Euro Crisis

Euro Crisis: Reheated

Italy's elections make default look more likely. But not without consequences.

The Italians are fed up with austerity.

No real surprise here, of course; everyone in Europe is fed up with austerity, except the people who are still lending money. And since moneylenders are not a majority of the Italian electorate, the result is what we saw a couple of days ago: an Italian election that delivered gridlock. Italy now has a divided government whose only mandate is to make the pain stop.

Naturally, markets freaked out, because unlike Greece, Italy is actually in a position to do so. The country has been running a "primary surplus" for a while, which means that if you strip out interest payments, the budget more than balances. Since Italy does not need a cash infusion from Germany to keep its current level of government surpluses, the third-largest economy in the eurozone has two options open to ease its current misery: default on its debt, or withdraw from the euro, and let devaluation vaporize much of that debt's face value.

This would not only relieve their debt burden, but might also give the country a bit of an economic boost. For many years, Italy maintained its competitiveness by serial devaluations. The favorable exchange rate made it possible for relatively inefficient, often family-owned, firms to sell quite a lot of product abroad. That's why many of my readers probably own Italian furniture or leather goods. Entering the euro improved credit conditions, but at the cost of manufacturing competitiveness. Exit might give them a nice export boost, relieving some of the crippling unemployment currently afflicting Italian workers.

But there's a catch to euro exit. For starters, Italian banks are heavy buyers of Italian government debt, so exit or default might simply trade the current crisis for a full-blown banking meltdown. Moreover, many lenders do not quite trust the Italian government to give them a square deal, and so an enormous amount of their debt is apparently issued under other legal regimes.

Most of the borrowing by Italian firms is denominated in euros. And since most of that debt is issued under foreign law, not Italian law, disputes will be adjudicated by foreign courts. Which means that debt will stay denominated in euros--and even Italian firms who want to stay current may have little choice other than default.

The resulting credit contraction would be terrible news for the Italian economy. It does no good to goose your manufacturing exports with a devaluation if your manufacturers can't buy raw materials.

On the other hand, the current system is doing no good for anyone. Mightn't Italy, after another few rounds of elections and recriminations, decide that anything must be better than the devil we know?

After three years, I still don't have an answer for that. Confident predictions of doom are easy to make--and often wrong. Governments manage to muddle through much more often than you think they possibly can. But they do sometimes reach the limits of that strategy. And with Italian unemployment still rising three years in, we may be seeing that limit.