Italy and the euro need to stay together, but even if they do, they still might not survive.
The globe's financial markets finally relaxed today after a week of mania over Italy's debt crisis. Despite some initial waffling, the country's government is poised to pass a series of reform measures meant to fix its shambling economy. That paves the way for Prime Minister Silvio Berlusconi to make good on his promise to bow out and let his likely successor, a widely respected former European commissioner, step in. Markets are up. European bond yields have eased.
Surely, as your read this, some frazzled banker is kicking back with a Campari and soda.
Yet, it's still too early to celebrate. Italy's reform legislation is the start of a solution, not the end of a crisis. Its economy, along with its marriage to the euro, will continue to be tested. And as desperately as the world needs that relationship to work, it may be doomed to fail.
WHAT'S HAPPENING IN ITALY NOW
The austerity measures making their way through Italy's parliament are an effort to save not only the country's economy but also the euro. Italy is the currency's third biggest economy, and its collapse, or possible defection back to the lira, its old currency, would have a devastating impact on the entire union. By taking steps such as privatizing services, selling state-owned real estate, and raising the retirement age, the government is hoping to win back the confidence of bond investors as well as its euro zone neighbors and salvage itself from disaster.
Those measures have already passed the parliament's upper house, and are expected to go for a final vote on Saturday. At that point, Prime Minister Silvio Berlusconi would step down. His heir apparent is Mario Monti, an economist and former European commissioner known as a consummate technocrat. In the clinical, data-oriented world of international finance and policy making, that's pretty much the highest compliment a public official can get, and his ascendance alone is abating some fears about Italy's future. In Europe's eyes, he's the man who can right the ship. But if he can't, the consequences will be ugly.
WHAT BREAKING UP WOULD LOOK LIKE
It's hard to exaggerate the gravity of Europe's situation. Italy is both too big to fail and too big to bail out. Italy's $2.6 trillion debt--that's more than four times what Lehman Brothers owed creditors when it filed for bankruptcy--reaches far and wide. But much of it lives with the banks of Germany and France -- the first and second largest economies in Europe. So a default would strike at the heart of the three largest markets in Europe. The result would be another global financial crisis.
Italy could address its problems by waving goodbye to the euro. Per the Economist:
Italy could write down its wages, prices and private debts at the same time as its public debts. All such contracts could be redenominated in a new lira, at a one-for-one exchange rate with the euro. The currrency would then "float" (ie, sink) to a discount to the departed euro on foreign-exchange markets. The size of that effective devaluation would measure the magnitude of Italy's default against its euro creditors. And the deeper cause of Italy's economic malaise, its chronic lack of cost competitiveness, would also then be addressed. A cheap new lira might even make Italian industry vibrant again.