When policy is reversed it takes longer for recovery


EVERY few months when the Spanish government announces the latest batch of economic and debt data, these numbers always turn out to be worse than expected and much worse than originally projected.


Ironically, this is exactly what we should expect under the circumstances.

Foreign minister Jose Manuel Garcia-Magallo compared the European Union to the doomed liner Titanic, saying that passengers would be saved only if all worked together to find a solution, the #i#Financial Times#i# reported recently.

It is that Garcia-Magallo is openly discussing the possibility of the “passengers” not being saved.

Usually in the beginning of a sovereign debt crisis we spend an unfortunately long time in which policymakers insist that the market is overreacting to bad news and that the problem – inevitably a short-term problem driven largely by illiquidity – can be resolved with patience and hard work.

There is no discussion of contingency plans because the contingency is unimaginable.

At some point however it becomes possible at least to acknowledge formally that policymakers might be forced into the contingency.

Once this happens, the debate becomes much more intelligent and the resolution of the crisis is speeded up.

As recently as six months ago one didn’t discuss in polite company in Madrid the possibility that Spain would leave the euro and restructure its debt.

The prospect was unthinkable and like many unthinkable things it could not be discussed.

This made it very unlikely that anyone except the radical parties of the left or right would be able to control the discussion and of course this was likely to lead to a more disorderly resolution.

But now perhaps things have changed.

If responsible policymakers, advisors, the press, and public intellectuals are indeed discussing and debating the future of the euro now, I am pretty sure that a real and open debate about Spain’s prospects will quickly move the consensus towards abandoning the euro.

The historical precedents suggest that typically policymakers postpone the decision to reverse the monetary straightjacket for as long as they can, and in the process they erect barriers towards such a reversal in the name of shoring up credibility.

These barriers work by increasing the cost of a policy reversal, and the point of this is to improve credibility in investors’ eyes by increasing the cost of “misbehavior” by policymakers.

Mexico did this in 1994 when, in order to convince an increasingly skeptical investor base that the central bank would not devalue the peso against the dollar, the Ministry of Finance shifted its domestic borrowing from peso-denominated funding to dollar-denominated funding, which of course would increase the debt-servicing cost of a devaluation for the government.

Unfortunately, when policy is reversed anyway, as was the case in Mexico in 1994, the cost indeed ends up being much higher, and it takes longer for the economy to recover.

In that sense the sooner Spain prepares for an abandonment of the euro the less painful it will be.

But of course it won’t be painless.  Whenever an analyst predicts that Spain will soon leave the euro he is almost always countered by someone who earnestly explains that Spain cannot leave the euro because the process will be too painful.

n 1993-94 of curse we were told that this was why Mexico could not possibly devalue, and in 2000 and 2001 this was why Argentina could not possibly break the currency board. It would have been too painful to devalue.

But of course Mexico and Argentina both did devalue and, yes, it was a very painful experience but they did it because the alternative was worse.

And likewise while it is true that Spain cannot leave the euro without experiencing a very painful process, the point is not that anyone is arguing that Spain should willingly and irrationally choose to endure pain.  Spain will leave the euro because the alternative is worse.



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