The first decision of Hell Week has taken place.  The people of Greece have blinked. Once again, they have chosen slow strangulation over jumping off the cliff and hoping to survive.

As many people have pointed out, the Greeks have essentially two options.  They can stay the course, squeezing their economy harder and ever harder in hopes of convincing their investors they are sincere.  Or they can default on their debts and leave the euro.  Everyone agrees that the immediate aftermath of such a default and devaluation will be catastrophic.  But no one knows what the longer range consequences will be.  Our experience with sovereign default and devaluation is sparse, but revealing.  Consider:

Russia, 1998:  The transition from Communism was disastrous in Russia. Coal miners and many other workers went unpaid.  Interest on sovereign debt alone exceeded tax revenue by 40%.  In much of Russia, the financial system had broken down so far that money ceased circulating altogether and the economy went on a barter system.  In an effort to keep the ruble at its currency peg and stem capital flight, interest rates were raised to as high as 150%, with devastating effects on any part of the economy that still had a working finance system.  None of this was sustainable.  On August 17, 1998, the Russian government default on its debts and let the ruble fall.  The immediate aftermath was catastrophic.  Inflation hit 84%.  Food prices rose by 100%. Import prices quadrupled. Many banks failed, and people lost their savings.  Yet recovery was rapid.  Much of the country was on a barter system and therefore unaffected by financial upheavals.  The rise in import prices allowed domestic industry, up till then undermined by cheap imports, to recover.  High oil prices also helped.

Argentine, 2001-2002:   Argentina was long troubled by severe inflation, and in 1991 it took the truly drastic step of making it "freely convertible" to U.S. dollars, i.e., requiring the central bank to have one dollar on hand for every peso in circulation, and to make the conversion for anyone who requested it.  Unfortunately, having so many dollars on hand required a lot of foreign borrowing, which ran up a lot of debt.  Furthermore, as the dollar went up, imports became cheaper and cheaper, gradually undermining domestic industry.  By 1999, investors were becoming increasingly nervous about Argentina's ability to make its payments.  Interest rates went higher and higher, causing great damage to the economy.  The shrinking economy cause increasing budget deficits.  The IMF demanded cuts and more cuts, which shrunk the economy even more.  As the currency peg looked less and less stable, people began converting their pesos into dollars, causing a general run on the currency.  The government froze bank accounts.  As in Russia, the situation was unsustainable.  The government defaulted in December 2001 and abandoned the currency peg in January, 2002.  The immediate aftermath was catastrophic.  The currency crashed, inflation surged to about 80%, peaking in April at 10% per month.  As foreign debts surged, many companies failed.  Unemployment hit 25%.  Yet recovery was rapid.  Exports surged once the peso fell.  More expensive imports allowed domestic industry to recover.  Growth rates exceeded 8% per year from 2003 to 2007.  High soy bean prices helped.

Iceland, 2008:  Iceland's 2008 financial crisis is considered the worst (relative to the size of the country) of all time.  Icelandic banks ran up 50 million euros of foreign debt, backed by an 8.5 million euro economy.  With foreign debts so much larger than its total economy, the central bank was unable to back Iceland's banks.  The Icelandic government nationalized the banks, found them unsalvageable, and allowed them to default on their external debts.  The internal banks have been reconstituted.  (The government did not default on its sovereign debt, but did allow the banks it was responsible for to default on theirs).  The currency plunged.  The immediate aftermath was catastrophic.  Supermarkets had no currency to buy imported goods.  People started hoarding. Half the shops were empty.  Yet Iceland is recovering surprisingly well, returning to an economy of fishing and aluminum smelting from one of banking.

Ecuador, 2008:  This one is less familiar and the outcome is still unclear.  But Ecuador apparently took advantage of the 2008 financial crisis to buy back its bonds at 35% of value.  Outcome remains unclear.

All of this is by way of saying that if Greece defaults and devalues, there is plenty of precedent to suggest that, after a traumatic beginning, it could turn out well in a surprisingly short time.  Or maybe not.  None of the successful defaulters had trading partners going through a major crisis at the same time.   All of them had currencies that at least physically existed.  Greece does not.  All the other countries were simply abandoning a single currency peg.  Greece threatens to break up an entire currency union.  So what worked in these other cases might not work for Greece.

This paper is one of many arguing that an Argentine-style default and devaluation would work for Greece.  But it offers another interesting, unconventional insight.  It quotes George Soros, who knows international creditors well and understands how they think, as saying that creditors want to make default as painful as possible in order to discourage it.  For any private borrower, creditors can seize collateral, but for a country that is not possible, so pain is the only "collateral" available.  The paper goes on to comment:

The European authorities look at Greece’s situation mainly from a creditor’s point of view. From this point of view it is not necessarily bad that the adjustment is painful. Furthermore, if the Troika [European Commission, European Central Bank and IMF] were to provide a program that allowed Greece to recover quickly, then Portugal, Ireland, Spain, and Italy would also expect something similar. That is another concern that the European authorities are likely taking into account, which can motivate them to back policies that are bad for Greece.

The European authorities also have ideological and political interests that can have a large impact on their policies. These two are difficult to separate, but they are very much on display in the documents and statements of the troika. Ideologically/politically, they want a smaller government in Greece, with less regulation, much lower wages, and weaker unions. . . . To the extent that these ideological/political priorities are more important to the European authorities than an economic recovery in Greece, there could be a lot of continued and even permanent, unnecessary suffering for the majority of Greeks.

From a creditor perspective, the worst case scenario would not be Greece defaulting, leaving the euro, and never recovering.  It would be Greece defaulting, leaving the euro, and bouncing back as rapidly as Russia, Argentina, and Iceland did under similar circumstances.   That would be disastrous because it would encourage other countries to do the same.

And yet, as the examples above illustrate, creditors have not generally been successful in their attempts to make default as painful as possible.  In all these cases, default has proven to be the better option, and recovery has been remarkably fast and strong.  All of which would seem to create another  incentive for creditors, although they show no sign of interest in it.  Make the alternatives to default less painful.

Hey, one can dream!