European View

History doesn't run in reverse

by Barry Eichengreen

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A good case can be made that creating the euro and Italy's participation were both historic mistakes. The problem, we now know, is that monetary union without banking union and political union will not work, or at least they will not work to everyone's satisfaction.

The first decade of the euro saw massive capital flows from Northern Europe, where interest rates were low, to Southern Europe, where they were higher (1). There was no Single Supervisor, and more generally no banking union, to take into account how lax regulation of French and German banks would impact those flows and how the recipient countries would be affected.

The resulting flows bid down interest rates across Southern Europe. Cheap finance for consumption created an artificial sense of prosperity, which encouraged the recipient countries to put off reforms. It financed rash investment decisions that have now come back to haunt the financial institutions that undertook them.

As a result, Italy finds itself burdened by a weak banking system, anemic growth, and German-inspired constraints on bank recapitalization. A growing number of Italians feel that their country is stuck and that something radical must be done to “unstick” it.

But acknowledging that adopting the euro was a mistake doesn't mean that abandoning it now is the best course of action. History doesn't run in reverse. Abandoning the euro would not solve Italy's problems.

The binding constraints on growth are product-market restrictions and an inefficient tax system that depress productivity and discourage investment. Italian readers don't need a lecture from a foreign economist about the need to reform these arrangements (2).

The question is whether abandoning the euro would hasten these reforms. The argument that it would, emphasizes that reintroducing the lira and depreciating it would boost Italian exports and growth. Since the size of the pie would be growing, vested interests would be less intent on protecting their fixed slice and more inclined to accept flexibility-enhancing reforms.

But the evidence does not uniformly suggest that countries do more reform when times are good (3). Neither does a comparison of Italy's experience in the relatively good years before 2007 and troubled years thereafter suggest that more prosperity makes for more reform. Indeed, these observations make one worry that reintroducing the lira would be seen as a kind of magic elixir that made further reform unnecessary.

In addition, abandoning the euro would have two serious costs. First, the financial consequences would be chaotic. Knowing that the lira had been introduced so that it could be depreciated against the euro, investors would flee. Italy's stock and bond markets would crash. Important financial institutions would be rendered insolvent. A bank holiday like that in Cyprus would ensue, followed by restrictions on deposit withdrawals. Capital controls like those just removed by Iceland – nearly a decade after their imposition – would have to be applied. This doesn't sound like the conditions for an early resumption of growth.

The euro's critics will object that these warnings are exaggerated. They will argue that the transition can be navigated smoothly. I don't think so (4). Earlier instances where monetary unions broke up smoothly occurred under very different circumstances with exactly zero relevance to Italy today (5).

The second cost would be jeopardizing Italy's access to the Single Market. Abandoning the euro would be seen by Italy's European partners as an unhelpful, unfriendly act. It would be seen as abrogating Italy's treaty obligations. Depreciating the lira would be seen as attempting to solve the problems of Italian exporters at the expense of their foreign competitors, causing Germany and others to retaliate with trade restrictions. The UK has learned that abandoning EU membership but retaining access to the Single Market is – how to put it politely? – challenging. Italy would learn that abandoning the euro but retaining full access to the Single Market was equally challenging.

None of this is to deny that there are flaws in the structure of the Euro Area that need to be addressed (6). This process should start with completing the EU's half-built banking union. It should extend to fully disconnecting the banks from the sovereign debt market by making them pay capital surcharges for holding government bonds, rather than maintaining the fiction that those bonds are risk free.

Reform should continue by returning responsibility for fiscal policy to national governments, where it belongs. National preferences over fiscal policy differ, and attempts at fiscal supervision by Brussels only aggravate tensions. The resulting disputes have worsened the prospects for political integration by creating conflict and disharmony. There is no national policy decision more intimate than how much to tax and on what to spend. The argument, popular in Germany, that repatriating budgetary policy to national governments is infeasible because the cross-border spillovers of fiscal policy are large is not supported by the evidence (7). If the fear is that fiscal misbehavior will destabilize the banks, forcing the ECB to respond with inflationary finance, then the solution is again to simply disconnect the banks from the sovereign debt market.

The third essential reform is then to jettison the EU's “bail in” rules that prevent the Italian government from using its own fiscal resources to recapitalize the banks.

Italy can advocate these reforms if it remains in the Euro Area. Outside, it will have little influence over the decisions of its neighbors. To be sure, absent reforms the euro will remain an albatross around the country's neck. But, fundamentally, whether the Italian economy sinks or swims will depend not on whether or not it is weighted down by this albatross but rather on whether it undertakes the necessary reforms at home.

Footnotes:

(1) Philip Lane, “Capital Flows in the Euro Area,” European Economy, Economic Papers 497 (2013)

(2) But if they want one, a good source is OECD, “Italy: Structural Reforms: Impact on Growth and Employment” (2015)

(3) Evidence to the contrary is in Romain Ranciere and Aaron Tornell, “Why Do Reforms Occur in Crisis Times?” unpublished manuscript, IMF and UCLA (2015)

(4) Barry Eichengreen, “The Break-Up of the Euro Zone,” in Alberto Alesina and Francesco Giavzzi (eds), Europe and the Euro (2010)

(5) Barry Eichengreen, “Sui Generis EMU,” in Marco Buti et al. (eds), The Euro: The First Decade (2010)

(6) I lay out the reform agenda as I see it in Barry Eichengreen and Charles Wyplosz, “Minimal Conditions for the Survival of the Euro,” Intereconomics (2016)

(7) See Maria-Grazia Attinasi, Magdalena Lalik and Igor Vetlov, “Fiscal Spillovers in the Euro Area: A Model-Based Analysis,” European Central Bank Working Paper no.2040 (March 2017)

Author is George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley.


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