Friday 20 Jul 2018 | 01:43 | SYDNEY
Friday 20 Jul 2018 | 01:43 | SYDNEY

Siren songs and golden straitjackets


Mark Thirlwell

11 June 2010 13:35

I've been posting recently about debt crises, fiscal rules and the Golden Straitjacket. Here, I want to think a little bit more about the political sustainability of the Golden Straitjacket approach.

One historical example of the Golden Straitjacket – and one which is explicitly cited in Dani Rodrik's idea of the trilemma – is the Gold Standard. As described, for example, in this essay by Barry Eichengreen and Peter Temin, by requiring governments to buy and sell gold at a fixed price, the Gold Standard imposed limits and disciplines on government policy that came to be seen as a sort of 'good housekeeping seal of approval'

As a result, although the world's major developed economies were knocked off the Gold Standard by the First World War, many policymakers were keen to return to these Golden Fetters as soon as possible after the conflict was over, hoping to signal their renewed commitment to 'sound' financial policies.

In the post-World War One world, however, the Gold Standard was no a longer viable policy option. Several factors were at work, but a substantial part of the explanation relates to the changing nature of labour markets and the shifting balance of power between labour and capital. 

Under the Gold Standard, countries running balance of payments deficits (and so leaking gold) had to adjust by reducing domestic costs and prices – especially wages. This required both (downwardly) flexible wages and either a pliable or a muzzled labour force. The spread of trade unionism, unemployment benefits and minimum wages undermined the first of these, while unionism and the extension of the franchise helped reverse the second. 

The attempt to return to old orthodoxies was a disaster. Indeed, in the inter-war period, it was those countries that abandoned the Gold Standard that tended to recover earlier. (Earlier this year, Paul de Grauwe had a piece in the FT noting the parallels between this experience and contemporary circumstances.) To make matters worse, the countries that stuck with the Gold Standard ended up turning relatively more to protectionist measures as an alternative way of restoring competitiveness. 

A modern example of a country attempting to don the Golden Straitjacket is Argentina, which on 1 April 1991 adopted the Convertibility Plan. The story of Argentina's experiment is set out in a good book by Paul Blustein.

Argentina had been plagued by a modern history of fiscal and monetary profligacy and hence suffered from persistently high inflation. The Convertibility Plan, which committed Argentina's central bank to freely exchange pesos for dollars at a rate of 1:1, was intended to provide a solution by imposing tough limits on the central bank's freedom of action: Argentine policymakers, like Odysseus, set about tying themselves to the mast of monetary rectitude in order to avoid the siren song of inflationary finance. 

Argentina's implementation of convertibility involved an explicitly high degree of lock-in by policymakers: for example, the dollar was allowed to circulate alongside the peso, producing a partially dollarised economy in which a rising share of loans were denominated in dollars, which in turn meant that any attempt to break the dollar-peso peg would have a calamitous impact on the country's banking system and many of its households. The pain of any alternative path was supposed to be so high that lock-in – and hence government credibility – was assured.

Initially, it worked. Convertibility helped bring down inflation at a rapid rate, Argentina enjoyed something of an economic boom, and the plan even managed to survive an early test in the shape of the 1994/95 Tequila crisis, with Argentina prepared to jack up interest rates and taxes in a display of commitment that won praise from financial markets. The IMF, which until then had been somewhat sceptical, was also impressed, and in the following years Argentina was to become, in Nancy Birdsall's memorable phrase, the 'spoiled child of the Washington Consensus'. Capital markets also bought the story, and Argentina benefited from significant capital inflows.

Unfortunately, Argentina's fiscal policy, labour markets and domestic politics proved incompatible with the Convertibility Plan in the long run. So when the economy had to deal with a series of shocks — first the Asian financial meltdown, then the Russian crisis, and finally Brazil's devaluation in early 1999 — it all ended in tears. Argentina found itself mired in recession, and the political and economic costs of the convertibility regime became too high to bear. 

Eventually, after several changes of president and large-scale public protests, the end came on 6 January 2002. At which point, of course, all of the lock-in that had been cited as ensuring that Argentina could never afford to abandon convertibility meant that, when convertibility was abandoned, the economic and social fallout was particularly nasty.

Which brings us back to Greece and the latest crisis. Several observers have already noted that there are a range of possible Argentine lessons that can be applied to Greece. One of these is the dangers of a loss of policy flexibility. 

In the case of Greece, the decision to join the euro was motivated in part by similar considerations to Argentina's decision to adopt Convertibility, although clearly a range of other important influences relating to the future of the European project were also at work. And like Argentina at the start of the Convertibility Plan, Greece initially benefited from donning the euro version of the Golden Straitjacket. One key difference was that the degree of Greece's lock-in to the euro was (and is) much greater than Argentina's to the Convertibility Plan, and hence the costs of exit would be even greater. 

Yet, as in the case of Argentina, Greek politicians have been unable to deliver the kinds of policies in other areas (primarily fiscal policy, in this case) that would make the commitment to the existing macro-economic regime fully credible. With the backing of €750 billion of European and IMF money, policymakers in Athens are making a belated attempt to deliver on the fiscal front. But the domestic politics of this – the risk of a prolonged period of austerity and sub-par growth – look poisonous.
The experience of both the Gold Standard and Argentina suggests that political pressures and large shocks can render the most beautifully tailored golden straitjacket terminally uncomfortable. That's a good reason for feeling rather sceptical about the chances of Greece delivering on the latest adjustment package. 

Granted, that's not quite the same as saying that governments have no chance when it comes to delivering the kind of austerity that Greece now requires: some recent research by Alberto Alesina, Dorian Carloni and Giampaolo Lecci suggests that the kind of fiscal adjustment now required in Europe has been politically feasible and politically survivable in the past. But it does highlight the immense difficulties involved.

Photo by Flickr user leguan001, used under a Creative Commons license.