If Italy thinks the unthinkable about the eurozone


What if a government decided to leave the European Monetary Union and abandon the Euro? A realistic question, and yet nobody dares to ask.

The agreements that established the euro contain no provisions to allow exit. However, if some government – let us suppose the Italian one – decided to leave, there is nothing Europe could or would do to stop it. But what exactly would a government set on such a course – or forced into it – do?

The objective would be to establish a currency – the new lira – which would substitute for the euro in domestic transactions but sell at a discount to the euro in international transactions. A bus fare of one euro would become a bus fare of one new lira but the external value of the new lira might fall to 75 euro cents in financial markets.

There are no precedents in advanced economies for such a policy. Currency unions have broken up before, but they have usually been de facto rather than legal currency unions – as between Britain and Ireland. Or the motives for the break-up have been political rather than economic. When Czechoslovakia split apart the aim was to preserve, rather than to alter, the terms of exchange between the two new states.

The laws that brought the euro into being said that contracts made in lire were to be interpreted as contracts made in euros at a prescribed conversion rate. But you cannot simply pass a law that contracts made in euros can in future be discharged in new lire. The plan would have to distinguish Italian contracts from others. But how? The Italian state would pay employees and pensioners in new lira. It might impose a temporary freeze on domestic prices and wages, whose lira amount could not exceed their old euro values. This is the familiar apparatus of crisis devaluation. But what of financial and commercial contracts made in euros before A-day but not yet completed?

The simple answer is that an agreement in euros stays in euros. But this is not politically feasible. Italians would not accept that their mortgages and credit-card debts, denominated in euros, would cost them one-third more to repay: and it would be absurd if the bank deposits of Italian residents were revalued by a similar amount.

The relevant principle of international law seems to be that debts are denominated in the currency of the place where they are to be paid. But in the modern world, that question often has no clear answer. The residence of parties to the contract also matters. This seems to give generally sensible answers when both are Italian, but in many cases one party is Italian and the other is not. What of multinational companies? Then there is an issue of legal jurisdiction. For example, many financial contracts are made under English law even if the transaction has nothing to do with England. An English court would want to uphold a valid Italian law, but it cannot be assumed it could or would, especially if that law seemed to favour Italians at the expense of other nationalities.

Businesses with activities in both Italy and other countries would find that some assets and liabilities had been converted to new lira while others remained in euros, and there would be large mismatches between the two. The likely losers would be multinational companies with Italian assets and dollar balance sheets: the likely gainers might be Italian retail financial institutions, which collect deposits in Italy and place them in other countries. The outcome would be a period of chaos in markets and a decade of work for lawyers.

Some people will conclude that these problems make a break-up of the euro impossible. This would be a profound error. History – not least the establishment of European monetary union itself – shows that, given political determination, practical problems will be overcome. Civil servants, lawyers and bankers are there to ensure that a client’s wishes are met even if misconceived and if the Bank of Italy does not have a plan in its safe, its officers have been failing in their plain duty.

Any international bank or business should contemplate these issues. But the consequences of such contemplation are grave: in financial markets, actions to protect against a contingency make that contingency more likely. That is why a debate on the fragmentation of the eurozone is a debate that no one dares have.

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