Will Italy Be the First to Pull Out of the Euro?

In my article on October 7 (“Will the Euro survival be at risk"), I sought to explain the threat to the European Monetary Union that the current crisis is posing and under what circumstances countries could pull out of the Euro.

Since that article, spreads on different sovereign bonds in the Euro region have accentuated greatly their divergence and in the past couple of weeks S&P has downgraded Greece and Spain and put under negative watch Ireland and Portugal.

A default by a Euro country in the next three years seems almost inevitable. In the Euro area, Belgium, Greece and Italy have public debt at or over 100% of GDP, these are unsustainable, particularly considering these countries' delusional continued willingness to support troubled banks and pursue counter-cyclical policies which in fact they cannot afford.

The absence of economic growth expected for these countries, the deteriorating fiscal position and the increase in sovereign spreads will make the indebtedness spiral out of control as, mathematically, it becomes an explosive rather than a converging series.

The favorable financing environment that ensued the launch of the Euro with converging spreads among member countries with very different credit risk profiles created in effect a disincentive for the worst offending countries to get their economic house in order.

These governments’ indebtedness ratios have remained contained since the adhesion to the Euro in part because of the previous benign interest rate environment and, primarily, because of creative accounting that took liabilities off the "official books", driven by the need to maintain the euro convergence criteria. Greece even pushed the envelope - its GDP jumped by 25% in 2006 thanks to a new method including more "accurately" the informal economy. In today's environment there is no more tolerance for this type of behavior, so the chickens are coming home to roost, so to speak.

A defaulting country could prefer to stay in the Euro to avoid a currency crisis on top of the default and a capital flight although this may not always be the case. Many investors in Russia in 1997 did not believe that a default and a devaluation by that country would occur simultaneously but it did.

In reality, it is unlikely that a small economy like Greece or Ireland would believe it could survive and prosper outside the Euro. Spain has had a relatively responsible behavior in the EU, has benefitted greatly from membership and the ghosts of isolationism are still too fresh in the collective memory.

I submit that the likely candidate for a split from the Euro is Italy. The country’s economy is large. There is a precedent: Italy abandoned the European Monetary system in 1992 (with the pound) and did not regret the decision. The country has been in stagnation for a long time and has entered a recession, the Euro is a convenient scape goat.

Remember Berlusconi in the 2005 election's statement that "Prodi's Euro screwed everybody"?

Comments

[Gedankonomist:]

The EU probably won't allow Italy to pull out.

Jan 21 10:05 AM

[John Polomny:]

How are they going to stop them. Not only will Italy pull out but eventually all the southern Europe weak sisters as the temptation to have ones own currency to freely debase will prove to great. Remember these are social democracies that respond tp pressure from Rome, Madrid, or Athens not Brussels.


On Jan 21 10:05 AM R JENSEN wrote:

> The EU probably won't allow Italy to pull out.

Jan 21 11:38 AM

[Steven Hansen:]

i am questioning why italy would pull out at the worst possible time. the whole world is in crisis - and the smaller currencies would be more at risk than the larger ones for instability.

the ecb's fiscal policy has disproportionally effected the weaker economies of the eurozone. i suspect, at some point, there will be some sort of compensation to italy, greece and spain to help them through this crisis.

Jan 21 11:29 PM

[Boadi:]

Yes no doubt they will get comp and we will end up paying towards it!


On Jan 21 11:29 PM The hand wrote:

> i am questioning why italy would pull out at the worst possible time.
> the whole world is in crisis - and the smaller currencies would be
> more at risk than the larger ones for instability.
>
> the ecb's fiscal policy has disproportionally effected the weaker
> economies of the eurozone. i suspect, at some point, there will be
> some sort of compensation to italy, greece and spain to help them
> through this crisis.
>

Feb 07 05:30 AM

[dany:]

Do you know how much gold does Italy have in Bankitalia???? please study it... we have 84 billion euros in gold... we are not so pure as you think babies....

Mar 03 04:10 PM

[Charlie Bottle:]

Dany, congratulations. Do you know how much sovereign debt Italy has?....About 2.5 trillion US$. That's 30X those goldreserves you mention. This s the "on balance" sheet liabilities. Euro governments have been creative in moving liabiltes "off balance sheet" so this is just a fraction of total libilities. Italy is broke and will likelly have to restructure debt...My guess in less than 3 years.

Mar 05 12:21 AM