September 13, 2006
My last post on exit options for EMU has caused quite some stir in the blogosphere. Not only the new blog on Roubini’s RGE Monitor, “Economonitor” by Felix Salmon, but also Edward Hugh on “a fistful of euros” and Claus Vistesen on “alpha.sources” as well as a good dozen on readers in the comment sections of these sites have reacted to my – obviously provocative – post.
Reactions have been mixed. While Felix seems to believe I am some madman, just by proposing that Argentina could be a role model in the eyes of anyone, even in those of Italian populists, Edward and Claus have been much more sympathetic. Some commentators have even proposed that there is an anglo-saxon conspiracy to derail the EMU project (hi Paris Ib).
Maybe I should first make again clear that I am not at all arguing Italy should leave EMU. I honestly believe that this would be catastrophic for the rest of the euro-zone as well as Italy, though I am not quite sure who would suffer most. Europe is very integrated tradewise and a heavy devaluation of a new lira would take heavy tolls on the rest of EMU (maybe even more than on the Italian economy as Italy might profit from the boost in competitiveness and only in the long run feel the pinch of higher interest rates). Felix is completely right that an Italian default-cum-devaluation might even cause systemic problems for the global financial system.
However, there are populist politicians in Italy arguing for leaving the Euro and they might at some point resort to the Argentine example. And even though some readers on “Economonitor” have argued that Italy cannot have any incentive to leave EMU given that it has benefited so much from lower interest rates in EMU, I believe there are realistic scenarios in which the incentive structure might fundamentally change. The problem is the trends in both Italian competitiveness and its debt level.
Italy has lost competitiveness
Italy over the past years has lost competitiveness to a shocking degree, mainly because wages kept rising with a trend of roughly three percent while productivity was flat while in Germany and other parts of EMU unit labour costs have risen much more slowly.
Gaining back competitiveness, as also EU commission officials admit behind closed doors, would require a number of years of domestic deflation in Italy. However, domestic deflation would almost suddenly worsen the debt burden: First, with low price increases, nominal GDP growth would be lower than otherwise, making the (nominally fixed) debt level increasingly burdensome. Second, as we have seen in Germany in the past years, a strategy of competitive devaluation by low domestic rates of wage increases puts heavy burdens on social security and tax systems which are all designed for an environment of an increasing nominal wage sum, depleting governing revenue. Given the already high debt burden and high budget deficit in Italy, it is not at all clear whether Italy could manage to keep the debt level within sustainable limits.
The main danger, however, might be political: During the time of adjustment, unemployment would surely rise (as it did in Germany and Argentina during their attempts to devalue in real terms). Populists might use exactly this development to crusade against the euro.
As some commentators on the other blogs have pointed out, the result would have to be a default on Italy’s debt (maybe only to the foreign part of it) and an exit of EMU, combined with a strong devaluation. This, of course would be a very messy outcome. However, there might be a point at which the Italian debt burden cannot be serviced anymore and this appears to be the least terrible solution in the eyes of Italian voters.
There would be a number of parallels to Argentina in this scenario: Argentina had also lost competitiveness in the 1990s, due to wage increases above those in its anchor country, the United States, but also due to the Brazilian devaluation in the late 1990s. Gaining back competitiveness by a policy of domestic deflation proved very hard, as it added to the budget problems. Argentina in the 1990s did have problems with extensive government spending. At least in the last years of the currency board, however, rising borrowing requirements were not mainly results of profligate spending, but also of the results of dismal business cycle developments. The government of Fernando de la Rua tried very seriously to limit spending and borrowing in 2001, but due to the rapidly deteriorating economic situation, tax revenue repeatedly came in worse than expected, leaving de la Rua’s team not much space to manoeuvre. In the end, it was the rising unemployment, a bank run and the following riots in the street which triggered the exit of the currency board and the default.
To Italy’s defence, one has to say that Mr. Prodi has understood the problems and is pushing both for measures to improve competitiveness and for measures to limit budget deficit to limit public debt (see Daniela’s post). However, it is far from clear whether he will succeed. He needs all the support he can get from other European leaders, including an end of the German devaluation-by-wage-restraint policy (see on this topic my previous post). As David Milleker has pointed out in his comment to my previous post on EMU exit options, a regional stabilisation fund to bolster divergent regional business cycles as the European unemployment insurance proposed by Daniela and me might be an option to make EMU working smoother.
After all, it would not only be Italians who were hurt by the worst-case-scenario pictured above: It would be other Europeans who lose their money invested in Italian bonds and it would be manufacturing workers in other European countries who lose their jobs both because Italy would not be able to afford their products anymore and because it would be a much stronger competitor. In the end, if a new lira devalued by 70 percent as the peso did in 2002, this would not only deplete Italian purchasing power, but also cut Italian labour cost by two thirds.