Global Debates

The state of the Italian economy clearly leaves a lot to be desired and the extent to which the left-wing parties in Romano Prodi’s coalition have vetoed substantial public spending cuts in the draft 2007 budget does nothing to inspire confidence that urgent remedies are on the way. Nonetheless, the constant drumbeat from mainly British commentators anticipating
Italy’s withdrawal from the eurozone testifies more to wishful thinking than political and economic common sense.

Today’s FT carries a piece by Simon Tilford of the Centre for European Reform based on his pamphlet “Will the eurozone crack”.  The paper’s editors are clearly attracted by disaster scenarios for the eurozone since this is the second article inside a month that the pink’un has published on this subject (see “If Italy thinks the unthinkable about the eurozone” by John Kay, FT September 12 2006).

Tilford, like other doomsayers,begins by highlighting
Italy’s inability to use devaluation to correct a lack of economic competitiveness brought on by low productivity and high wage increases. He then goes on to doubt that Italy would be able to achieve the necessary labour and product market reforms, triggering a loss of confidence in financial markets that skyrockets the costs of servicing the country’s enormous public debt. Eventually, he suggests,
Italy could be forced out of the eurozone by an inability to sustain debt servicing and a public opinion revolt against euro membership.

Why should a reputable think tank like the CER publish such nonsense? The European Central Bank strongly believes that this and any other scenario forcing
Italy out of the euro is cloud cuckoo economics. Well they would wouldn’t they, you might ask? But the best brief rejoinder to Tilford, Kay and others has come from Malcolm Levitt, once Barclays Bank’s EU adviser and no starry eyed europhile. He acknowledged the possibility of the Tilford scenario in the last paragraph of a letter to the FT on September 20 after listing six reasons why it would be lunacy for
Italy to leave the euro zone. Here is his letter:

Sir, John Kay (“If Italy thinks the unthinkable about the eurozone”, September 12) on Italy quitting the eurozone does not address some major issues.First, legally it would involve leaving the European Union, including the single market and customs union, with a devastating impact on Italy’s trade and economy.Second, news of prior negotiations would cause a collapse in Italian bonds (because of heightened legal, liquidity and default risk) and a massive increase in interest rates; unilateral, unannounced departure would have a similar effect.Third, not only would Italian debtors and foreign creditors clash, so would Italian creditors, demanding high post-euro interest rates on outstanding debt and creditors insisting on lower original euroera rates.Fourth, to talk of potential devaluation of the lira to 75 euro cents is meaningless: there is no lira. The new currency could be called lira or green cheese; the question is what opening parity should be announced?It should be sustainable and based on some fundamental assessment; it might even be 75 cents to the lira; of course, it might well collapse within seconds, exacerbating the problems outlined above.Fifth, the key issue is why would Italy want to quit? To regain control over interest rates, when the result would be a huge rise? To engineer a cut in the terms of trade to stimulate export growth?It would imply a cut in domestic welfare and to succeed would need to be accompanied by serious deflation, via the interest rate route forced upon Italy, and a budget squeeze, together with sustained efforts to improve the efficiency of labour and product markets – which are available in theory within the eurozone and without the turmoil that quitting would induce.Sixth, on the basis of the above reasoning, quitting could cause huge damage to the political, social and economic fabric of Italy, on a scale not seen since the 1920s. But all governments do mad things; like joining monetary unions in the wrong circumstances.However another scenario, which Prof Kay did not discuss, would be for Italy to be forced out: as a result of a collapse of investor confidence demonstrated by a collapse in bond prices and hike in interest rates on a scale that other eurozone governments and the European Central Bank refuse to offset. There are no current reasons to regard this as likely.Malcolm Levitt,London SE13 7ED, UK