European View

Tied hands: the illusionary long term benefits of Italy’s euro exit

by Markus Brunnermeier and Harold James

24 Exclusive content for IT24

Italy is currently in a dark wood – una selva oscura – where the straight way out looks blocked (ché la diritta via era smarrita). That way out is also dangerous.

The most obvious and most frequently-cited of Italy’s gains from a possible euro exit involve regaining competitiveness by what would amount to a devaluation; and some sort of effective default on government debt that would necessarily accompany the exit (since otherwise the burden of a euro-denominated debt would be intolerable).

But these gains are quite illusory, because the competitiveness gain would be likely to be quickly reversed by increased wage settlements as prices increase – driven by imports of basic or essential goods (in Italy’s case energy).

Potential short-run gains would be outweighed by worries about the long term uncertainties and the policy chaos that would follow the exit. The exit mechanism would do little to tackle the long-term Italian problem of competitiveness. Rather Italy would suffer from higher inflation which immediately translates into higher interest burdens for government and for enterprises. Even worse, heightened uncertainty would send interest rates even further upwards as investors start to charge higher risk premia.

It is also worth imaging what would have happened if Italy not been a part of the Eurozone. In the aftermath of the global financial crisis of 2007-8 capital flows reversed, and produced dramatic contractions in some Eurozone countries, but were just as severe in European countries that were in the EU but not in the euro (like Romania) or not in the EU at all (like Serbia). What euro membership produced was access to stabilization facilities, ECB purchases of bonds, and TARGET2 balances. So outside the euro, Italy would be even more exposed to the gales of the international capital market.

The only realistic and potential long term gain from exit would come through the removal of what has become a heavy political-psychological burden: the idea that it is the euro that imposes the restraints that make it impossible for Italy to regain competitiveness. The pervasiveness of this idea among Italians – from senior officials and many academics to the wisdom of the street – is the real source of Italy’s difficulties.

Essentially the euro has too often become an excuse for doing nothing to address competitiveness issues.

The euro does act as a constraint. The old arguments for joining it were in Italy usually put in terms of constraints, “tying hands.” The fiscal conditions associated with euro membership created external restraints that made time-inconsistent policies impossible. As a result it was impossible to make a quick dash for growth with a fiscal stimulus that pushed a temporary surge but which then led to higher wage cost levels. The permanent exchange rate tie ended the endless cycle of booms that ended with inflation and surging costs and then required a devaluation to restore competitiveness.

The constraints would also mean lower interest rates, and cheaper government borrowing, and that would be passed on to better credit conditions for companies. But cheaper borrowing in the 2000s did little to raise productivity.

The problem with the imposition of external constraints is that it also establishes a psychological mechanism of blame transference. When the policy that results from those external constraints does not produce growth, then the euro is reinterpreted as a trap. When wage growth occurred despite the external constraint, and growth faltered, there was no way out. The euro thus is responsible for trapping Italy into a low competitiveness scenario. Italy is suffering from the story that Italians told when they wanted to join the single currency.

But the other side also feels that it is in a trap. Sometimes Germany is portrayed as the major beneficiary of the euro – especially in southern Europe. But Germans do not see the trade gains – especially when southern Europe is buying less German exports, fewer automobiles and machine tools as consumption and investment have both collapsed. They see instead the financial claims building up in the payments system, the TARGET2 balances that result from the counterpart to money transfers to the southern banking system.

The situation in which both sides think that they are trapped looks like a variant of the famous Master and Slave dialectic in Hegel’s Phenomenology of Spirit. Both sides are equally bound. The Slave is not recognized as fully human, or as an equal by the Master, and is not free. The Master is free, but does not find that he is recognized as a human by the Slave. He is constantly worried by the fragility of the relationship, and the fact that the Slave is building up an alternative universe of values, in which the Master is not represented.

Some argue that the ”good” scenario about breaking out of the Master and Slave dialectic would be that without the euro, Italians would start to realize that no one is responsible for their problems except themselves.

They would be more inclined to criticize governments that did not deliver on economic reforms, or imposed fiscal burdens that weighed down innovative enterprise, or stifled business with restrictions. They would work to innovate, they would cultivate the niche global markets that they are losing, and they would capitalize on Italy’s historical strengths in design, craftsmanship etc. They would collaborate in networks across Italy’s successful and dynamic industrial districts.

But that hope is an illusion – there would always be someone else to blame. It is important to note that nothing that currently obstructs Italians from doing any of these acts of economic construction has to do with the concrete impositions of the euro and its legal framework in the Stability and Growth Pact. The only exception is a critical one: the budget constraint. But that European limitation should be reinterpreted as a mechanism for guiding public finance away from short term stimulus and toward long term dynamic growth targets.

Europe could help Italy be designing a growth framework that would include a climate of stability and certainty, but where specific Italian problems – including the difficult task of securing the frontier and managing flows of refugees – could be tackled.

There is a less painful way of shocking Italians into taking responsibility for their own destiny than by pushing them into a radical leap into an uncertain future. Italians should stop thinking of Europe as “tying their hands” and think of Europe as a source of capital, technology, ideas and also a big market that lets them “use their hands.” Otherwise they will find themselves on the way into Inferno.