European View

Europe’s foresight and the destiny of the euro

by Luigi Zingales

IT
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The first phase of the debate on the euro showed how the single currency is above all a political choice. In a democracy, political choices can be changed by voters. Can we therefore deduce that if one day the Italians no longer wanted the euro, they could easily get out of it?

To respond to that question, the second phase of the debate focused on the legal and economic feasibility of an exit. The information that we received from the top legal experts in the field was not reassuring. The good news (you could say) is probably that the Italian public debt could be re-denominated in lira, despite the renegotiation clauses (Contractual Action Clauses) introduced in 2013. But clauses or no clauses – as the law professor Hal Scott reminded us – this is a risky initiative, which in any case would produce an enormous legal controversy with all the uncertainty and costs that comes with that.

Regarding companies that have issued bonds on the European market, we are sure that the debt would remain in euros. For companies like oil major ENI, which have the large part of their revenues in dollars, this would not be a big problem. For firms like Telecom Italia, who make the large part of their revenues in Italy and therefore in lira, it would be an issue. A 30-40% devaluation in the lira would equal a similar increase in the weight of their debt, with a subsequent risk of default. The same conclusion applies to the main Italian banks, who issue bonds on the international markets. With many companies and banks at risk of default (or in fact in default), the Italian economy would not only fail to benefit from the inevitable devaluation that the new lira would undergo, but it would enter a recession caused by the inevitable reduction in investments of struggling companies. It would be difficult for the increase in internal demand fueled by the reduction in imports (that would become much more costly due to the devaluation) to make up for this fall in investments, also because total consumption would decline, seeing as the devaluation of the lira would make all Italians poorer. In the words of the former German Chancellor Helmut Schmidt: “This is the strength of the euro, that no one can leave it without seriously damaging their country and their economy.”

The costs of the exit

In the short term, therefore, the costs of a unilateral exit from the euro would be very high, also if the exit happened in an unexpected way.

But it would be difficult for such a decision to be taken by surprise. As the experience of Indian demonetization demonstrated, a currency change has to be prepared with the involvement of hundreds of people.

It would be hard for this to remain a secret in the country of Pulcinella. Therefore, at the minimum hint of a re-denomination, the Italians would revert to withdrawing cash from their bank accounts, to avoid seeing it converted into lira. To block the run on the banks which would bring them to their knees, the government would have to fix limits on the withdrawal of cash, as the Greek government did in the summer of 2015.

This would have a strong negative effect on trade and an even more negative effect on the confidence of citizens toward banks and the government, with serious consequences in the short and long-term period. The block on withdrawals would especially hit small account holders. For the well-off, a rich black market for exports of capital would develop through under-invoicing for exports and over-invoicing for imports.

Even if the long-term benefits exceeded the costs (and that is not an easy assessment to make), in normal conditions no government would risk a similar move because it would not survive the popular anger to live to see the benefits: during the Argentinian crisis, the country had five presidents in 15 days. A unilateral exit from the euro by Italy, therefore, will never take place in normal conditions: if it happens, it will be a desperate act of a government that does not have a future.

Up to now we have discussed a unilateral exit by Italy. A total dissolution of the euro could be easier to handle (at least from the legal point of view) but it is hard to imagine, because it is unthinkable that all the other countries would agree with this decision. A consensual divorce between Italy and the rest of the euro area could resolve some of the legal problems identified by Hal Scott, but it would be difficult for it to resolve the economic problems. In particular, a consensual divorce would call for a long period of limits on bank withdrawals and capital movements, with severe negative consequences on economic activity and acute political tensions.

The simplest solution would be for Germany (and the strongest countries economically) to exit the euro, and create an alternative currency (the northern euro or neuro) which would appreciate strongly against the euro. But why would Germany take that step? At the moment, it is benefiting economically from an undervalued currency, without paying any cost. In fact, the existence of the euro guarantees German government bonds a monopoly as risk-free bonds, reducing the cost of financing the German public debt. The only thing that could push the Germans to exit the euro would be the fear of inflation or fear of being forced to pay the costs of others. The rules imposed by the monetary treaties rule out the first scenario. The lack of any form of fiscal union makes the second scenario impossible.

If we have to die in the euro, is it at least possible to complete the monetary union with the necessary institutions to make it function (from a federal insurance on deposits and a federal insurance against unemployment)? Unfortunately, the same motives that make it unthinkable for Germany to leave the euro also make it improbable that Germany will be willing to accept reforms that at least in the short-term period would involve some costs for the German taxpayer. Having all the benefits and none of the costs of the common currency, why should Germans ever accept these reforms?

The only hope lies in German foresight. The euro has put Italy in a cage that it cannot escape from, but in which it does not seem capable of prospering. If the situation continues to drag on like this, Italy risks starting to behave like a caged animal: it will turn to desperate moves, which could have negative consequences for the entire eurozone, Germany included.

After the elections in September, Angela Merkel will have a unique opportunity to display this foresight. Launching what with every probability will be her last chancellorship, she should be more interested in the judgment of history than the opinion of her voters.

For Italy, this is a unique opportunity. There are two possible strategies to face it. The first (riskier) option is to show our desperation and our willingness to take extreme solutions, to instill fear in our German partners. The second (preferable) option is to demonstrate our seriousness and willingness to do our part in agreements that make the monetary union more sustainable. What does not work is switching between one extreme and the other almost daily, as we have done so far.


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