In light of the crisis in Italy, Nouriel Roubini’s comments on the Eurozone back in 2006 have been getting a fair amount of buzz. And in fact this buzz is well deserved.He recently reposted the blog post he wrote in 2006, after speaking at Davos, and apparently offending the Italian Finance Minister Tremonti (who is still the finance minister for the time being), by calling for Eurozone doom.
The key thing here is how spot-on his assessment of the pain points were.
And unfortunately, the lack of serious economic reforms in Italy implies that there is a growing risk that Italy may end up like Argentina. This is not a foregone conclusion but, if Italy does not reform, an exit from EMU within 5 years is not totally unlikely. Indeed, like Argentina, Italy faces a growing competitiveness loss given an increasingly overvalued currency and the risk of falling exports and growing current account deficit. The growth slowdown will make the public deficit and debt worse and potentially unsustainable over time. And if a devaluation cannot be used to reduce real wages, the real exchange rate overvaluation will be undone via a slow and painful process of wage and price deflation. But such deflation will keep real rates high and exacerbate the growth and fiscal crisis. Without necessary reforms, eventually this vicious circle of stagdeflation would force Italy to exit EMU, return to the Lira and default on its Euro debts. Some argue that Italy or other EMU laggards would not exit EMU because a sharp devaluation of the new Lira – needed to regain the lost competitiveness – would make the real value Euro debt much higher and unsustainable for the government, the private sector and households. But look at what happened to Argentina: it devalued and given the balance sheet effects of the depreciation on their US debts it was forced to pesify its dollar debts. Similarly, Italy would be forced to liralize its Euro debts. If Italy were to exit EMU this effective default on domestic and external – public and private – Euro debt obligation would become unavoidable. And a sovereign nation is able to follow such policies – EMU exit, return to national currency and effective default on Euro debt – regardless of any legal or formal constraints that the EMU treaty imposes in terms of no exit clauses. This is not science fiction as Argentina was forced to do the same.
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