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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About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

57 thoughts on “Italy and the Eurozone

  1. Charly (with all due respect) neither Sweden nor Denmark were original members of the EEC. Italy was a founding member. Sweden and Denmark have not been instrumental in the European project. So while you presume to understand the European culture, or even indeed to DEFINE it, Europeans (meaning the founding members of the EEC) obviously don’t see it the same way you do. Sweden and Denmark are late comers who joined in once it was obvious that the EEC was a success. As, indeed, the Euro is a success. Despite attempts by people like John Kay to destabilize the Euro.

    Britain attempted to join, was turned down twice, and finally joined to the chagrin of some existing members. Many see the British merely as sand in the wheels, preventing progress and generally behaving badly because Britain is not at the helm of the project. Norway is still not a member either of the EEC or of the Euro. Scandinavia is not really the centre of the European project AT ALL. The countries who joined opportunistically after it became clear that the EEC was a success neither define the EEC, the Euro, or the goals of the European project. But then you don’t know that because you know nothing about the topic at hand. If you wish to pass comment about what EUROPE is it would be helpful if you were at least a litte familiar with Europe itself.

    Your offensive comment adds NOTHING to the discussion here. But then that wasn’t really your intention, was it?

  2. I wrote Europe, not EU and i did not do that by accident. Scandinavia has a population smaller than the Benelux so the fact that they aren’t the core of Europe is obvious. But Germany, which is the core, is cultural very close to Scandinavia.Add France and their historic view of the Italians and i seriously doubt that you can call Italy a essential part of the Union. But has Italian i bet you would think differently about that

  3. We are talking the EURO here. The EURO is part of the EEC. The EURO has been a natural progression from the EEC monetary system. And it works. Italy is a founding member of the EEC and a founding member of the EURO. For a lot of people in Europe Italy is more important and more central to European culture than say the descendents of the vandals and visigoths and those who used to be (and in some quarters still are) called barbarians. Perhaps you are not aware of that.

    Watch say “My Big Fact Greek Wedding” to get a slightly different perspective. The culture of Northern Europe is not universally revered. Although you may not be aware of that fact, it is still true. The Anglo-Saxon world, and indeed Germans, seem to be obsessed with the success of the Roman Empire (and both have tried to emulate that success with laughable results), at the same time though there seems to be this need to denigrate Italy which was the centre of the Roman Empire and the Renaissance. What is it with you guys: jealousy ?

  4. And one thing you seem to have missed: France went to war with GERMANY over and over and over over the past few centuries. There is no history of anything like that kind of hostility between France and Italy. NONE. Don’t know where you get your views boy, but they need serious revising.

  5. France had the institutional ideal of having natural borders like the Pyrenees, Alps and Rhine. Conquering the area between Ile de France and the Alps was easy. Mostly because that part of France isn’t that fertile. The area between the Ile de France and the Rhine is fertile which makes keeping it much harder

  6. Italy’s certainly a major player in the European Union. Leaving aside the question of where northern Italy fits–central Europe, perhaps?–the Mediterranean has been a major participant in Europe’s various exchanges. If nothing else, at the beginning of the European project the Mediterranean was Europe’s first true periphery.

  7. These ideas about Italy are based on ignorance and prejudice. There are no facts quoted and that is also the basis for the discussion of Italy’s ‘potential’ to exit from the Euro. I’ve heard this type of thing before. A big U.S. players spread the word in the 1990s that: a) Italy would default on outstanding Government debt in order to encourage Lira selling (this particular player was obviously short Lira). The rumour spreading ignored the fact that pretty much ALL of Italy’s Government debt was held by Italian households and not even traded on the secondary market. Default was unlikely, it in fact did not take place.

    This type of “analysis” and rumour mongering usually hides a bottom line somewhere for somebody and it plays on the ignorance of economic facts and prejudice about Italy and Italians. Italy’s transformation to an industrial power post WWII was on par with the transformation of Japan. Fact. Now that the Americans no longer have an interest in Italian political affairs, after the fall of the Berlin War (ie. to keep the Comunists out and to prevent ‘strong’ government via an imposed post-War constitution), there has also been progress on political stability, electoral reform etc.

    The facts do not support a negative outlook on Italy, quite the reverse. I won’t go into them here but evenutally I will post on my blog, just because I can’t stand this total ignorance passing for analysis. Has anyone here even quoted a single statistic or real hard fact regarding the Italian economy ? I can’t find any.

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