Today's comments by Italian PM Silvio Berlusconi that the Euro has been a "disaster" and a "ripoff" are certainly dangerous and reckless: Berlusconi is playing with politics and fire by using the euro card as a way to attack Prodi and the center-left coalition in anticipation of political elections where the center-left may regain power. Until now only the hot heads in the Northern League - like Minister Maroni - were trashing EMU and suggesting that Italy should dump the euro and return to the Lira. But now Berlusconi himself is making such incendiary remarks. Of course, as the wiser economics minister Siniscalco has suggested, returning to the lira would sharply increase the public debt servicing costs as Italian interest rates may sharply increase; after all Italy benefited a lot from the convergence of short term and long term interest rates to European level in the transition to EMU.

But, in spite of these hot-headed and dangerous comments of Berlusconi, one needs to ask the hard economic questions: what will happen to the Italian economy if Italy stays in EMU? Would Italy be better off by returning to the lira? What would be the economic and financial consequences of returning to the lira? As economists, we need to ask and answer these difficult questions as the case for Italy staying in EMU is not all clear cut.

Those who argue that EMU and the euro have been a disaster compare Italy with Argentina. The argument is as follows: Italy entered EMU at an overvalued real exchange rate. Then Euro sharply appreciated relative to the US dollar in 2002-2004 (in spite of its modest weakening in 2005) and Italian firms further lost competitiveness. Also, Italy's traded sector is in direct competition with China and Asia: some estimates suggest that about 20% of Italian GDP is under direct threat from China and Asia as Italy specializes in more labor-intensive lower value-added exports such as textiles, apparel, shoes, light manufacturing, etc. How can Italy compete with Chinese and Asian costs, the critics of EMU ask?

And indeed, the recent economic growth performance of Italy has been dismal with growth stagnation and now a recession. Like Argentina in the late 1990s, the external competitivenss shocks could lead to a protracted and deepening recession in Italy and to a price deflation spiral that would increase real interest rates in spite of low nominal interest rates. Also, recession and high real rates will worsen the public debt dynamics by increasing further fiscal deficits and increasing even more an already very high level of public debt. Eventually, like Argentina, Italy may need a nominal and real devaluation to restore competitiveness and growth. In the case of Argentina this meant dumping the currency board and the dollar peg. In the case of Italy, that would mean to dump the euro and go back to the lira. Like Argentina, Italy may need a very large real depreciation of the new lira - relative to the Euro - to regain competitiveness.

Of course, the ideal way to deal with this competitiveness issue would be for Italy to accelerate its structural economic reforms. Italy has already done that to some extent: the labor market today is much more flexible than a decade ago as various forms of part time and unofficial and underground employment are now the norm in Italy. Still, real wages may need to fall much more in order to achieve a real depreciation and, if real wages are downward rigid, Italy may need a painful period of deflation with falling nominal wages and prices to achieve the necessary real depreciation. And like in Argentina, such deflationary process may lead to lower growth and higher real interest rates and thus worsen the debt dynamics.

Thus, Italy may need a real depreciation via a nominal depreciation to achieve the needed recovery in competitiveness; this would then require dumping the euro and going back to the lira. This competitiveness argument has some merit even if the main reason why the Italian economy has stagnated has been that the Berlusconi government has done little or nothing to reform the Italian economy in the last few years. Berlusconi is a sleazy crook who made his first financial fortunes by exploiting his political connections to build a media empire and monopoly; so much for free-market neoliberalism!  And he has been enmeshed in endless scandals and criminal investigations and trials. So, for him to bash today Prodi and the center left and the euro for the problems of Italy is a self-serving apology for the utter failures of his own policies.

But, in spite of these self-serving and dangerous comments, Italy does face a real competitiveness problem, in the same way that Argentina has a competitiveness problem given its external shocks. So, if Italy could achieve a surgical real depreciation of its currency via a move back to the lira, the competitiveness problem could be addressed. Of course, this real devaluation of the new lira would imply a sharp reduction of Italian real wages in Euro terms; so, Italy could regain competitiveness in world markets by effectively reducing its real wages.

However, the main problem with moving back to the lira is not the issue of the effect of a real depreciation on competitiveness as that effect, coeteris paribus, would be a positive for Italian growth. The real problem for Italy would be, once it moved back to the lira, to decide what to do with its euro denominated debts, the liabilities in euros of its government, of its private sector and of its households. And dealing with the balance sheet effects of a move back to the lira on the euro debts of Italy would be a much bigger financial mess than anything else. This was also the essential problem that Argentina faced and that led to default and pesification of its dollar and foreign currency liabilities (for the Argentina case and the dilemma it faced regarding dollarization, float, default and pesification see my two 2001 papers here and here).

Let us consider this problem in more detail. Any time a country that has foreign currency liabilities decides to depreciate its currency, the real value in local currency of its foreign  currency debts goes up. This is what is referred to as the balance sheet effect of a real depreciation. In the case of Italy, say a 30% depreciation of the new lira relative to the Euro would imply that the real value of all Euro denominated debts of the government, corporates and households would go up by 30%. Some of these balance sheet effects would be a redistribution of wealth to non residents: the liabilities of the Italian government, corporates and households owed to foreigners would increase. But some of it is redistribution of wealth within Italy: for example, holders of euro assets such as Italian holders of the public debt in euros would be richer while the real burden of such euro debt for the italian government, already burdened by a high debt to GDP ratio, would go up by 30%. So, already a semi-insolvent Italian government would likely become fully insolvent if its real debt to GDP ratio would go up by 30% overnite.

How to solve these balance sheet effects of a real devaluation? As the experience of Argentina shows, the solutions are painful regardless of. Italy could decide to honor all of its euro liabilities, whether they are owed by the government, the private financial and corporate sector or its households. And, indeed, Northern League supporters of the return to the lira have argued that Italy would want to maintain its euro debts after dumping the euro.  But like in the case of Argentina, many private sector agents may not be able to afford an increase in their real euro debts of the size of the real depreciation of the lira. So, households may default on their euro mortgages, firms may default on their euro debts and even the government may have to restructure and reduce its euro public debt. So, outright default with all its ugly consequences is one solution to problem of the balance sheet effects of a real devaluation.

Alternatively, like in the case of Argentina, Italy could decide to "de-dollarize" and "pesify" or, in this case it is more correct to say, Italy would have to "de-euroize" and "lira-lize" its euro debts. So, like Argentina that pesified its domestic and foreign dollar liabilities, Italy would have to convert into the new liras its euros debts (see also the comments of Bloomberg columnist Gilbert along the same lines).

Who will bear the burden of this lira-lization? In the case of Argentina, the country was a net foreign debtor and thus, pesification implied that non-residents holders of Argentine dollar liabilities lost. But even in the case of Argentina, some of the dollar assets and liabilities were domestic and thus pesification implied redistribution of wealth from dollar creditors whose real assets fell in value after pesification to dollar debtors whose dollar debts were pesified and thus reduced as their were converted from dollars into pesos at an exchange rate value below the new market value after the move to the float. In the case of Italy, specific agents and firms in the economy may be net borrowers relative to the rest of the world but the country, as a whole, does not have a large amount of foreign debt. So, the losses from lira-lization of euro debts would be mostly redistribution of wealth and capital levies among different domestic agents, firms and the government. For example, lira-lization of the public debt would be a capital levy, i.e. a wealth tax, on all holders of Italian public debt.

Still, the losses to non-residents may still be severe as in the integrated European financial markets many non-residents hold Italian public debt in euros and many Italian financial institutions and banks have euro liabilities owed to non residents. Thus, lira-lization of Italian euro debts could have massive financial effects on other European financial institutions that hold such Italian euro liabilities. Severe contagion from an Italian default and lira-lization could occur and lead to painful systemic effects on European financial markets.

Of course, other problematic consequences would ensue: the external value of the euro would sharply fall as the probability that other EMU countries - Germany, Greece, etc. - would follow the Italian example would increase (see an interesting study by HSBC on the risks faced by EMU). And, certainly, the interest rate on the new italian lira debts would sharply increase as both devaluation and default risk would be sharply higher for a while. Of course, the Argentina example suggests that after a devaluation, default and de-dollarization have been associated with a severe economic and financial crisis, the economy would sharply recover and interest rates may fall as long as inflation is kept under control via some inflation targeting regime.

But Berlusconi and Italy should not delude themselves that going back to the lira would be painless and easy: before growth recovers, you would have devaluation, default, lira-lization of euro debts, bank runs and a systemic banking crisis, a systemic corporate crisis and a financial meltdown with severe international consequences. 

Is it worth for Italy to pay such costs to achieve a real depreciation and resume growth? The real costs of financial crises are massive  and Italy should try to avoid such an crisis scenario but, unless Italy dumps the Berlusconi gang,  changes government soon and starts a process of meaningful economic reforms to restore growth and competitiveness, Italy may end up, like Argentina with no choice: it may have to go back to the lira, devalue, default and lira-lize its euro debts.  In the case of Argentina, the move to a float, default and pesification became unvoidable given the size of the external shocks that hit its economy, the fact that it had a large and growing current account deficit, it had experienced a sharp real appreciation that needed to be undone and it had a public debt burden that was clearly unsustainable. Italy's fundamentals are not as bad as the current account is in a surplus, the lira is not massively overvalued, the external shocks are more modest and given, its primary surplus, the debt levels are high but not spiraling out of control.

So, hopefully Italy will avoid an ugly financial crisis, but it will take better economic policies than those of Berlusconi to prevent this potential and disastrous mess. And certainly the reckless comments by Berlusconi today are stupid: they do not solve the Italian economy's problems and they risk to lead to a self-fullfilling increase in Italian euro debt interest rates that may trigger a deeper economic downturn that could then trigger an otherwise avoidable currency and debt crisis. As correctly argued by Morgan Stanley's Chaney, the Euro is a convenient scapegoat but, if Berlusconi and Italy play with fire Rome will burn and its modern Nero Emperor - Mr. Berlusconi himself - may end up destroying Italy while immolating himself on the top of this funerary pire. If Mr. Berlusconi has suicidal tendencies he can get rid of himself and provide such a generous and long-needed gift to his country-men; unless he is a modern Nero madman, he should not take the entire country with him and burn Rome again. Italy deserves better.

As you may have already noticed, today I am involved in a Wall Street Journal Econoblog debate with David Altig on the issue of the Chinese currency revaluation. So, I suggest that you go to this free link to read about my views on this currency move. Feel free to add your comments there or here on my RGE blog. I look forward to your comments and interpretations.

The Financial Times reported on Friday as its lead story that the US expects Chinese currency revaluation:

The Bush administration has told key senators that it expects China to revalue its currency in August ahead of a planned visit to Washington by President Hu Jintao in September, according to people familiar with the matter.

Senators Charles Schumer and Lindsey Graham, co-sponsors of a bill that would impose a 27.5 per cent tariff on Chinese imports, agreed to delay a vote on their bill after receiving what they regarded as an assurance that China will move on its currency next month.

In a June meeting attended by Alan Greenspan, Federal Reserve chairman, John Snow, Treasury secretary, told the senators that he believed China would allow the value of the renminbi to increase against the dollar in August, the people familiar with the discussion said.

Dear readers of my blog, starting some time this coming week my blog will move and will be integrated in my companion project, the Roubini Global Economic (RGE) Monitor (www.rgemonitor.com). This RGE Monitor will also, at the same time, be redesigned in a major way both in terms of look/design and content. You will be automatically redirected to the new location of the blog on the RGE Monitor; at that point you may want to bookmark for your convenience that new location. With this switchtover, I also plan to blog more regularly to provide you on a regular basis with my views and insights on the global economy.