This post originally appeared on Credit Writedowns
Editorial note: this article is neither a policy recommendation or a prediction. Rather, this articles looks to outline one potential outcome of the current policy choices in the European sovereign debt crisis, building upon the discussion from three recent articles “Deflationary crisis responses”, “Predicting the future of policy making”, and “Why France will be forced out of the eurozone”.
One week ago today, I was running through Italian default scenarios because the policy choices in the sovereign debt crisis have narrowed with most of the risk being on the downside. At the time, I asked “Could Italy unilaterally exit the euro zone and redenominated euro debts at par into a new Lira currency to forestall the default? Perhaps. That is something to consider at a later date. For now, here’s what will happen if Italy defaults.”
That later date is now. So let’s get cracking on what would bring about a unilateral Italian exit and how it could be accomplished.
Nationalism and “Beggar Thy Neighbour” economic policy
Let me quote something as a jumping off point which applies here that I wrote nearly three years ago about Ireland and what I correctly predicted would be a banking crisis.
Ireland must threaten to leave now if it wants to maximize any EU help it expects to receive, before the scope of other EU banking crises become apparent. Weakness in the financial sector has infected all of the Eurozone members. I have mentioned that Austria has a weak banking system (see posts here and here). But, there is even growing evidence that Germany too has a fragile banking system. To be clear: this is an ‘every nation for itself’ strategy pitting Eurozone members against each other, where those nations savvy enough to request help sooner are likely to benefit at the expense of others. The question is whether the Germans would go along with this. If they do not, tensions will rise and that will change the calculus for Portugal, Italy, Ireland, Greece, and Spain. I don’t have a view on this as yet because the situation is still evolving. However, I lean toward believing the Eurozone will remain intact even while individual nations or banking systems collapse.
As events occur in Eurozone banking, I will keep you abreast on developments.
–The Eurozone and the spectre of banking collapse, Feb 2009
When the chips are down, an us versus them mentality starts to seep into policy choices. What happens is that significant economic downturns create economic distress that causes people to circle the wagons. One day, it’s boom time; all is well and we are full of hope for the future. We are minding our business, working hard, tending to our families and enjoying life. The next thing you know, the economy is in a deep slump; we or some of our neighbours are jobless, penniless… and angry. What caused this? Who caused this?
When times are tough, people start looking for someone to blame. And usually it is not the In-group which gets the blame; it’s usually “them”: out-groups like minorities, immigrants and foreigners. Dylan Grice calls this “in-group bias” and predicts the following:
The historic and psychological evidence clearly links economic dislocation with the scapegoating of out-groups and, of course, the eurozone edifice stands increasingly lonely and tall as a lightning rod for the latter. I believe the likelihood is that over the course of the next decade or so, the trend will be towards greater fiscal problems and greater economic problems. I believe these problems will increase the temperature of debates about whose fault it all is, and that as the conclusion to these debates becomes more polarized they will play into the hands of nationalist, anti-immigrant and increasingly, anti-euro sentiment.
If the downturn is protracted enough and deep enough, this us versus them mentality spreads into the mainstream at the political and national level. And we see economic nationalism, an ‘every nation for itself’ strategy enter mainstream politics. That’s what World War I, the Great Depression and World War II were all about. So I expect no different here with the sovereign debt crisis if policy choices point mostly to downside scenarios.
The saving grace highlighted in the Irish example above is that it really does take longer for these things to play out than one expects. I was talking about the European banking crisis in early 2009 and here it is late in 2011. So that tells me, with the right leaders and right policy choices, none of these downside scenarios is automatic. They may be likely, but there is reason to hope and exhort leaders to prevent calamity.
The Current Situation in Euroland
Unfortunately, these last three years have been largely wasted. Instead of bank recapitalisation, credit writedowns and rebalancing in the euro zone, we have seen self-serving and one-sided morality tales of sinful fiscal profligacy and creditor-centric policy solutions that are wholly inadequate to fix the institutional deficits of the euro zone. This morality tale is really a fairy tale. Spain is the perfect example of a country that never should have joined the euro zone. It had a fiscal sur right through to 2007 and still has better numbers on debt than Germany. The last of the three articles upon which this discussion is built, the excerpt I posted last night by Philip Whyte and Simon Tilford, is magnificent in laying these unfortunate circumstances.
The question then is what now? How do the Europeans escape this roach motel of an economic prison they have constructed while still respecting the laws of the existing unworkable institutional structure? No one wants a free for all.
We see now that Italy will default without the central bank acting as a lender of last resort. And Italy’s default would trigger a cascade of interconnected bank runs default and Depression as did the insolvency of Creditanstalt in 1931. German policy makers are aware of this. The Irish Times has written how Merkel’s pragmatic allies offer hope of new outlook whereby the euro zone evolves toward a more integrated fiscal union with penalties for free riders and an exit clause for those that can’t make it. Germany is moving fast to implement this solution.
Alas, this is a flawed project for two reasons. First, trying to make the ‘sinners’ of the eurozone periphery more Germanic fails to understand the dynamics of intra-European capital and current account balances. Put crassly, the euro zone is one giant vendor financing scheme. You can’t have Germany and Spain both running current account sures with each other at the same time. The imbalances will continue.
Second, Policy makers have run out of time. They caused this problem by dithering; we wouldn’t be here if they had cut the cord early on. I still think the ECB will move eventually. But it will be too late; the debt deflation will have already set in, aided and abetted by a growth-crushing fiscal policy strait jacket that in the last month has moved from the periphery to France, Italy and Austria as contagion has spread.
The Italian Job
Even so, the ECB may not move at all. And therefore, we must run through the various worst-case policy remedies available and think about which one could be chosen.
What about a unilateral exit from the euro zone? I ran through the exit scenario a year ago and it looked bleak, one reason I saw it as unlikely at the time. But things have deteriorated and so the best alternative to a negotiated agreement for policy makers in Italy may well be exit.
So I have been thinking about this and have come up with an outline plan. The plan is based on how countries exited the gold standard during the Great Depression. I have said many times that the euro is like gold.
The euro has acted as an internal gold standard to euro zone members in that it prevents governments from printing money and devaluing to escape economic hardship and it ensures that large fiscal imbalances cannot be sustained and eventually lead to crisis.
I like to think of the Euro as gold and the Euro countries as having implicitly retained their national currencies with a fixed rate to the Euro. If you recall, that actually was the setup when the countries pegged their currencies to the ECU before Euro money was introduced.
So the euro area countries can de-peg like the gold standard countries did and unwind the euro structure by running the “euroization” process in reverse. Here’s how one could do it.
- Plan. The Italian government can plan for a redenomination into New Lira in secret that takes advantage of the Italian law jurisdiction over their sovereign debt obligations.
- Law. “Euroization” would remain in place and the euro would continue as the currency of physical payment. However, New Lira would become the national currency, pegged at 1,936.27, exactly the same rate as the Lira was fixed on 31 December 1998 and converted into euros on 1 January 2002. All debt under Italian law would be redenominated into New Lira at the 1,936.27 New Lira exchange rate peg. This would effectively bring us back to 31 December 2001 for Italy.
- Taxes. The government would announce that henceforth it will tax exclusively in New Lira. All municipal governments would be required by law to tax in New Lira.
- Banks. Like the Argentines before them, the Italian government would convert all euro bank accounts legally into New Lira. The systems would process as if it were euros because of the fixed peg, but legally the money would be New Lira. This would make the Italian economy “euroized” but make the banking system redenominated into New Lira.
- Retail. Retailers, all sellers of Italian goods, would then be forced to return to the double accounting treatment of pre-2002 whereby they denominate all transactions in both Lira and Euros. Again, the paper money would be euros and each euro would initially be worth 1,936.27 New Lira. The electronic money would legally be New Lira, even while the systems said euro.
- Float. On day one, immediately after redominating, the Italian government would drop the 1,936.27 New Lira exchange rate peg and float the new Lira as a freely floating currency. From that day forward, foreign currency adjustments would need to be made between euro and New Lira.
- Physical currency. New Lira would be printed by the Bank of Italy and introduced to replace euros.
The hard part is about capital flight, inflation and the cost of retooling the systems for New Lira. But this is all a one time cost. Warren Mosler wrote up a plan like this for Greece that Randall Wray featured here last week. In his scenario, euro bank deposits remain as euros and existing euro denominated debt would remain in euros as well.
Staying in the zone. The political repercussions of a redomination would be huge. Although I have talked about this as a eurozone exit, it could be just a redomination, meaning that the New Lira would depreciate and Italy could fully re-euroize the economy without leaving the euro zone. Since we’re running through scenarios, we should consider this outcome, as countries in the Depression did eventually re-peg to gold via the Bretton Woods currency regime. But I think the impetus here is to escape the euro and the persistent current account deficits as well as to escape the anti-growth policies of the euro zone that have caused Italian sovereign debt levels to spike. Moreover, it is unlikely that the German plan of fiscal oversight, penalties and exclusion would solve Italy’s fundamental problems of low growth and eroding uncompetitiveness in a currency with an elevated value.
Inflation. This would be mitigated by the taxation policy which would give the new currency value. But we see how Iceland has battled inflation in the wake of a large currency depreciation. In some ways you could consider this a one-time standard of living adjustment. But the adjustment will be severe since markets tend to overshoot to the downside. It’s not clear how low a New Lira would sink, and so inflation would be a big problem.
Bank solvency. This was the biggest issue to begin with. The redomination solves Italian bank solvency since all their accounts would be in New Lira. But this solution heaps all of the burden of adjustment onto foreign lenders via the exchange rate adjustment. German, Dutch and French banks would be insolvent if the New Lira lost a lot of value as they would be repaid in depreciated currency. I think this point highlights what I have been saying about apportioning losses in a creditor-friendly way. The foreign lenders have used the fact that the euro is one zone to lend cross-border and increase their return on equity. They bear some of the responsibility for the credit growth in the periphery. The foreign currency losses they would take from a New Lira demonstrates this.
National Solvency. That problem would be solved. The burden of adjustment would then fall to the exchange rate.
Contagion. Clearly, an Italian exit would break apart the euro zone. All of the countries now on the hot seat would consider redominating as well. Once a euro exit takes place, it would be a mad rush to follow. In France in particular, politicians would be desperate to redenominate and depreciate the currency in order to escape the foreign currency losses. Thus would begin a currency way via competitive currency devaluation.
In conclusion, a unilateral exit would be a devastating event for Italy and the euro zone. Inflation would be high but bank and national solvency issues would recede. If the exit were done under these nationalistic pre-conditions of redomination, most of the adjustment burden would fall on foreign creditors. Italy would become export competitive again and could focus on economic growth strategies instead of ones of fiscal adjustment. The benefit of this particular plan is that it can be implemented quite quickly.
Just as during the Great Depression, those countries that left the gold standard first saw the earliest return to economic growth. I would expect the same to be true here again for the euro area countries today.