan is required. Another pre-condition for success: it cannot be seen to be imposed from abroad. Without national support, failed adjustment plan follows failed adjustment plan.

Fresh money to support each new package is loaned under the rubric: “extend and pretend”. Finally, a plan gains traction. But in the intervening period, strange political fauna can emerge. This was particularly true in Latin America, where democracy was then only ankle deep. Yet is it odd that the new Italian defense minister is a military man rather than a civilian? Spanish democracy is less than seven years older than Brazil’s, and unified Italy is two-thirds the age of most Latin republics.

Finally, of course, bear in mind that the adjustment is very painful. Latin America’s “lost decade” meant years of falling real wages and rising unemployment. As social unrest grows, old scapegoats are often resurrected. In Latin America, with its colonial history, the backlash was against the “Washington Consensus”. In Europe, where Germany is the banker, it may be 20th-century history. But rising anger is hardly surprising. When has a debtor ever said anything nice about its creditor?

Europe, of course, is not Latin America. If anything it is in a worse situation. It is more indebted and probably less able to stomach tough adjustment programs. “They don’t know how to suffer,” Ernesto Zedillo, the former Mexican president, has said of southern Europe.

European banks are also part of the crisis, which is as much a problem of over-lending as over-borrowing. At least in Latin America, the banks were mostly abroad. Europe should have one factor in its favor. With stronger institutions, it could reach the right solution faster. But higher economic costs always follow poor and tardy policy making.