Nearly a decade ago, Barry Eichengreen conjured a prescient scenario for the exit of Italy from the euro:

“Households and firms anticipating that domestic deposits would be redenominated into lira, which would then lose value against the euro, would shift their deposits to other euro area banks. In the worst case, a system-wide bank run could follow. Investors anticipating that their claims on the Italian government would be redenominated into lira would presumably shift into claims on other euro area governments, leading to a bond market crisis. If the precipitating factor was parliamentary debate over abandoning the lira, it would be unlikely that the ECB would provide extensive lender-of-last-resort support. And if the government was already in a tenuous fiscal position, it would not be able to borrow in order to bail out the banks and buy back its debt. This would be the mother of all financial crises.” (Our emphasis.)

After years of calm, fears of such a redenomination—prompted by the attitudes toward monetary union of Italy’s now-governing parties and the potential for another round of early elections—revived turbulence in Italian markets last week. Highlighting the worry about near-term prospects in a thinner market, two-year bond yields briefly spiked by more than 2 percentage points (see first chart below), even as benchmark German bond yields declined by around 15 basis points to as low as -0.8%. Credit default swaps on medium-term Italian government debt, as well as on several Italian banks, also vaulted higher (see second chart). Late in the week, the formation of a new government helped settle market conditions, but uncertainty lingers about Italy’s commitment to the euro.

Italian government bond yields (percent), 2009-1 June 2018 Note: The data are weekly, with the exception of daily observations for the final week ending 1 June 2018. Source: Bloomberg.

Italy: five-year sovereign credit default swap (basis points), 2008-1 June 2018 While we as yet have no evidence of a bank run, we would not be surprised if the data from the euro area’s Target2 system reveals continued shifts out of Italian banks (see our earlier note on Target2). Faced with an incomplete banking union, euro-area depositors have an incentive to move funds out of banks in countries facing heightened political risk, ebbing economic fortunes or both, and into those in “safer” jurisdictions. A remarkable warning last week from Bank of Italy Governor Visco—that “we must never forget the very serious risk of losing the irreplaceable asset of trust”—highlights just how easy it remains to trigger such a run within the monetary union.

And we have warned in the past that an Italian exit from the euro would be disastrous not only for Italy, but for many others as well (see our earlier post). To prevent (or more likely, to limit) a system-wide bank panic, an exit from the euro would have to be in the dead of night, with no prior announcement, and be accompanied by capital controls. Once applied, capital controls could take years to remove, angering those in Italy, and making those outside wary. It also is uncertain whether Italian authorities would have sufficient credibility to engineer a real (inflation-adjusted) depreciation of their new currency, whatever they choose to call it. Trust, once sacrificed, is difficult to recoup.

In the aftermath of an exit, doubts about the government’s willingness to ensure fiscal sustainability and to limit the volume of the “new lira” would favor high inflation rather than a currency-induced gain in competitiveness. Among OECD countries, Italy’s ratio of general government net debt to GDP ratio of 118% at end-2017 is second only to Japan’s 153% (see IMF WEO database). With the duration of the debt at about seven years, on average the Italian government must refinance debt equal to 17% of GDP each year, in addition to any non-interest deficits (see also here). Consequently, a loss of trust that sharply boosts government financing costs would put Italy on an unsustainable fiscal path—even without the spending increases and tax cuts sought by the new populist coalition.

Put differently, high-debt countries like Italy typically operate in a sensitive world in which a loss of confidence—manifested as a sufficient rise in the risk premium on their debt—will put them on an explosive debt path, triggering a self-fulfilling crisis. In this sense, the fiscal corset that Italy currently wears reflects the unavoidable debt and deficit arithmetic imposed by a standard budget constraint, not some arbitrary rules set by nameless bureaucrats in Brussels or Frankfurt. In the context of monetary union—in which sovereigns can and have defaulted—even temporary bouts of fear about the political commitment to debt sustainability can be sufficient to trigger the enormous bond market fluctuations like those witnessed in Italy last week.

The stark implication of this is that, rather than stimulating growth, a significant easing of the fiscal stance could easily trigger fears of fiscal dominance and a run on Italian banks. Imagine, for example, that a future Italian government—facing a plunge in the private demand for its debt—seeks alternative avenues of finance. In mid-2001, the cash-strapped provinces of Argentina adopted a classic destabilizing strategy when they issued an increasing volume of bonds shaped and formatted like currency notes, paying their workers with these instruments and encouraging their use as a means of exchange, including for the payment of taxes, credit card balances and mortgage obligations. The federal government followed suit. The images below show a one-peso Patacón from the province of Buenos Aires—the economically most important province and the largest issuer of such bills. The inscription on the reverse highlights the financial emergency and declares that these bills will pay 107% of their face value roughly a year after their issuance.

Province of Buenos Aires: Patacón issued in 2001 (front and back) Source: Timothy Kehoe, Figure 15, “What can we learn from the current crisis in Argentina?”, 2003.

The point is that, while legally a bond, such quasi-money is in reality a parallel currency. It is a sign that the fiscal authority has taken over the issuance of money from the central bank. The resulting loss of monetary discipline is a clear threat to price stability.

In Argentina, consistent with Gresham’s law, the quasi-money created by various fiscal authorities substituted for the official, central-bank-issued, pesos in transactions, “exhibiting a very high velocity of circulation, reflecting inferior status to the peso in terms of store of value and unit of account.” And, as the government first imposed controls in December 2001 and then defaulted on its external debt, quasi-money continued to grow rapidly: by late 2002, it was equivalent to roughly half of all peso-denominated currency in circulation (see page 34 in the 2002 IMF Article IV Consultation with Argentina).

Amazingly, the anti-establishment coalition in Italy already has advocated the creation of just such a quasi-currency, called mini-BOTs: small-format, small-denomination, non-interest-bearing, printed Treasury bills that—despite not qualifying as legal tender—could nonetheless be used to pay taxes or state services (including gasoline!). These new instruments would help fund a combination of tax cuts and increased government spending, but—according to advocates—would not count as debt subject to EMU rules. It is no wonder that financial market participants fear fiscal dominance over the central bank that eventually would compel euro exit and the reintroduction of a devalued national currency.

We have argued on several occasions that the greatest threat to the euro and to European Monetary Union is political (see here and here). As currently designed, with an incomplete banking union and insufficient risk-sharing to combat asymmetric regional shocks, the monetary union remains fragile. Lacking a common framework for deposit insurance and bank resolution, a euro in Rome is not identical to a euro in Frankfurt―and everyone knows it.

The ECB’s extreme commitment since 2012 to do “whatever it takes” to intermediate between the financial systems of the core and the periphery has held the system together, so far. For six years, the central bank has preserved the euro by offsetting and slowing bank runs from the periphery to the core. Where necessary, it continues to substitute for private cross-border intermediation through the ongoing expansion of its balance sheet, which now substantially exceeds that of the Fed (both in absolute size and relative to GDP). As of March, aggregate Target2 claims—which mirror the ECB’s cross-border efforts—were at a record €1.3 trillion, nearly 30% of the ECB’s balance sheet (see here).

However, the ECB can scarcely ignore explicit violations of the Maastricht rules, including a none-too-subtle effort to circumvent monetary control and fiscal discipline through the issuance of a parallel currency. Were future Italian leaders to embark on a large fiscal expansion financed by quasi-money, they would again test the ECB’s commitment as well as the patience of voters and politicians in core economies of the monetary union. For the euro area as a whole, Italy is surely too big to fail, but how the latest threat to the euro is resolved likely depends far more on the preferences of Italian voters than on the actions of policymakers elsewhere.

In his compelling analysis entitled “The Breakup of the Euro,” Barry Eichengreen suggested that the cost would be so high that no country with a sufficiently long horizon would be inclined to exit from the monetary union. We agree in theory. But in practice, it is precisely when troubled times shorten political horizons that the risks of a crisis surge. Follow @MoneyBanking1
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