First the weak countries needed to reduce both fiscal and current account deficits, even at the cost of higher unemployment and lower growth. However, this strategy would have failed completely, if the Fed had not decided to provide more money to fund the American housing markets and the European trade surpluses via U.S. consumer spending.
A similar austerity strategy was applied in 1982 during the Latin American debt crisis, quite successful at the beginning, but at the end the Mexicans and others ended up in a lost decade and debt write-offs.
The Latin American Lost Decade: ”In response to the crisis most nations abandoned their import substitution industrialization (ISI) models of economy and adopted an export-oriented industrialization strategy, usually the neoliberal strategy encouraged by the IMF, though there are exceptions such as Chile and Costa Rica who adopted reformist strategies. A massive process of capital outflow, particularly to the United States, served to depreciate the exchange rates, thereby raising the real interest rate. Real GDP growth rate for the region was only 2.3 percent between 1980 and 1985, but in per capita terms Latin America experienced negative growth of almost 9 percent. Between 1982 and 1985, Latin America paid back 108 billion dollars.”
The Latin Americans had a weak currency to enforce their export-oriented industrialization, but the weak European countries do not have this advantage. On the other side, debt repayment is easier in a common currency especially when sustained by longer-term repayment schedules. We are quite sure that the Latin American crisis could have ended far earlier, when great parts of the debt would had been written off earlier, like recently done with Iceland, Greece and as it will be potentially done with Cyprus, Portugal and Spain.
By mid-2012 Iceland was regarded as one of Europe’s recovery success stories. It has had two years of economic growth. Unemployment was down to 6.3% and Iceland was attracting immigrants to fill jobs. Currency devaluation effectively reduced wages by 50% making exports more competitive and imports more expensive. Ten year government bonds were issued below 6%, lower than some of the PIIGS nations in the EU (Portugal, Italy, Ireland, Greece, and Spain). Tryggvi Thor Herbertsson, a member of parliament, noted that adjustments via currency devaluations are less painful than government labor policies and negotiations.
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