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Macroeconomics and the Clash of Civilizations

Is Italy likely to exit the EMU in the future?

February 17, 2006

Is Italy likely to exit the EMU in the future?

I lead the life of an economic analyst and university professor. Involved in such a career, it does not happen often that a panel discussion assessing the economic prospects of countries around the world is turned into a mud-wrestling session.

The prospect for such a turn of events is especially low if you are engaged, as I was, in a debate with the head of the European Central Bank, the EU Commissioner for Economic Affairs — and Italy’s Economic Minister and Deputy Prime Minister, Giulio Tremonti.

And yet, as I presented my thoughts about the problems and risks faced by the European Monetary Union (EMU) and the risks of a break-up, this is precisely what happened. My offense? I had just begun to argue the case that Italy looks increasingly, in my view, quite similar to Argentina before its financial crisis.

I was interrupted in the middle of my remarks by Minister Tremonti, who went into a temper tantrum and shouted — to the consternation of all participants — at me: “Go Back to Turkey!”

As it happens, I was born in Istanbul — and I grew up in Italy — as I had noted at the beginning of my remarks.

I replied to the irascible minister that his boss, Prime Minister Berlusconi, had declared in public that the euro has been a “disaster” for Italy. To which the minister retorted with another round of insults.

More than offensive to me, his burst of uncivilized anger was an insult to the decent Turks who are currently trying to negotiate an agreement to enter into the EU.

Also, while both Argentina and Turkey had a severe financial crisis in 2001, the former went into a severe currency, banking, corporate and sovereign debt crisis that was associated with the largest sovereign debt default in history. Turkey, instead, pursued a policy of fiscal adjustment, macroeconomic and structural reforms that avoided a sovereign default.

While Italy’s economic troubles increasingly look like those of Argentina, Italy may learn a lesson or two from Turkey’s reform on how to put itself on the right track. In terms of macroeconomic and structural fundamentals, Turkey looks today like a better and more fitting candidate for EMU than Italy.

So, instead of insulting the hard-working Turks, Mr. Tremonti may himself want to go to Turkey and learn a few lessons on sound economic policies.

But let me report now some of my constructive remarks on EMU that triggered the outburst of the minister.

I was an early and strong supporter of the idea of a European Monetary Union, but my current concerns are that, while EMU has lead to a process of convergence of nominal variables (inflation, interest rates, etc.), it has also been associated with a process of increased divergence in economic performance, especially regarding economic growth rates.

This economic performance divergence is a serious problem for some EMU countries (Italy, Portugal and Greece) and it may eventually lead to a collapse of EMU.

And unfortunately, the lack of serious economic reforms in Italy implies that there is a growing risk that Italy may end up like Argentina. This is not a foregone conclusion, but — if Italy does not reform — an exit from EMU within five years is not entirely unlikely.

Indeed, like Argentina, Italy faces a growing competitiveness loss given an increasingly overvalued currency and a risk of falling exports and growing current account deficit. The growth slowdown will make the country’s public deficit and debt worse — and potentially unsustainable — over time.

And if a devaluation cannot be used to reduce real wages, the real exchange rate overvaluation will be undone via a slow and painful process of wage and price deflation.

But such deflation will keep real interest rates high and exacerbate the growth and fiscal crisis. Without necessary reforms, eventually this vicious circle of “stagdeflation” would force Italy to exit EMU, return to the lira — and default on its euro-denominated debts.

Some argue that Italy or other EMU laggards would not exit EMU, because a sharp devaluation of the new lira — needed to regain the lost competitiveness — would make the real value of euro debt much higher and unsustainable for the government, the private sector and households.

But look at what happened to Argentina: it devalued its currency and given the balance sheet effects of the depreciation on the country’s U.S. dollar-denominated debts, it was forced to convert its dollar-denominated debts into pesos.

Similarly, Italy would be forced to liralize its Euro debts. If Italy were to exit EMU, this effective default on domestic and external — public and private — euro debt obligations would become unavoidable.

And a sovereign nation is able to follow such policies — EMU exit, return to national currency and effective default on euro debt — regardless of any legal or formal constraints that the EMU treaty imposes in terms of no exit clauses.

This is not science fiction as Argentina was forced to do the same.

What would be the systemic effect of such Italian exit from EMU?

The consequences would be extremely severe on EU capital markets, as Italy would also default on some of its external debt — the part of its euro debts held by non-residents.

The contagion effects to other EU capital markets and banks would be severe as well.

And the “no bailout rule” of the European Central Bank would become effectively threatened as the ECB would be forced to monetize both liquidity and solvency-induced runs in Italy and other eurozone members to avoid a systemic effect on EU financial markets.

In conclusion, my view is that EMU can work and has worked for the eurozone countries that have reformed and are reforming.

But, unless Italy and other eurozone laggards change their policies to pursue serious economic reforms that restore competitiveness and growth, they will eventually be forced to exit EMU.

This would be a disaster, but a disaster that may become unavoidable unless policies change.

And I am currently pessimistic about the chances that such changes may occur, given the policymakers and policies currently in place in countries like Italy.

It was this range of remarks that triggered the temper tantrum of Mr. Tremonti that embarrassed him and his government in front of a prestigious world forum.

The hapless minister was obviously already defensive. Italy had taken a beating at Davos, with Goldman Sachs’ chief economist Jim O’Neill saying that Italy was only good for soccer and food — and with Italy being ranked in the low 40s next to Botswana in the World Competitiveness Report of the WEF.

His semi-racist offense at Italy being compared to Botswana (“We are not Africa”) rang as hollow as his calls for me to go back to Turkey. Botswana happens to be one of the African countries with better institutions and with an impressive record of economic growth.

Maybe Italian policymakers should show some humility and could learn a lesson or two on sound economic policies from countries such as Turkey or Botswana.