Friday, September 15, 2006

Italy and the Eurozone

John Kay had an article in the Financial Times earlier in the week, and this seems to have caused quite a ripple around the blogsphere (Eurozone Watch, Economonitor, Claus Vistesen at Alpha Sources). The article was about whether or not it was technically possible for Italy to leave the Eurozone. (Update: Sebastian has a fresh post over at Eurozone Watch Blog continuing the discussion).

John Kay's conclusion, and it is supported by a very reasoned commentary by Sebastien Dullien at Eurozone Watch Blog (welcome Sebastain and Daniela), is that there is no in-principle technical difficulty in exit. The most authoritative piece of work on this topic that I know of comes from Harvard International financial law specialist Hal Scott. The paper was written back in 1998, and was provocatively entitled "When the Euro Falls Apart". Despite the title the paper is a tightly reasoned piece of work whose main conclusion is that not only is euro-exit technically perfectly feasibe, in fact the mechanisms which would make this possible were incorporated from the start (in particular keeping independent central banks with their own reserves). I think those who were able to think clearly back then - and were able to use some emotional intelligence - were always aware that there were question marks over Italy's ability to go the distance.

So the problem is not a technical one. But as John Kay indicates it *is* a political one:

"But what of financial and commercial contracts made in euros before A-day but not yet completed?

The simple answer is that an agreement in euros stays in euros. But this is not politically feasible. Italians would not accept that their mortgages and credit-card debts, denominated in euros, would cost them one-third more to repay: and it would be absurd if the bank deposits of Italian residents were revalued by a similar amount.

The relevant principle of international law seems to be that debts are denominated in the currency of the place where they are to be paid. But in the modern world, that question often has no clear answer

This then is going to be the question *when* Italy leaves (I say *when* since I have no doubt that she will, the demography makes that inevitable, and here, and here, and here). So it is perfectly coherent to argue that Italy can leave. This however is the moment when the debate normally veers off in a southerly direction - towards Argentina - and Argenitina seems, as usual, to generate more heat than light, since the argument tends to move away from Italy and its specific problems, towards a 'what really happened to Argentian debate" (welcome new blogger Felix), which is, of course interesting, but sometimes it is helpful to discuss just one thing at a time. So going round a rather more circuitous route, let's think for a moment about what just happened in Turkey and in Hungary. Two economies which were on an unsustainable external deficit course were brought back sharply into line by a sudden, large drop in the value of the local currency. Judging by posts and comments on this site we seem generally to be agreed that having such flexibility was a good thing, since it enabled these economies to correct and adapt before a big crisis (hard landing) situation built up.

So what about Italy? Well Italy as we know cannot go down this road, and Italy has, in fact, used the cheap finance made available by the eurozone not to reform, but to avoid reforming. This, at least, was the conclusion reached by two highly respected European economists (Romain Duval and Jørgen Elmeskov) in a widely quoted paper entitled The effects of EMU on Structural Reforms in Labour and Product Markets

So Italy is unable to correct, and the inbuilt problem is growing. The Italian economist Francesco Daveri (who is a specialist in technological change and ageing) makes the important point in this podcast for Radio Economics that Italian economic growth *peaked* in the 1950's at around 5% per annum. Since that time it has dropped steadily at the rate of about 1% per decade, and in the 1990s was at an annual rate of about 1% per annum. Following this trajectory, and what we already know, it is not unreasonable to imagine that this decade the Italian economy will flatline (an average of 0% growth) and possibly enter negative territory in the next one (say -1% pa 2010-2020). Of course this situation makes a complete nonesense of the neoclassical theory of 'steady state' growth, but that is a problem for that particular theory, it doesn't mean that what is happening isn't hapening (I have a post about this issue in the context of Germany, Japan and Italy on Demography Matters). So the question is, where does that leave the problem of Italian public debt currently running at 105 - 110% of GDP? Unsustainable, that's where it leaves it. And the only way for Italy really to get to grips with the situation is to recognise that it cannot resolve this problem and default. This default is unlikely to be possible inside the eurozone, and hence Italy will leave. This is a question of simple economics, not popularist politicians.

Which brings us to the last point before the last: won't this cause chaos? Well of course it will, this is why it would be better that people come to terms with this rationally rather than making it an emotive topic.

Now for the last point. John Kay rightly laments:

Any international bank or business should contemplate these issues. But the consequences of such contemplation are grave: in financial markets, actions to protect against a contingency make that contingency more likely. That is why a debate on the fragmentation of the eurozone is a debate that no one dares have.

And John Kay is right, debate on this topic will probably make default happen sooner. I remember the heartsearching Paul Krugman went through when it became obvious Argentina was going to default. Such situations pose special problems for those economists who can, to some extent, see what is happening. But my conclusion was in that case, and it remains the same today, that if something is unsustainable it is better to recognise this sooner rather than later: quite simply the damage is less. If Argentina had defaulted one year earlier, then the politics of the default transition would have been much easier. Basically, if you ask people to make a lot of sacrifices for a project that can't work you can hardly blame them if they are not in the mood for another round of sacrifices after it turns out that the earlier sacrifices were in vain. This is as true for the Italy of 2007 as it was for the Argentina of 2000. I think we would all do well to remember that.

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