Xavier Cirera and Neil McCulloch - 14 May 2010

It is still too early to judge whether the new EU-IMF loan facility will succeed in 'saving' Greece from default and prevent contagion spreading to Spain and Portugal. However, there are three interesting questions that emerge from the very recent introduction of this facility. Firstly why has this facility only just come about now? Secondly why is this crisis any different to those that have happened and will happen again in developing countries? Finally does history suggest that countries recover faster when they don't follow IMF strictures?

Why did they wait so long to agree?

Even in the early stages of the Eurozone design, the risk of default by a euro country was considered a serious concern. But there was no agreement on a stabilisation fund or the introduction of an active role from the European Central Bank (ECB) and the preferred political choice for stability was fiscal rules, detailed within the Maastricht Treaty. The thinking behind this stance was that it would discourage countries from ‘free riding' fiscal deficits at the expense of other Eurozone' countries inflation and tax payers' money for bail out. The reality is that even countries that have managed to keep their fiscal deficits under the Maastricht criteria limit, have been unable to control soaring fiscal deficits as a result of the crisis.

But the question remains, why have EU countries waited so long to agree on this facility? The only way for such a facility to work is for there to be significant centralised control of European budgets and this was politically unacceptable when the treaty was being negotiated. It has taken a serious crisis to force countries to accept the level of external intervention in their fiscal policies necessary to provide stability within a currency union.

Why should Greece be treated differently?

The second question relates to the role of the IMF and its future approach to currency crisis in developing countries. How different is the current Greece crisis from Argentina's 2002 currency crisis? Argentina defaulted on its debt, rightly abandoning the unsustainable exchange rate regime that had been introduced with the full support of the IMF at large adjustment costs to the population. In the future will the IMF fund facilities to bail out developing countries in a similar situation to Greece? It seems unlikely.

It is debateable whether this would even be desirable. Profligate expenditure followed by currency crises is not a new phenomenon. In the 1980s and 1990s the IMF attempted to impose strict fiscal adjustment on developing countries that had gotten themselves into such difficulties - under the rubric of structural adjustment. General consensus agrees on two reasons why this failed. First, the level of austerity that governments had to impose was politically unacceptable and so governments did not generally follow through on the packages. Second, and more fundamentally, it did not make sense economically.

Default, adjustment and inflation

In fact most of these countries recovered through a combination of three factors - default, exchange rate adjustment, and inflation. Defaulting provided countries with additional resources since interest payments were not being made. Exchange rate adjustment crucially made countries much more competitive on international markets. Inflation eroded the value of their domestic debts far more rapidly than any austerity programme ever could.

Of course the short-term consequences of this path are disastrous, certainly at least as painful as any austerity programme since they prevent any access to the international capital market for a period of time. But history would also suggest that default when accompanied by subsequent prudential policies can be a more effective and politically acceptable way back to growth, than shackling a country to a currency unsuited to its needs and attempting to build competitiveness through government imposed deflation. When it costs so much to hold things together, one has to ask seriously whether it might be better to let things go.

Xavier Cirera and Neil McCulloch are Research Fellows in the Globalisation Team at the Institute of Development Studies.

Image: Yannis Kontos, Polaris/Panos