European View

The costs and benefits of “ExItaly”

by Biagio Bossone

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Durand and Villemot (2016) examine the effects of Italy's possible exit from the euro (“ExItaly”). According to their estimates, the “new lira” would be revalued by 1% in comparison with the rest of the Eurozone due to the foreign trade surplus; they concluded that these consequences are nothing to get worked up about.

A reassuring conclusion, when compared with the pessimistic predictions made by the analysts who evaluated the effects of a Euro breakup—keeping the negative balance sheet effects in mind (Nordvig and Firoozye, 2012).

The evaluations by Realfonzo and Viscione (2015) are less apodictic, considering what Italy went through after the 1992 crisis: they observe that, following ExItaly, growth and employment will depend more on the quality of the monetary and fiscal policies that are adopted than the new exchange rate.

Who's right, and who's wrong?

Adjusting the flows, or the debt stocks?
In a global economy that's dominated by finance—where the volume of financial transactions is more than 70 times greater than the total annual foreign exports and investments throughout the world—it's difficult to imagine that an event like ExItaly could take place in an orderly fashion that would allow the exchange rates to gently adjust to the new equilibriums between the national purchasing powers and the interest rates, in a way that efficiently reflects the inflation differentials.

That goes double for a heavily-indebted economy like Italy's, in which the uncertainties pertaining to an unprecedented situation would trigger rather unpredictable adjustment dynamics which are due more to how the debt stock values are considered (debt sustainability, the appeal of the new currency) than the flow imbalances (trade balances).

On the other hand, it's impossible to create realistic conjectures on the advantages and disadvantages of ExItaly without precise theories regarding the policy regime that would accompany them, and without considering the credibility that such a regime would be awarded by the public and the markets.

ExItaly
Let's look at three options. In the first one, Italy utilizes its newly-regained economic sovereignty for expanisive purposes. It introduces the new lira, invokes the Lex Monetae (Garner, 2001), and redenominates its debt. The government uses its regained ability to “print” money in order to protect itself from the risk of defaulting, as well as to finance the deficit with currency. In this way, it maintains low interest rates and stimulates demand with inflation being contained by the heightened output gap.

The Bank of Italy would strive to purchase the portion of the current public debt (as well as the newly-created debt) denominated by the new currency which the market isn't willing to absorb at low rates. This would entail a potential loss of control over the supply of new lire and over the limits on the expansion of public accounts, with the risk of lowering the value of the new currency and shrinking the demand for assets in this currency; it would result in rising inflation and the destruction of purchasing power and material wealth.

With the second option, the Bank of Italy would aim to support trust in the new lira, would increase the interest rates in order to contain the exchange rate's potential overshooting, would refuse to monetize the debt and deficit, and would allow the aggregated demand to adjust to the market's interest rates.

The fiscal authorities, for their part, reintroduce regulations in order to govern the debt and the budget. This option reduces the impact of the devaluation and enforces limits on the newly-regained economic sovereignty, creating a—somewhat paradoxical—situation in which Italy leaves the euro and re-adopts the same policies that it adopted before leaving!

With the third option, the government and the Bank of Italy take advantage of the sovereignty in the context of reforming the policy regime. They agree to a monetization plan for a significant percentage of the public debt, e.g. adopting Pâris and Wyplosz's PADRE proposal (2014), thus reestablishing better debt sustainability conditions, while the Parliament introduces:

• A dual objective for the monetary policy, in the pursuit of price stability and full employment (Saraceno, 2015)
• Stabilization of the debt/GDP relationship around the new post-monetization value
• The commitment to maintaining a balanced structural deficit, allowing for the non-cyclical use of taxation but with the obligation for a cyclical balanced budget
• Calling for the government and the Bank of Italy to coordinate in situations where the monetary policy proves ineffective (Ball et al., 2016).

This new regime frees Italy from the debt trap, restoring ample but controlled margins regarding the use of demand policies, and allows the country to switch to the new currency in an orderly fashion. The effects on the exchange rate depend upon the reform's credibility, but the external value of the currency benefits from the debt's increased sustainability and the best possible outlooks for growth.

As we've already outlined in these columns, should such an option prove unachievable, it would be better for Italy to remain in the euro but to adopt a “fiscal currency” as a monetary tool in order to complement the euro, which would allow Italy to support demand without violating the Eurozone's rules (Bossone et al., 2017).

The path to govern Italy's exit from the euro would be narrow. The exit's potential advantages would come much more from the policy regime that would accompany it than the devaluation of the exchange rate, as much as it could be contained.


Bibliographical References
Amato, M., L. Fantacci, D. B. Papadimitriou, e G. Zezza (2016), Going Forward from B to A? Proposals for the Eurozone Crisis, Working Paper No. 866, Levy Economics Institute of Bard College

Balls E, J Howat and A Stansbury (2016), Central Bank Independence Revisited: After the financial crisis, what should a model central bank look like?, M-RCBG Associate Working Paper No. 67.

Bossone B., M. Cattaneo, M. Costa e S. Sylos Labini (2017b), Moneta Fiscale: il punto della situazione, Micromega, in via di pubblicazione.

Durand, C., e S. Villemot (2016), Balance Sheets after the EMU: an Assessment of the Redenomination Risk, Working paper 2016-31, OFCE, October.

Garner, B. A. (2001), A Dictionary of Modern Legal Usage, Oxford University Press.

Nordvig, J., e N. Firoozye (2012), Rethinking the European monetary union, Wolfson Economics Prize 2012.

Pâris, P., e C. Wyplosz (2014), The PADRE plan: Politically Acceptable Debt Restructuring in the Eurozone, VoxEu, 28 January.

Realfonzo, R., e A. Viscione (2015), Gli effetti di un'uscita dall'euro su crescita, occupazione e salari, Economia & Politica, 22 gennaio.

Saraceno F. (2015), Challenges for the ECB in times of deflation, Employment Working Paper No. 183, ILO Employment Policy Department. Geneva: International labor Organization.


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