photo: Elliott Brown
Durand and Villemot (2016) examine two nncreasingly likely Eurozone scenarios – a single country exit and the complete breakup – concluding that while both scenarios should be taken seriously, their consequences should not be exaggerated. In particular, in the case Italy were to leave the euro – the scenario I will henceforth call ‘ExItaly’ – the authors estimate that the ‘new lira’ would revalue by 1% vis-à-vis the rest of the Eurozone, owing to the country’s current account surplus position. It is certainly a reassuring conclusion if confronted with the pessimistic predictions of those who argue that the balance sheet effects of exit events would be large (e.g., Nordvig and Firoozye 2012) or that breaking up the Eurozone would be more costly and difficult than holding it together.
According to an alternative scenario, Italy’s regained external competitiveness after leaving the euro would induce all other southern European countries (including France) to follow through, thereby causing the end of the euro. More prudently, Realfonzo and Viscione (2015) consider ExItaly as a way to economic recovery, but draw from the 1992 European exchange rate crisis the lesson that output growth and employment depend more on the quality of monetary and fiscal policies following exit than on the abandonment of the old exchange rate arrangement per se. I will return to this critical issue below.
Who’s right and who’s wrong? And what would be the consequences of ExItaly for Italy and for Europe?
Smooth flow adjustments or traumatic asset price bumps?
In a world economy dominated by finance – where the total turnover in FX markets exceeds $5 trillion per day as compared to total global exports of goods and services and foreign direct investment totaling $24.5 trillion in a whole year – it is hard to imagine that a euro exit or breakup event would unfold in such an orderly fashion that exchange rates would smoothly adjust to the new purchasing power parities and interest rates would efficiently reflect anticipated inflation differentials.
In the case of a heavily indebted country like Italy, a much more likely scenario would be one where Knightian uncertainty in the presence of unprecedented political and economic circumstances would trigger unpredictable asset price dynamics. These would be driven more by stock (debt sustainability) considerations than flow (external trade) imbalances, they would incorporate large risk premium factors, and would possibly settle at ‘bad’ equilibrium levels for a long while.
Yet, as one tries to look through the thick blanket of uncertainty, no realistic predictions could be attempted without making hypotheses on the underlying policy regime adopted by the country exiting the euro. Importantly, the choice of regime would affect the country’s policy credibility and would in turn be affected by it.
ExItaly and policy regime options
Let’s examine the following three options.
Exploiting policy sovereignty
Italy introduces the new lira and invokes the Lex Monetae (Garner 2001) to redenominate its debt into the new currency at a given conversion rate. The aspiration behind this option is that the Government would recover policy sovereignty and use it to pursue expansionary objectives free of external constraints, while its regained power to print money protects it from the risk of defaulting on its own debt obligations. Accordingly, with the suppression of central bank independence, monetary financing of the deficit keeps interest rates permanently low, reduces the cost of servicing the debt, and sustains a high level of aggregate demand. With low subdued prices and wages, there is no concern for undesirable inflationary consequences.
Letting aside any legal impediments to debt redenomination (Weidemaier and Gulati 2017), the question is about the real chances of success of this option. The answer lies on the issue of policy credibility. In the absence of fiscal and monetary policy backstops (as implicitly assumed under this option) and the consequent high risk of policy moral hazard perceived by the markets, the new lira would seriously suffer from lack of confidence. In such a scenario, the Bank of Italy would have one of two options:
- Peg the interest rate on public debt to an artificially low level – it would then have to commit to purchasing all the outstanding and newly issued (redenominated) public debt that the market is no longer willing to absorb (if not at very high interest rates) especially considering debt redenomination as technically a default. This causes the Bank of Italy to lose control over the supply of the new lira and effectively removes the budget constraint from government: the expected internal and external value of the new lira falls freely, crushing the demand for Italy’s debt (as well as for all liabilities denominated in the new lira) which has to be entirely financed by the Bank of Italy. This prompts further injections of new liras. Exchange rate overshooting would be deep and persistent, and the contractionary and income regressive effects of inflation may no longer be ignored.
A comparison of this option with the debt monetization de facto pursued in the aftermath of the global crisis by the central banks of the US, UK and Japan through QE does not hold – these countries’ currencies never lost the confidence of the markets, while the unknown new lira would not be supported by comparable credibility capital. Besides, QE is a different story. It is not about deficit financing, it is done when the interest rate is at its lower bound and is carried out by highly credible central banks within their price stability mandates. In the case above, the action would be undertaken because markets want to get rid of the debt.
- Alternatively, the Bank of Italy aims to prop confidence in the new lira – it thus raises interest rates to wherever the markets so determines, and refuses to accommodate budget monetization and to support demand. The fiscal authorities, on their side, need to reintroduce rules to govern debt and the budget. Also, the lack of confidence require the authorities to plan and enact the changeover to the new lira very rapidly and secretly in order to prevent flight-to-quality reactions from the markets and the public – a practical impossibility. This option put a limit on the full exploitation of policy sovereignty.
An ‘unconstrained’ policy regime for Italy exiting the euro could become a source of instability for all of Europe and beyond. Whatever small probability one would assign to this scenario, its potentially damaging consequences should induce wise politicians and policymakers to never neglect its possible occurrence.
Fixing the debt and restoring confidence
As above, the new lira is introduced and debt is redenominated. However, having a clear concern for market reactions, the Italian authorities signal – ex ante – a commitment to a new policy regime. This consists of Government and the Bank of Italy to agree on a one-off monetization plan of a large share of the public debt, similar to the PADRE proposal by Pâris and Wyplosz (2014). The plan is intended to enable Italy to restore debt sustainability, and is accompanied by a redesign of the country’s economic policy architecture that involves the introduction of:
- A dual objective for monetary policy of price stability and full employment (Saraceno 2015), accompanied by strong accountability mechanisms for the Bank of Italy. The Bank of Italy’s new mandate could in fact be further extended to include the use of macro-prudential instruments to ensure financial stability.
- A debt-break rule establishing a ceiling to the stock of public debt as a ratio of GDP, to be monitored and enforced by Parliament and providing for a qualified majority to revisit the ceiling under extraordinary circumstances.
- A government obligation to maintain a structural balanced budget, with flexibility for using fiscal policy counter-cyclically and a commitment to balance the budget across cycles.
- An understanding that Government and the Bank of Italy would coordinate their acts in the event of severe recessions (Bossone 2015; Ball et al 2016).
Such a policy regime would free Italy from the debt trap that currently constrains its policy space beyond reason, permit its smooth transition to the new domestic currency, and allow it to recover the use of demand management policy while preventing irresponsible policy actions from prejudicing medium-term financial stability. The new regime would have to be more than well communicated, though.
Even so, the credibility issue is still there – the very decision to exit could work as a powerful signal that undermines it.
Introducing ‘fiscal money’
Ideally, ExItaly should be considered only from a position of national economic and political strength – a very far cry from today’s situation. Such strength might enable the Italian government to exert on its euro partners the pressure needed to reform the architecture of the union in a desirable direction, before eventually deciding to exit should this pressure fail to hold the desired results.
Under the circumstances, a position of strength could be achieved only by reviving the domestic economy through a demand policy. This can be done via the introduction of fiscal money in the form of tax credit certificates issued to households and firms (Bossone and Cattaneo 2106a,b). These certificates grant holders the right to claim for tax rebates two years after their issuance, but can also be securitized and immediately spent on goods and services. They represent additional disposable income for households and a tax wedge cut on firms’ wage bills, which boosts export and import substitution. The issuance of certificates would not alter the current budget deficit (Eurostat 2014), and with an income multiplier slightly less than one their effect on output over their two-year maturity would be such as to generate enough fiscal revenues to cover for the cost of the future tax rebates. With an income multiplier of 1.2, on the other hand, a yearly issuance of certificates in the order of little more than 1% of GDP would close Italy’s output gap in four years (Mediobanca 2015), improve the country’s fiscal deficit and reduce its debt/GDP ratio.
The fiscal money option would allow Italy (and any Eurozone crisis country) to create and utilize fiscal space without violating the Fiscal Compact, without threatening the integrity of the euro or triggering financial market instability. This option would prepare Italy to a soft exit from the euro, if such decision were ever to be taken. The fiscal money instrument (and its supporting infrastructure) would facilitate the transition of the country to the new domestic currency.
A growing Italy, which reduces its debt burden, is good for the country, for Europe and the rest of the world.
The consequences of ExItaly are not independent of the policy regime that would accompany it. The choice of regime would have a direct reflection on the policy credibility that would inevitably influence global market expectations, especially since Italy’s massive public debt makes its economy vulnerable to market sentiment, irrespective of the currency of debt denomination. This would in turn affect the final outcome of the exit process.
Adopting proper institutional arrangements is the only way towards credibility, but even that would not be enough – the proof of the pudding would only be in the eating. Meanwhile, the markets would focus on risks. The first fear would be the exit itself.
Evaluating all available policy regime options in the light of their bearings on policy credibility is therefore essential to minimize the systemic risks that Italy, as well as Europe and the broader international economy would all face in the event of ExItaly.
Author’s note: I wish to deeply thank Charles Wyplosz for his very helpful remarks on a previous version of this article. Of course, I am the only responsible for the opinions expressed in it.
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 According to the authors’ estimates, in a breakup scenario the revaluation of the “new lira” against the rest of the Eurozone would be associated with the much larger exchange rate appreciation of Germany (+14%), Luxembourg (+14%), the Netherlands (+15%), and Austria (+15%) and, symmetrically, the significant devaluation of Belgium (−17%), Greece (−38%),
Spain (−10%), France (−11%), Portugal (−14%) and Finland (–18%).
 From a quotation of Barry Eichengreen intervening at a panel discussion of the American Economic Association’s meeting, as reported by Greg Robb, “As Greek euro exit would be ‘Lehman Brothers squared’: economist”, MarketWatch, January 5, 2015.
 I am grateful to Marco Cattaneo for calling to my attention the possibility of such scenario.
 When talking about Italy and the 1992-1996 period following the European exchange rate crisis, reference is usually made to Italy’s commercial balance of payments, but no mention is made of the fact that GDP collapsed in 1993 (the year after the lira exited the Exchange Rate Mechanism) and 300 thousand jobs were lost in that year and the next, showing that the, increase in export did not create enough employment to offset the jobs that were lost.
 Data on FX turnover are from Moore et al (2016) and refer to year 2015; data on trade and investment are from the World Trade Organization’s International Trade Statistics 2015, and refer to 2014.
 This is the opposite of the QE context. In fact, it would rather be a sort of ECB’s Outright Monetary Transactions (OMT). OMT was a success because not a single euro was spent. If the ECB would have had to undertake large scale purchases, doubts would have surfaced. In a post-exit situation, it would be quite unlikely that such a result could be achieved.
 There are so many examples of central banks becoming hostages to governments (Germany in the 1920s, postwar US before the accord, Zimbabwe, Argentina, and many more) that the disasters brought about by fiscal dominance cannot be in doubt.
 Fiscal money is any claims, private or public, which the state accepts from holders to discharge their fiscal obligations either in the form of rebates on their full value (tax discounts) or as effective value transfers (payments) to the state. Fiscal money claims are not legal tender, and may not be convertible by the state in legal tender. However, they are negotiable, transferable to third parties, and exchangeable in the market.