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The lure to leave the euro may prove irresistible

January 13, 2012: 5:00 AM ET

Greece, Italy, and the other embattled eurozone nations may need to start looking out for themselves and consider leaving the euro. Better to be Argentina than Latvia.


Argentina did it. Can Greece?

FORTUNE -- 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.

The euro's fatal problem isn't spending

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.

So how have Argentina and Latvia performed since choosing between the "Exit" and "Tough it out" approaches? After its devaluation in January of 2002, Argentina's GDP went into freefall, unemployment reached 20%, and the peso dropped to four to the dollar. But amazingly, Argentina was growing briskly again by the fourth quarter of 2002. And by 2004 -- a mere ten quarters from the onset of its recession-turned-depression -- its GDP had climbed back to its previous peak. From 2002 to 2011, its output jumped 94%, or over 40% adjusted for inflation, the fastest number in the Western Hemisphere, and twice the pace of Brazil.

How to make money on negative yields

Argentina is far from a miracle. Its inflation is surging again, and it's despised by international investors since defaulting on $100 billion in foreign debt. Indeed, it put plenty of pain on other nations and creditors. Don't bet that a Greece or Italy will refrain from doing the same if it can stage an Argentinian-scale comeback.

In Latvia, GDP fell over 22% in 2008 and 2009. But it still chose to remain tied to the euro, especially since the IMF and EU granted it 7.5 billion euros in bailout funds, almost 40% of current GDP. It's done a good job increasing its productivity by guiding investment into such areas as computers and pharmaceuticals. It also grew about 5% in 2011, though the rate is projected to fall to 1% or less this year.

Still, Latvia is stuck with a currency that's far too expensive to allow the kind of export explosion that rescued Argentina. It faces years of slogging to get back to the kind of prosperity Argentina regained so fast. Unemployment stands at 12%, and the IMF projects that Latvia won't see a return to total output it posted at the peak in 2008, adjusted for inflation, until at least 2016.

How low will the euro go?

The question is whether Europe's weaklings are willing to suffer through the kind of long, grueling process Latvia adopted to slowly restore its competitiveness. So far, their reforms are scant.

"It's the dilemma that Greece and the others are now facing," says Stancil. "The ailing nations are starting to figure out what the other path is, and that it's extremely tempting. It's painful, but it may be the best of only bad options."

If those countries decide to do what's best for them, not what they're being told, the "Exit route" will prevail. For every month the crisis lingers, the more alluring the exit looks.

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About This Author
Shawn Tully
Shawn Tully
Senior EDITOR-AT-LARGE, Fortune

Shawn Tully has been writing feature stories for Fortune since 1980. He's covered stories as varied as the Vatican's finances, the exile of fugitive commodities trader Marc Rich, and the disastrous merger between Guidant and Boston Scientific. He specializes in banking, federal budget and spending issues, and health care. Tully holds a B.A. in English from Princeton University, an M.B.A. from the University of Chicago, and a master's in Applied Economics from the Universite Catholique de Louvain in Belgium.

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