Italy's Parallel Currency Temptation

|
Includes: ADRU, DBEU, DBEZ, DBIT, DEUR, DEZU, DRR, EEA, EPV, ERO, EUFL, EUFN, EUFX, EUO, EURL, EWI, EZU, FEEU, FEP, FEU, FEUZ, FEZ, FIEE, FIEU, FLIY, FXE, GSEU, HEDJ, HEWI, HEZU, HFXE, IEUR, IEV, PTEU, RFEU, UEUR, ULE, UPV, URR, VGK
by: Desmond Lachman

As the Italian economy stalls yet again and as the budget standoff with its European partners intensifies, the idea of a parallel currency for Italy is again being floated. The basic idea would be to have the Italian government increase public expenditure to kick-start the economy and to finance that increased spending by issuing government IOUs that could be used to pay future taxes.

Forza Italia leader Silvio Berlusconi speaks at the Quirinale palace in Rome, Italy, April 12, 2018. REUTERS/Max Rossi

It is claimed that taking this approach would allow the Italian government to support the economy by increasing public spending without flouting the Eurozone's rules on unduly increasing public debt. While debt issued by the Italian government falls under the Eurozone's public debt definition, it is claimed that government IOUs that can be used for future tax payments do not.

Even if the European Commission were to accept an Italian claim that tax-related IOUs should not be included as public debt, there are at least three reasons to think that it would be a singularly bad idea for Italy to go down the parallel currency route.

The most compelling reason is that the issuance of a parallel currency would almost certainly be viewed by the markets as a weakening of the Italian government's commitment to remain in the Euro. That would lead to a further significant widening in Italian bond spreads from their present level of around 300 basis points. It would do so since investors would need to be compensated for the increased risk that Italy might at some future date indeed exit the Euro.

The net result would very likely be that any support that the Italian economy might receive from increased government spending would be more than offset by the higher interest rates that Italian companies and households might be required to pay.

There is also the real risk that introduction of a parallel currency would lead to a full-blown Italian credit crunch. This would seem to be especially the case in the context of an Italian banking system that is saddled with non-performing loans and that holds around 10 percent of its balance sheet in Italian government bonds. As Italian government bond prices fall, the Italian banking system's capital base would be further eroded. Such a process has already been in evidence since the March 2018 Italian elections.

A second reason to think that government IOU-financed public spending increases are a bad idea is that they are bound to raise serious questions about Italy's public debt sustainability. Even if the markets were to accept the argument that such IOUs should not be considered as public debt, they do constitute a claim on future government tax revenues. As such, they must be viewed as weakening the government's future ability to meet its public debt service payments by reducing the future tax revenue stream at the government's disposal.

Yet a third reason to question the desirability of an IOU-financed public spending boost is that it runs the danger of creating the equivalent of a fiscal cliff. In the same way that the economy might be boosted by the increased IOU-financed public spending, so too will it be adversely affected by a reversion of public spending to its former level. For this not to happen, one would have to assume that the Italian government would continue boosting the economy indefinitely with ever-increasing amounts of IOU-financed public spending.

With the Italian economy again on the cusp of an economic recession, it is understandable that the Italian government would like to boost the country's economy. However, it would be ill-advised to go down the parallel currency route to do so. By inviting a further widening in Italian bond spreads, the government would risk tipping the economy into a deflationary spiral that would only exacerbate its public debt and banking sector problems.