Long-Run Lira?

|
Includes: DBIT, DRR, ERO, EUFX, EUO, EWI, FXE, HEWI, ULE, URR
by: John Cochrane

Luigi Zingales inaugurated a series of essays in Il Sole 24 Ore, an Italian newspaper, on whether Italy should stay in or get out of the euro, and graciously asked me to contribute. My view here in English, here in Italian.

To be clear, I kept to Luigi's terms of the debate. This piece is only about whether Italy is better off in the long run with a common currency. Whether it gets anything out of an exit, a devaluation, a default now is for another day. And this is just about currency, not about leaving the EU, not about debt or austerity, not about whether Europe needs a fiscal union, or the rest of it. (Some subsequent correspondence verifies the wisdom, but also the difficulty, of talking about one thing at a time.)

Return to the lira? A long-run view (Not very good English title)
The euro isn't perfect, but it isn't bad. (Much better Italian title)

Should Italy have her own currency and run her own monetary policy? For today, let's focus on the long-run question, leaving out for now the transition and any immediate benefits and costs. When contemplating a divorce, it is wise to focus on what life will be like when everything is settled, not just who will have to wash today's stack of dirty dishes.

Remember first that monetary policy cannot substantially improve long-run growth. Long-run growth comes from people and productivity, how much each person can produce per hour of work. In turn, productivity comes from innovation, new companies, new ways of doing business, and new products. Like in the case of Uber, consumers benefit and existing producers are disrupted. Improvements in long-run growth come only from structural reform, not monetary machination. Money is like oil in a car. Bad monetary policy, like too little oil, can drag an economy down. But after a point, more oil will not help you to go faster - you need a bigger engine.

In the short run, monetary policy can also "stimulate" an economy. It's like an afternoon espresso - good when you're feeling a little sluggish, but not wise to drink all the time, and in the end, no substitute for diet and exercise. And that is the major advantage offered for an independent currency and monetary policy - the possibility that a wise monetary authority can offset bad shocks with occasional bursts of devaluation and inflation.

But "wise" is a major caution. When the central bank lowers interest rates, inflates, or devalues, that helps exporters but hurts importers; it helps government finances but lowers the real amount the government pays its workers, pensioners and bond holders; it helps borrowers but hurts those who lent money to the government, homes and businesses.

Once hurt, they wise up. Anticipating the next devaluation and inflation, workers and pensioners demand indexed wages and pensions. Bond investors demand higher interest rates.

So, having your own currency really only works for a government whose finances are in sound shape and whose public institutions are strong enough to resist the constant clamor for one more inflation. Just this once. Again and again.

Staying in the euro thus represents an important pre-commitment. By forswearing the ability to easily devalue and inflate ex-post, Italy benefits from much better credit and investment ex-ante. It is up to her to use this credit wisely, as Greece so notably did not.

Devaluing and inflating is said to work because prices and wages are "sticky" and do not quickly adapt to inflation. Thus, people are fooled into working harder than they would otherwise, or into accepting wage and price declines they would refuse if they could see them directly. But, if used often, they too will wake up and stickiness vanishes.

Furthermore, devaluation and inflation to exploit such stickiness can address an overall level of wages or prices that is too high, but it cannot address an industry or a region that is too high while another is too low. And variation across industries and regions is larger than variation across countries. If stickiness is the problem, it would be much better to remove all the policies that encourage sticky prices and wages in the first place. For Italy, in particular, the arguments for one currency are really arguments for two currencies, one for the North and one for the South.

If that sounds unappealing, perhaps one currency is unappealing too.

Italy will face tight limits on what it can accomplish with wise monetary policy. Let us hope that having its own currency means Italy still somehow remains a member of the European Union, or at least its somewhat free-trade and free-investment area, like Denmark, Norway, or pre-Brexit UK. Let us hope that Italians can still buy and sell goods freely across Europe, that they can conduct their business in euro or lira, own bank accounts in both currencies, freely buy and sell securities, work in Europe and hire whom they please.

Do not take all of this for granted. The first thing many governments do, faced with weak currencies and government debt problems, or noticing their monetary stimulus efforts have little effect, is to force their citizens to use that weak currency, to ban foreign bank accounts, to limit citizens' rights to buy and sell euros or to borrow or invest abroad. They limit foreign banks in order to prop up domestic banks which must hold domestic currency and debt. They limit the interest citizens get at banks and allocate bank credit.

All this passes under bureaucratic bromides like "capital controls." Economists call it "financial repression," which gives a better sense of its effect. This is the kind of monetary policy that, like removing oil from a car, can really slow it down. And it is not clear that Italy can even leave the euro without leaving the EU.

If Italy remains open, as she must to grow, monetary policy will always be constrained by the exchange rate and competition from the euro. Too much loosening will cut the exchange rate too much, and vice versa. Wild exchange rate fluctuations are bad for business and investment all around. Italians will just use euros instead, undermining the value of a domestic currency, leading to capital controls. Even Iceland is now thinking it should peg to the euro. Switzerland and, to a lesser extent, Denmark are fighting hard to keep their currencies from rising.

So will Italy be better off in the long run, back with her old sweetheart, the lira? A well-managed currency within an economy open to trade, capital and people can have some benefits. The experience of pre-Brexit UK, Denmark, Switzerland, Norway or Sweden offers small advantages, some challenges and no particular disasters so far. The experience of pre-euro Italy is less encouraging, that of pre-euro Greece less so and that of many small countries challenged by debt and growth still less so. Round after round of inflation and devaluation did not produce prosperity, and capital and exchange controls hurt growth substantially.

In the end, no monetary machination can substitute for a dynamic real economy. The euro, while not perfect, is pretty good, and it offers an important pre-commitment against bad policy. The dangers and temptations of a lira do not, in my view, compensate for the loss of an occasional afternoon espresso of stimulus.