MIGHT the euro break up? Ever since the launch of the single currency, my answer to this question has been the same. In theory, a break-up is quite possible, even likely. In practice, it is completely out of the question, at least in the foreseeable future.
After the French and Dutch referendums I have had to revise my views. Senior Italian politicians have started openly to discuss the “exit option”. And they are right to do so, as their country slides deeper into recession while the European Commission issues lunatic demands for higher taxes and the European Central Bank stands by idly, quietly murmuring: “We told you so”.
This is an ominously familiar pattern for those who remember how Helmut Schlesinger, the president of the Bundesbank, methodically sabotaged Italy’s membership of the European monetary system in 1992.
It is hardly surprising, therefore, that reputable economists are issuing papers with such titles as “Italy: the next Argentina?”, and that some of the shrewder hedge funds are calling in lawyers to check on legal options if Italy decides to replace the euro with a “new lira” as the currency of denomination for Italian bonds.
Given these previously unthinkable developments, I have revised my view about a euro break-up. I still think it very unlikely but my argument for the single currency’s survival must be turned on its head. A break-up now seems plausible in practice but in theory it is totally unnecessary and could be easily avoided if European policymakers rediscovered a modicum of common sense.
To begin with, the practicalities. There is little doubt that Italy could gain short-term economic benefits from leaving the euro. By devaluing its currency, Italy could immediately boost exports, jobs and manufacturing investment — as it managed to do repeatedly up to 1999. Moreover, the real value of Italy’s huge public debt, equivalent to some 105 per cent of GDP, could be slashed by devaluation.
If Italy left the euro, the Government’s long-term bonds would continue to pay the present interest rate of only 3.5 per cent, but in lire instead of euros. Thus, the government’s liabilities would be transferred from a strong currency, over which it has no control, into a weak currency, which it could print at will. This may seem unfair and even fraudulent but such are the prerogatives of sovereign governments — legal opinion and historical precedent are both quite clear on this point.
To maximise the benefit from this effective debt default, the Italian Government would need to lock in today’s euro interest rates by extending the maturity of its debts for as long as possible before exiting the euro. This is exactly what the Government appears to have been doing. Italy’s average debt maturity is now over five years, roughly twice as long as in 1999, and a sensible exit strategy would be to extend this maturity to ten years or beyond.
Luckily for Italy, investors seem willing to buy unlimited quantities of ultra-long bonds denominated in euros at paltry yields of about 3.5 per cent. If Italy could fix all its debts at this level before ditching the euro, and if long-term lira rates initially shot up to 10 per cent after devaluation, the government’s debt would instantly be reduced to only 70 per cent of GDP. Italy’s fiscal problems could be solved at a stroke.
Italians might have to pay higher interest rates on future borrowings. But given that Italy has the world’s highest savings rate and little debt in the private sector, this should not be too much of a problem, provided the devaluation strategy was successful in reviving economic growth.
Growth is, of course, the nub of the issue: would exiting the euro stimulate growth in Italy in the same way as escape from the ERM did in 1992? The answer is almost certainly yes, provided the initial devaluation was big enough and the new lira was then allowed to float freely. The central bank could then manage interest rates to support the domestic economy and control inflation, rather than support the currency.
However, the benefits of an exit strategy today would clearly be smaller than they were in 1992, since interest rates and the currency both start from far lower levels than they did then.
This is where we move from historical experience to more reassuring theory. Italy would probably gain some benefits from unilateral devaluation. But, in theory at least, it could do better by staying in the euro, provided pro-growth policies were adopted by the eurozone.
The real economic problem in Italy is not weak exports but inadequate consumer spending, which in turn undermines investment, employment and government finances. The best response to underconsumption and mass unemployment, not only in Italy but throughout Europe, would not be devaluation but a bold reduction in interest rates — at least to the “emergency” level of 1 per cent that revived the US economy in 2003, and preferably to zero, as in Switzerland and Japan.
Such monetary easing would encourage a cycle of consumer borrowing and spending, employment growth, rising property prices and even higher borrowing and spending.
A lower euro would be a useful by-product of such a monetary easing but not the main point. To confirm this view I conducted a simple simulation on the global Oxford Economic Forecasting macroeconomic model. This suggests that a reduction in short-term interest rates to zero would increase growth to 3.2 per cent in Italy and to 3.5 per cent in the eurozone. Italian unemployment would be reduced to below 7 per cent at the end of the two-year forecast period and the government budget deficit would almost disappear. A smaller interest rate cut to 1 per cent would produce 2.7 per cent growth and roughly halve the government deficit.
The most convincing mechanism for a monetary solution to Europe’s economic and financial problems is evident from the charts, which show the enormous scope for higher household borrowing.
They also show the inverse relationship between household borrowing and government finances. When consumers start borrowing aggressively — as in Spain in the past decade, when mortgage debt increased from 10 to 42 per cent of GDP — this stimulates rapid economic growth, tax revenues and improves government finances. Where householders refuse to borrow — as they have in Italy, where the ratio of mortgage debt to GDP is only 11 per cent — the economy stagnates and governments are condemned to near-bankruptcy.
European leaders face a simple choice. Either slash interest rates to revive economic growth, cut unemployment and stabilise budget deficits. Or accept the break up of the euro and quite possibly the collapse of the European Union.
