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For the eurozone, auf Wiedersehen would be better than ciao

During the euro crisis in 2012, a Greek exit from the euro was the fear. Today, an Italian exit is the worry.

All along, contrarians have called for Germany to leave the eurozone, observing that the currency union’s central problem is a severe imbalance, with Germany so much larger, so much more robust economically and so much more export-driven than all others. Remove it and the zone’s problems would disappear.

Today, this contrarian idea is even more compelling.

In 2012, when tiny Greece threatened to trigger a chain-reaction exodus from the currency union, the threat could be contained with much lesser action — a multi-year Greek bailout costing only about $300 billion, cheap relative to euro zone GDP of about $12 trillion.

Italy is the third-largest member of the eurozone. With its $2 trillion economy, Italy is too big to be contained with a bailout, especially since the European Central Bank’s quantitative easing program has exhausted most of the firepower that would be required. The ECB has amassed a colossal $5.5 trillion in assets.

Despite six years of incremental reforms and massive ECB money stimulus, Italy’s economy is stagnant and debt-ridden and its population frustrated.

Italians have elected an anti-establishment coalition government which has advocated exit, at least as “Plan B,” and an exit now enjoys increasing support in the mainstream media.

If Italian exit is an increasingly acceptable alternative, why not a German exit? The key question is, which exit would be better?

The first advantage of a German exit is that it would be a discreet one-and-done event. The euro would plunge in value, rendering any other exit a pointless exercise. Indeed, by delivering enhanced trade competitiveness, improved balances of payments and reduced external debt, it would create a “golden cage” locking other members in place.

With the new German mark trading at a substantial premium to the devalued euro and, thus, Germany no longer a feasible safe haven, depositors in southern Europe would have no place to run — and, with the threat removed of forced conversion of their bank accounts into a much less valuable currency of their own country, no reason to run.

In contrast, an Italian exit wouldn’t likely devalue the euro. Remaining members would not be locked in, nor would they enjoy any positive impacts. Italy might inspire copycats, leading to dangerous instability, if not outright disintegration of the currency union.

An Italian exit is a large, unpredictable and largely uncontainable risk to the eurozone and the European and world economies.

So what are the forces that might propel Italy to an exit and how strong are they?

First, with an Italian exit now considered a more acceptable policy alternative, it becomes more likely.

Second, it will be difficult for the new government to improve the economy and reduce popular frustration. Italy’s ratio of government debt to GDP is 130 percent, among the highest in the world. It faces a classic Catch 22: countries with high debt levels have trouble growing because debt service absorbs so much resource, yet countries with stagnating economies cannot reduce debt.

The coalition campaigned on a program to shake things up. Combined, the two coalition parties proposed to increase social spending and reduce taxes, an expensive fiscal mix that would open a wide Italian budget deficit and exacerbate Italy’s precarious financial condition — and break eurozone rules, inviting a dangerous standoff with Brussels and Berlin. Enforcing rules might push Italy to exit; not doing so might encourage others to break them. Either way, the zone weakens.

Global economic conditions look potentially challenging. With rising U.S. interest rates and the ECB maintaining negative interest rates at least through mid-2019, the enormous and increasing gap will be problematic.

Worse yet, recession may hit after the long post-recession expansion and shrink economies, but not debt. Even worse, recession-fighting tools would not be available. Current record low interest rates would preclude use of traditional interest rate cuts, and still overloaded central bank balance sheets would rule out new quantitative easing programs.

So, many forces militate toward an Italian exit — and a dangerous one with no apparent mitigating measures available.

A German exit would be better, both inherently and as a measure to preempt and preclude so dangerous an Italian departure.

It would address the eurozone’s fundamental problem of a powerful German economy (about 30 percent of zone GDP) that keeps the euro at a value well above what it would be without Berlin. The other eurozone members are hamstrung with an overvalued currency, while Germany effectively enjoys a significantly undervalued one.

Therein lies the rub. In exiting, Germany would give up this currency advantage. Exiting would be a major act of self-sacrifice.

Indeed, Germany would experience upward currency valuation and major associated disadvantages that are the exact opposite of all the advantages of devaluation enjoyed by the countries remaining in the zone.

Germany and Europe face a choice: 1) a German exit that would preserve the eurozone and improve conditions everywhere except Germany, whose great strength could absorb much of the blow; or 2) risk an Italian exit that might well lead to the dissolution of the eurozone, a major economic reversal and a huge setback to the post-World War II “European project” designed to bind the continent in peaceful harmony.

A German exit may not be so contrarian an idea after all.

As appeared in The Hill on June 21, 2018.


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