Could Italy fall out of the Eurozone by accident?
- It is unlikely that Italy' would intentionally give up its membership of the euro under the current administration
- In this publication, we present a thought experiment in which Italy could nevertheless unintentionally fall out of the Eurozone as a result of a sequence of unwise decisions by Italian policymakers
- It would take quite a few policy errors and incorrect estimates for things to reach that point
- The risk that this will happen is thus extremely low. But if it happens, the economic consequences for Italy and the rest of the Eurozone would be serious
- It is important that readers understand that the scenario outlined here is not a forecast, it is rather a sort of hypothetical reasoning. The story is about what would have to go wrong for the dramatic outcome of an unintended withdrawal by Italy from the Eurozone to materialise
Although the current Italian administration is Eurosceptic and objects to Europe’s budget rules, it is highly unlikely that it would intentionally give up Italy’s membership of the euro. Indeed, the government has repeatedly stated that it does not intend to take Italy out of the Eurozone. Moreover, the Italian constitution would make it very difficult if they would want to do it by the book. At the same time, the government is not particularly enthusiastic about the European budgetary rules and proposes to adopt a fiscal policy that tests the limits of the Stability and Growth Pact (SGP). In addition, there are plans in the coalition agreement that could lead to a total derailment of the budget, but these are not as yet included in next year’s budget. The question is whether the government intends to implement these plans at some point.
We believe that when push comes to shove, Italian politicians will (sufficiently) conform to the European guidelines as they have in the past. Yet there is still the question of what would happen if they do not. Could it be that government policy could lead to Italy unintentionally leaving the Eurozone? The answer is yes it could. Indeed there on could draw a scenario in which Italy would unintentionally leave the Eurozone as a result of a sequence of unwise decisions by Italian policymakers. It is important to note that current legislation does not offer the possibility of an exit from the Eurozone. The European Treaty states that the introduction of the euro is ‘irreversible’. But developments could acquire their own dynamic, and an unstoppable sequence of events could be set in motion, even unintentionally.
A scenario is not a forecast
This publication is a thought experiment to show how an unintended departure from the Eurozone could occur, which under current legislation would also mean a departure from the EU. It would take quite a few policy errors and miscalculations for things to reach that point. As such, the risk that it will occur is low. But if it happens, the economic consequences for Italy and the rest of the Eurozone would be serious.
It is important that readers understand that the scenario outlined here is not a forecast, it is rather a sort of hypothetical reasoning. The story shows what would need to go wrong for such a dramatic outcome to materialise. As already stated, many wrong decisions would have to be made and every decision involves a moment in which other choices could be made. The point of the story is that these moments need to be considered as carefully as possible and readers can themselves estimate the direction in which Italy and the EU are moving on the basis of the choices actually made. We will list the key decision moments explicitly in this article, after which we will review them again and briefly describe the possible alternatives.
In this scenario Italy heads for a direct confrontation with the EU. Italy will not play by Europe’s budget rules, the government’s finances will rapidly unravel and it will decide not to correct this (decision moment 1). In this scenario that leads to increasing friction with the EU, which ultimately spirals out of control, with the result that Italy gradually forfeits its credit with other EU countries. Italy’s fiscal policy would also lead to loss of confidence in the banks by Italian savers and loss of confidence by national and international investors that the Italian government will be able to meet its financial obligations. In this scenario, the dysfunctional relationship between the Italian government and the EU would mean that the Italian government would not request financial support (decision moment 2). In due course, if Italy is faced with a shortage of domestic money, the country would introduce a parallel currency to cover its spending, hoping thus to find an innovative way of getting around the budget rules (decision moment 3). Since these actions, which are roughly similar to the actions stated in the coalition agreement by the May 2018 administration, would mean the complete abandonment of cooperation with the rest of the EU, the EU would also not intervene if the Italian government completely loses control of the situation (decision moment 4). This would result in chaos. The country would end up on a slippery slope to an exit. The negative shocks would be very severe and the effects would be long lasting.
How things could go wrong
The process would begin with the reaction of financial markets to an irresponsible fiscal policy. The formation of the current populist 5-star-League administration, its coalition agreement and the (assumed) budgetary plans for 2019 have already led to higher interest rates on Italian government bonds. Over time, the higher interest expenses for the Italian government will, with a delay, lead to Italian government debt becoming less sustainable. We not that debt sustainability is currently not yet an issue. But this will become a problem if the new Cabinet ignores the market signals and ultimately implements the entire stimulus package outlined in the coalition agreement, i.e. a huge stimulus package amounting to more than 5 per cent of GDP. This is what we are assuming in this scenario. It would lead to a sharp increase in the Italian government deficit, leading to higher government debt. The costs of this policy would not be fully compensated by the increase in economic growth that would result from the stimulus measures. The government’s creditworthiness would decline, yields on government paper would shoot up and credit rating agencies would reduce their sovereign ratings towards or even to junk status. This would automatically push up yields further, since some institutional investors would then no longer be able to hold this government paper.
Fears that the Italian government is heading for a conflict with Europe would increase as a result. The Italian government could then decide to continue along this path. In fact this is the run-up to decision moment 1: government finances would be out of control and the Italian government would do nothing.
Fearing that the government is heading towards an exit from the Eurozone, or that the current policy would lead to this, Italian people would start withdrawing cash from the banks. This would be a rational choice in their position, since euro notes will be accepted throughout the Eurozone, and whether this would apply to their bank balances after a euro-exit would be questionable. There would be a threat of a run on the banks. Initially, liquidity problems at commercial banks could perhaps be addressed by emergency funding from the central bank. But ultimately the central bank would be forced to impose a limit on the amount of money that could be encashed, similar to the measures we have already seen in Greece and Cyprus. The rapid decline in confidence would have an immediate negative effect on economic growth: Italians would save more, domestic consumption would weaken and growth would decline. People in a position to do so would transfer their money to foreign bank accounts. International investors would sell their Italian investments and withdraw their money from Italy as far as possible. Banca d’Italia could be forced to impose restrictions on cross-border capital transfers. But the bank would not have much policy space to do so, since once it restricts the ability of international investors to repatriate their money from Italy this would be seen by investors as a credit event, or the country in fact would remain in default with respect to its financial obligations. This would also contravene European rules. (decision moment 5). The central bank could forbid large transfers by Italian residents to other countries, however, but this would offer only partial protection.
International investors currently hold around one third of Italian government debt. Foreign buyers would be the first to disappear. Domestic investors would have to increase their purchases to plug the gap, but it is unlikely that they would do so voluntarily. Fears of a further deterioration in Italian government finances would mean that domestic investors would be less and less keen to buy Italian government bonds. They would move into foreign paper, or if they were prevented from investing internationally, they would move into cash, cryptocurrencies or gold, for instance. The prices of Italian government bonds would fall and effective yields would increase sharply. The government would however have to redeem maturing loans and also fund the budget deficit, and thus be forced to issue new loans. But there would not be enough investors willing to subscribe to these loans. The government would then no longer be able to meet its redemption obligations and would not have sufficient resources to implement its budget. The government however could decide to continue with the direction it has taken and cover its deficits by introducing a parallel currency and/or have the central bank purchase new loans (monetary finance) (decision moment 6). This is explicitly forbidden under European treaties. This would seem to mark the passing of the point of no return.
By using the parallel currency ‘only’ to pay government suppliers and civil servants and not introducing it as legal tender, the Italian government could perhaps avoid direct contravention of the European treaties for some time. Yet it would probably mean that the will in other Member States to assist Italy would wane further. Without financial assistance from abroad, such a semi-parallel currency would not be adequate to cover the deficits and only a fully-fledged currency or monetary finance would offer a ‘solution’.
For this last possibility, there would be two options. The governor of the central bank could, on the basis of the text of the European Treaty, refuse to do this and also prohibit commercial banks from purchasing government bonds on issue (option one). He could in theory maintain this until the end of his appointed term in 2023. However there is a high probability that as a last bastion of monetary orthodoxy, he would be forced to resign under heavy political and/or social pressure. This raises the possibility of option two: the Italian central bank could ignore the prohibition of monetary finance and purchase newly issued government loans directly on issue with newly created money, and/or the commercial banks could be forced by the regulator to purchase new government loans on issue, using liquidity created by the central bank if necessary. Both these actions would lead to rapid growth of Italian money supply. On top of this, there would be the issue of the domestic parallel currency already mentioned.
Monetary financing by the Banca d’Italia would lead to a ‘leak’ in the European System of Central Banks (ESCB, which consists of the ECB and national central banks): the Italian action would undermine the monetary policy of the ECB and would thus directly affect the entire Eurozone. The only option remaining to the ESCB at that point would be to separate the Italian central bank from the rest of the Eurozone. There would be no other option at that point. Since the antics in Italy could disrupt monetary stability throughout the Eurozone, European government leaders would support this decision by the ECB. At that point, the ECB would cease to equalise transactions between Italy and other countries and Italy would be in effect removed from the euro giral payment system.
If the Italian government were to persist in its confrontational course, as assumed in our thought experiment, things could unravel very quickly. A currency shortage would be ‘solved’ by bringing more emergency currency into circulation (decision moment 7). According to the well-known Gresham’s law (‘bad money always drives out good’), which in this case would certainly be the case, this emergency money would prevail in circulation and euro notes would be hoarded, meaning that the emergency money would lose value against the euro in daily practice. Euro notes would after all retain their value throughout the Eurozone at all times, while the emergency money would have no value outside Italy. The assets of the banks would increasingly consist of government loans. If the government is not willing or able to guarantee redemption of these loans in euros instead of emergency money, banks will start to denominate their liabilities in emergency money as well (decision moment 8), in order to prevent losses on government loans bringing the banking system down. This emergency money would therefore develop into the New Lira, meaning an exit from the Eurozone will practically be a fact, even though it might not yet be the case in legal terms.
The damage to the Italian economy would be huge. The country would no longer be able to raise money on international financial markets at reasonable rates. International trade would mostly come to a halt, since transactions could no longer be financially settled with foreign banks. Printing money would continue for as long as the government persists in its policy, leading to monetary finance on a massive scale. The combination of rapid growth of the money supply, imported inflation from remaining imports, a central bank subject to political control and a government that has taken a disastrous direction would lead to rapidly rising inflation. Hyperinflation would lie in wait.
Relations with other countries would continue to be tense for a long time. Assets held by Italians in other countries would not be repatriated, for obvious reasons. Foreigners would demand payment of claims in hard currency (euros, or dollars), and foreign creditors would not accept payment in New Lira. This could lead to legal wrangling lasting for decades. A scenario similar to that seen in Argentina or even Venezuela would be a real possibility. It would be highly likely that Italy would have to turn to the IMF for support. But the IMF would ultimately only provide support if Italy adopts a more sensible policy, that would probably be very similar to the policy rules of the Eurozone. A restructuring of Italian debt would also become inevitable. It could be that the EU would assist the IMF in a support programme (which would probably be a precondition for the IMF), but a return to the euro would no longer be feasible. It could be that the New Lira will eventually be accepted as a normal currency like other EU currencies such as the Danish krone or the Polish zloty. But before this could happen, all the practical legal issues would have to be resolved.
Trade between Italy and the EU and EMU would be seriously damaged. Italian importers would have to pay for goods in advance in euros. Credit insurance would no longer be available. Italian exporters would suffer from the fact that Italy is no longer a member of the Internal Market and would therefore have to pay import tariffs. The weakness of the New Lira would make Italian exports relatively cheap and this would offer some compensation, but not enough to compensate for the total economic shock.
This is a thoroughly unattractive scenario for the Eurozone as well. The crisis would most likely bring about a serious loss of confidence and capital outflows from other Member States with weak balance sheets, particularly if there are eurosceptic governments in these countries. As a result consumer and business spending would contract, with a negative effect on inflation and interest rates. Only the likely initial weakening of the euro on the currency markets and possibly a slightly more accommodative budgetary policy would offer some counterweight. Higher import prices as a result of the weaker euro could possibly mitigate the downward pressure on inflation a little, but not enough for the ECB to raise interest rates. Nonetheless, bond yields in the Eurozone could rise due to increasing risk premiums. The extent to which this happens will among other things depend on whether Italy’s departure leads to concerns regarding the continued existence of the Eurozone. To limit the negative effects for the Eurozone, it is thus also important that the other Eurozone governments and the European institutions act collectively to nip such concerns in the bud. Any increase in risk premiums in the rest of the Eurozone would indeed be less (or much less) than the increase in Italy, especially in countries whose government paper is considered to be the safest, such as German and Dutch paper. Yields could actually fall in these latter countries as a result of a flight to safety combined with a certain home bias.
If yields fall or remain low for longer due to worsening inflation expectations, this would be bad news for banks, insurers and most definitely pension funds in the EMU. The opposite could be true if yields rise, but since we believe that yields will only rise if risk premiums rise, the potential positive effect of higher yields would be offset by a simultaneous decline in equity prices.
The ultimate impact for the Eurozone (Member States) depends on whether the Eurozone continues to exist. We believe it will, and if it does the Eurozone economy will recover after a sharp dip. The loss of prosperity will be significant, but less than in Italy.
What would all this entail for Italy?
The simple answer is: nothing positive. The problems in Italy are not caused by the euro, and therefore cannot be solved by leaving the Eurozone. The history of the pre-euro era, when Italy had its own currency but was not able to pursue a sound monetary policy, offers no positive indications in this respect. A chaotic Italian exit scenario would do a lot of damage, for the Eurozone as a whole, but most of all for Italy. The country could slip into stagnation, hyperinflation and political turbulence.
The decision moments and the consequences of alternative choices
As explained above, this scenario involves a situation in which the wrong choices are made at critical decision moments. We will now look at the other decisions that could be made. It is relevant to note that the longer Italy pursues the path of wrong decisions, the more difficult it will be to reverse the direction taken.
Decision moment 1: Government finances unravel rapidly and the government decides not to remedy this
Italy could of course decide to back down and not implement some of the proposed plans. This alternative decision is quite a likely outcome. The government would then probably fall.
Decision moment 2: The Italian government decides not to ask for EU support
In reality, Italy is likely to ask for support from the EU if this becomes necessary. And then, the country would blame ‘Europe’ for the measures needed, which would undoubtedly be highly unpopular. In Greece, Tsipras has followed this roadmap. If however the choice is made not to ask for European support (and the conditions that would be attached to this), this would be a strong alarm signal. Italy would then be on a course that would be increasingly difficult to reverse.
Decision moment 3: Italy tries to get around the budgetary rules by issuing a parallel currency
This would be a logical consequence of the wrong decision being made at decision moment 2. The alternative would be to restructure the government’s debt (or to remain in default), or to still ask for European support at this stage. Eventually, domestic investors could be forced to roll over government debt ‘voluntarily’. If the wrong choice is made here and Italy does not back down, the country will be on a very slippery slope. All signals would be on yellow.
Decision moment 4: The EU does not intervene if things go wrong
The EU could of course still decide to help Italy if matters look like getting out of hand. This is not very likely, however, if Italy is not willing to change course and adhere to the policy measures required in return for the financial support. Simply helping out Italy without any conditionality could send the signal to other countries that neglecting the rules of the game pays off.
Decision moment 5: Banca d’Italia imposes restrictions on cross-border capital transfers
A decision could be made not to do this, but then there would have to be a change of course towards Europe, and more specifically the ECB, for support. This would be forthcoming, but with policy conditions attached. This would mean a serious back-down by the Italian government, almost certainly leading to the fall of the government.
Decision moment 6: The Italian government decides to persist with the course it has taken and to introduce monetary financing
This is a crucial decision moment. If a government decides to ignore important elements of European legislation, in this case the prohibition of monetary financing, this could seriously affect financial stability in the rest of Europe and it will be almost impossible for things to turn out well. Of course, people could still decide to change policy (see decision moment 5). But if the wrong choice is made at this point, progress in the wrong direction would seem irreversible. All the signals would be red.
Decision moment 7: Italy decides to put more emergency currency in circulation
Or it may decide not to do this. The alternative would be a shortage of money and a stagnating economy. An appeal could still be made to ‘Europe’, but the political loss of face keeps getting larger. After decision 6, the journey to an Italexit has really begun.
Decision moment 8: The banks decide to denominate their liabilities, and therefore also deposits, in the emergency currency
The alternative would be a high probability of large (and possibly unbearable) losses for the Italian banks. In reality, the banks would have no choice.
How likely is all of this?
The scenario described in this article is currently highly unlikely. It is what is known as a low probability/high impact scenario. While most of the initial statements from the new Italian administration were little cause for comfort, so far the Minister of Finance in particular has done everything to assure the financial markets that the government will strive to reduce the level of government debt. There is also sufficient support among the Italian population for continued euro membership, although the Italians are closing ranks on this issue among Member States (just over 60 per cent support the euro). The majority realises that Italy, which is still a rich country, has a lot to lose. The disaster in Argentina, also once a rich country that has moved further and further towards the abyss due to persistently poor policy, may be an instructive example.
As long as the right choices are made at the first or the second decision moments (on reconsideration), there is little reason to fear an Italexit. But things could go wrong. Populist politicians that put the country in confrontation with the EU on the basis of incorrect analyses and biased information could do a lot of harm. Decision moment 3 is therefore also an important turning point. If the wrong choice is made here, things could go downhill rapidly. Italy could still change course until decision moment 6, albeit with increasing political damage. If the wrong decision is made at this point, there is a real chance of disaster.
The EU would then have no choice but to take a strong stance. In a situation of direct confrontation with a Member State that refuses to comply with the agreements, the EU would have to prioritise the interests of the EU as a whole and in this case the interests of the EU Member States that do play by the rules. A tough ‘game of chicken’ could then get out of hand and Italy and the EU would have a huge mess on their hands, in which the population would ultimately come off worst. Hopefully, and probably, the situation in Italy will not reach this point. But one cannot describe the current situation as fully reassuring.