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.But returning to the lira would still be a "catastrophic financial event," as Barry Eichengreen, a professor at the University of California at Berkeley blunty put it to me. It wouldn't technically be a default, but it would amount to the same thing, leading to a continental recession that drags down the world. The problems would grow from there. Aside from the logistical nightmare of reintroducing a national currency on the fly, it would likely lead to a run on Italian banks as depositors rushed to grab as many valuable euros as possible before the big switch (that's assuming, of course, the euro itself didn't crater in value). Italy would also lose the trade advantages that come with membership in the EU, which could erase the benefit of a cheap lira. After all, most of its exports go to other European countries. For it to be truly worth departing, Italy's economy would have to deteriorate to a point where it would have nothing to lose from relinquishing the euro, and everything to gain from wrestling back control of its currency. We haven't reached that point yet. But we might. WHY ITALY COULD STILL FAIL Italy's leaders are taking the first tentative steps toward fixing their country's mess. In return, they expect more support from the European Central Bank, and possibly the IMF. But there's a possibility all of this will be for naught. The interim government will have to contend with the same cantankerous parliament that made life miserable for the old leadership. Election year is 2013. Given that its entire mission is to implement the unpopular belt-tightening measures sought by Europe's leaders, there's no telling whether it will be able to win the kind of popular support needed to sustain a reform effort. And rest assured: the challenges ahead will be grueling. As the Independent reports, the current austerity legislation "contains none of the painful labor market reforms, such as making it easier to fire workers, that have been strongly opposed by unions." That's a big problem. As I wrote yesterday, Italy's broken labor market is one of the most important factors hamstringing its economy. Fixing that system might be politically poisonous, but it's crucial. There's also the little question of whether the budget cutting measures sought by Europe's leaders are the right prescription for an economy that isn't growing. Italy's crisis is complicated. The upshot is simpler. Either the idea of a single currency works, or it doesn't. Either Italy can be pressured to act more like Germany, and all will be well, or it may have been folly all along to think you could take away a country's control over its currency while leaving it control of its politics. It's tough to ponder the fallout from that failure. But as Eichengreen put it to me, "The inconceivable becomes conceivable in strange economic times."
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