Should Italy leave the Euro?

Michele asked me about Italy leaving the Euro. Here’s her question:

i’m italian and a friend of mine claims that in order to solve all our economic problems we should exit the euro and devalue the currency.
he than claims that devaluating a currency doesn’t bring inflation…

note that i just want to refute the claim that devaluations don’t bring inflation, not his entire claim.

sadly i don’t have a competent guy in economics at hand and i really need a check on the whole thing.
i’d really like to read your take on this account.


Short answer: he may be right. But he is looking at only a small part of the big picture. Leaving the Euro will be a big mistake for Italy, economically.

To understand what is going on in Italy,

what exactly their problem is, see this article. Very short version: too much consumption, too little production.

To understand the role the Euro plays in Italy, see this one. Short version: Germany pays for all the wild Italian feasting and merrymaking.

Since Italy’s problem is too many parasitic jobs and too few productive jobs, playing around with the money, calling it Euros or Lira, will not change anything. The govt has to take a good hard look at all the ways it is harming the economy and stop doing them. Their guide should be: Does this cause less production? If yes, get rid of it.

In addition to the basic problem of not enough production to pay its bills, Italy has gotten itself into a deeper mess caused by their basic problem. Since Italians do not support themselves by producing things, they have borrowed a lot of money to pay for their high living, and now cannot afford to repay. This secondary problem, debt the Italians cannot repay, is the one Michele’s friend wants to solve. And his solution is elegant in its simplicity. Don’t repay, or at least repay with useless garbage. And that is what devaluation means, make no mistake. It is a euphemism for “turn your currency into useless garbage”.

To do this, Italy will have to stop using Euros as their currency and start using Lira. Then they will tell everyone that for every Euro they owe, they will repay with a Lira.

The only question that remains is, how will the Italians make sure the Lira will be useless garbage, money that has little actual purchasing power? Michele is worried that they will do it by printing a lot of these new Lira, so many that, by the laws of supply and demand, its purchasing power will go down. This is inflation for two reasons. First of all, the classical definition of inflation is increasing the money supply, printing new money. Which will happen, she fears. Second, the new definition of inflation is higher prices, which she also fears will happen. And if the govt does indeed print tons of Lira, she will be right on both counts.

But her friend may be right, and she may have nothing to fear. Perhaps the Italian govt will not print mountains of Lira. They may find that the Lira will become useless garbage very soon without massive printing. Since Italy has been producing less and less every year for decades, foreigners may soon see no point in possessing Liras. After all, the only use of Lira to a German is to buy Italian products, and if there are no Italian products, he will have no use for Lira.  Why trade valuable foreign currency for something you cannot use? So that the Lira’s worth on the foreign exchange market will be very low.

Bottom line, maybe in time there will be no demand for the Lira. In other words, the Lira will turn into useless garbage not because the Italian govt will increase its supply, but because it is doomed to be worthless anyway. A currency that will not be able to buy anything, because almost nothing is made in Italy, will be useless garbage from the get go.

Now there is a difference between Michele’s way of ruining the Lira, by printing mountains of it, and her friends way, by relying on the new Lira’s becoming worthless from because there will be nothing to buy. Michele’s way will ruin the Lira for everyone, Italians included. When there is a lot of Lira in existence, it loses value for everyone. But her friend’s way might save the Lira within Italy. After all, people have to go shopping and pay their taxes, especially the latter. The govt will need Lira to pay its debts and to function. Foreigners will have no use for a Lira, but Italians certainly will.

But again, when Italy makes little to nothing, Italians will have to import everything. And then they will find, to their horror, that they cannot buy any foreign products with their new Lira, because foreigners have no use for them. In other words, prices of imported goods will rise under her pal’s scheme, as well. And since Italy makes very little, meaning Italians import almost everything, that means prices for almost everything will rise. So her pal may be saving Italy from monetary inflation, but the price inflation is sure to come.

As long as Germany is stupid enough and cowardly enough to pay all Italy’s bills, which they will do to keep Italy in the Euro [see above link], Italy is best off being smart enough and cynical enough to let them do it.

Nor is there any moral reason to leave the Euro, unless you think repaying your debts with useless garbage is the ethical thing to do.

9 thoughts on “Should Italy leave the Euro?

  1. Andris Birkmanis 02/01/2013 at 09:23 Reply

    You seem to ignore the moral argument, focusing on the utilitarian instead?
    Are Italians morally right accepting the funds extorted from German public?

  2. Smiling Dave 02/01/2013 at 09:40 Reply

    Very good point. Indeed the article’s main focus is an analysis of the economic repercussions of staying or leaving. As Mises wrote, economics as a science makes no value judgements, contenting itself with laying out what will happen.

    But since you’ve asked, let’s rephrase the question. Is the Italian govt morally right letting the German govt extort German citizens for the benefit of the German and Italian govts [= staying in the Euro], or is the Italian govt morally right extorting from everyone who lent it money, plus all Italian citizens [=leaving and devaluating].

    I’m glad I’m not the King Solomon who has to decide this question.

    Ideally, Italy stays in the Euro, German citizenry show some backbone, and morality is satisfied.

    Alternately, Italy leaves, but repays debtors in Euro anyway.

  3. Silvano 02/01/2013 at 14:32 Reply

    Basically you don’t realize why (some) people think leaving the euro could be a good option – or the least harmful.

    1. There is a simple legal principle which holds and it’s widely recognised in international law: Lex Monetae. A sovereign state chooses which currency it will use, hence all debits & credits relationship agreed under its own legislation are going to be settled in that currency. And no party can claim default. Roughly 90% of the Italian Public Debt is issued under the Italian law, so just a small fraction issued at London and NY has to be repayed in euro. Every bond issue clearly defines under which legislation it is issued and which could rules it. This is very clear and obvious for every professional bond broker, banker, etc.

    2. Italy runs a wide primary surplus, which basically means the Government collects more taxes it spends before paying interests. This means the possibility to keep an almost balanced budget running a mix of fiscal and monetary policy not so much different from UK. which devaluated GBP suddenly in 2008 after financial crisis. UK – surprise – reported an increase in consumer prices just around 3.5-4.5% which could be considered significant but it’s not “hyperinflation”. Indeed Poland did the same and Zlotly is still traded in forex. There is a significative evidence in international economics literature that currency devaluations for small and middle size countries are often “passive” responses to a shock (someone calls them “defensive devaluation” in opposition to explicit mercantilistic policies, but I don’t like war-word applied to economics).

    3. There is a big difference from USA and Eurozone: the former is an Optimal Currency Area (OCA), the latter no. In a world where languages are different, laws are different, institutions are different, mobility of labor and mobility of several factors of production are reduced usually floating rates perform better. Well, that’s the world where we live in.

    4. Devaluation doesn’t mean boosting export immediately. J effect is a well known effect. But after last economic contraction also the balance of trade turned positive in Italy. Italy already experienced currencies devaluation when it was a member of European ERM and the so-called pass-through effect is known to be limited for the country. In fact in 1992 (after the last devaluation of ITL) CPI decreased. To be true also Euro experienced wide movents downward vs USD since its born (the last one in 2012 when EUR/USD reached ~1.20) and no hyperinflation occurred. Better said, no significant variation over the CPI trendline occurred.

    5. Balanced assessments usually estimate the “proper” amount of devaluation considering moslty the evolution of CPI differentials, plus some other variables and a possible overshooting effect. Italy pegged its currency in 1997 and since then reported a cumulate CPI differential vs Germany, Belgium, Holland (ex-Deutsche Mark area) of more or less 10-13%. Depending on the model, realistic estimations of a devalution vs Euro range from 10 up to 25% (so the worst scenario is quite similar to what already happened in 1992). Note: the % would be higher vs an imaginary Euro-North than toward USD and JPY. Anyway, even with a significant overshoot at the beginning, leaving the Euro zone it’s not a monetary suicide even if no one denies transition costs.

    Last, but not least: forget about USA for a while and think about small-medium open economies. Let’s say, think about Spain. Fixing a too high exchange rate is for several aspects like fixing a too low interest rate: the real interest rate of borrowing from foreign countries becames too low and you can have a credit inflationary boom-bust cycle which is reflected in the balance of trade (FDI are debts like hot money and capital inflows, and a too high and protracted trade deficit could be a sign of overconsumption). You can apply the basic hint of ABCT even in a context you may dislike: (managed / dirty) floating fiat currencies and it still holds. The balance of trade explanation of the Eurozone crisis is stated usually in Keynesian terms, but properly understood and “translated” it has also a (strong) Austrian flavour.

    • Smiling Dave 02/02/2013 at 07:15 Reply

      For me to better grasp what you are saying, I have some questions.
      Are we agreed on the following:
      1. Leaving the Euro is going to be for the purpose of devaluing the new currency.
      2. Devaluing means the creditors will be paid off in money worth less than the money they handed over.
      3. Devaluing is done by printing money, aka inflation.
      4. Printing money steals purchasing power from everyone who has the old money.
      5. No matter the size of the country, it is not defending itself from anything by reducing the purchasing power of the citizenry.
      6. A country benefits in all ways from currency that has a higher exchange rate, and loses in all ways [even the exporters] when the exchange rate goes down, i.e. when its money is devalued.

      If you disagree, which of the above do you disagree with? Why do you you disagree?
      If you agree to all of them, why is devaluing a good idea?

  4. Silvano 02/02/2013 at 18:56 Reply

    1. Leaving (or breaking) the euro is just a mean to move toward a floating exchanges system since the Eurozone is not an optimal currency area. No serious economist disagree on this and that’s why some economists forecasted a break up since its born. The majority of politicians, burocrats, mainstream economist simply think it’s better to move toward more integration (a centralized banking union, fiscal union, political union, etc.). Anyway, politicians in Bruxelles already have their agenda, which basically is “more of the same”: it’s a top down process of “nation building” (also) through economic shocks. That’s not a conspiracy, that’s what they openly said since its ideation.

    2. We live in a world of fiat monies. It doesn’t matter what you like or what I like, that’s the world we live in. European countries managed their exchange rates trying to coordinate them since 1973. Sudden “devaluations” or “revaluations” can happen just when monetary authorities commit themselves to hold a fixed peg and this is a political decision by definition, not a free market one. On the contrary when exchange ratios aren’t fixed you generally have smoother processes. If this is a big problem for you, buy an option or a future. Indeed free markets offer a wide range of solutions to cope with uncertainty and currency risks.

    3&4. You can’t print a money which is not demanded. If you don’t believe me take a piece of paper, write down “Smiling Dave Note”, go to supermarket, then tell me how many stuff you bought. Sorry for praxeologists, but there isn’t an undisputed theory of exchange rates determination. In the (very) long run real exchanges rates may tend – more or less – to converge,in the short and middle run fluctuations are extremely wide and volatile and the Purchase Paritiy Doctrine has almost no explanatory power for them. As I know there are:
    – traditional flows model where the demand and supply of currencies depend by import-export flows;
    – models based on asset market approach (monetary & portfolio approach depending if you consider valid the hypothesis of perfect substitution between national and foreign assets or not).
    For sure the exchange ratio is the relative price between two currencies, but it’s vacuous stating it’s determined by the quantities offered and demanded without saying which are the determinants (i.e. without specifing why people demand and offer such currencies in such quantities). Even the price of iron is the relative price of iron expressed in USD, but no one determines the equilibrium price of iron studying the USD monetary market…

    5. The size of the country matters, at least if you want to pass an examination in International Economics since you have to study two kind of models. One without effects for the rest of the world, and the other one with. The choice is related with how many variables you can consider exogenous in your analysis. The issue of this topic is if exiting from euro is inflationary per se, assuming inflation for people mean an increase in consumer prices level. It doesn’t matter if this is not an Austrian definition: people are simply interested in what can happen to consumer prices in real term and if they will skyrocket or not and the answer is no, likely it won’t happen (unless a kind of Chavez style president will be appointed soon after). It never happened before in any country of the Euro area since 1973 up to 1999 (there had been a lot devaluations / realigments). The Fed, which issues the reserve currency of the world is on a (very) expansionary path, and it is the USD, nor the Euro, nor a new Deutche Mark the corner stone of international trade. So, in my opinion CPI will probably rise in Italy in case of Italy leaving the Euro, but not as much Michele (your reader) could think.

    6. Every devaluation is a revaluation for someone else (by definition). So why German would oppose a strenghten of their currency? Why it’s mandatory to keep a fixed peg (politically decided) and to not devaluate for at least 2 years if you want to join the Eurozone? And what do you mean for “high exchange rate”? What do you mean with “high”? Is it “always good” fixing a peg outside the equilibrium? Would you consider a good idea to peg USD to EUR? Is it so bad for UK or Sweden living outside the Eurozone? Is it so bad currency competitions?

    It’s widely known that a fixed exchange rate, perfect mobility of capitals and monetary independence are an inconsistent triad and also mobility of factors and labor is much less within Europe that within USA. Even the degree of intra-regional trade is lower and prices are more sticky. So the economic side of the problem in short is if the gains of partecipating to a currency area (which is not optimal) are outweighting its costs or not and what’s best for the future. Not surprisingly this is an open and complex question.

    • Smiling Dave 02/02/2013 at 19:22 Reply

      I see we differ too widely in our most basic assumptions to continue. Thank you for your insightful comments.

  5. […] were, a first-row seat to the Euroshow. For prior discussions of the Euro on this humble blog, see here and […]

  6. […] Read more: Effects on Italy: Should Italy leave the Euro The Voluntaryist Reader […]

  7. […] Read more: Effects on Austria: Should Italy leave the Euro The Voluntaryist Reader […]

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