Italy, not Greece, is the country that has the strongest case for leaving the euro, says a new report from Bank of America Merrill Lynch. The report lands as former Prime Minister Silvio Berlusconi—who is skeptical of the euro—positions himself to campaign for a return to the premiership. “We are all asking him to run, and I believe in the end, he will decide to lead the party,” People of Liberty Secretary General Angelino Alfano told Sky TG24 television on July 11.
The Merrill Lynch report has Italy tied with Ireland as the two countries with strong incentives to leave the euro, but co-author David Woo said in a July 13 interview that Italy is the country to watch. The Merrill analysis, which Woo did with fellow foreign exchange strategist Athanasios Vamvakidis, doesn’t say Italy will or should exit the euro. It simply ranks the countries by their relative incentives to leave and puts Italy and Ireland at the top of the heap.
Why Italy? Because, like other countries that are suffering from being yoked to the strong euro currency, Italy would benefit from increased export competitiveness, Merrill says in its July 10 report. And unlike some other troubled countries, Italy could probably stage a relatively orderly exit, the report says. Its government is running a small primary surplus—that is, not counting interest payments. A bigger challenge is that it has a significant current account deficit, which means that it needs a constant inflow of foreign capital to pay its bills.
Of course, export-led growth is only one consideration for a country. The most counterintuitive part of the analysis says that borrowing costs would fall for peripheral countries, especially Greece, Portugal, and Ireland, because the ability to print their own money would reassure markets that the likelihood of a default had fallen.
Woo says that if an exit from the euro is orderly, investors would quickly forgive Italy, even though that would lower the value of their Italian bonds. He cites the case of Russia, which defaulted on sovereign debt in 1998 and a year or so later had one of the world’s best-performing stock markets. “The market has a very short memory. If you have the right policies, and there are opportunities for investors to make money, the market doesn’t really care,” Woo says.
Debtor nations such as Italy would also benefit by redenominating their debts into less valuable local currencies. This, of course, assumes that Italy could simply declare that 100 euros in debt is now 100 lire. Doing so “may not automatically lead to a default,” the authors say, because the local law that governs most sovereign debt issuance gives governments wide latitude to restructure their obligations without triggering a default.
O.K., if Italy has a relatively weak incentive to stay in the euro, could Germany bribe it to stay in, since Germany would suffer from an Italian exit? Here Vamvakidis and Woo turn to game theory, the decision-making tool developed by such giants as John von Neumann and John “A Beautiful Mind” Nash. They conclude that Italy would have an incentive to exit even after Germany paid a bribe. Knowing that, Germany would never pay the bribe in the first place, not wanting to throw money away.
Here’s their bottom line: “Italy has more incentives than Greece to voluntarily exit the euro zone, in our view, while it will be more expensive for Germany to keep Italy in the euro zone. This means that Italy could be even more reluctant than Greece to accept tough conditionalities for staying.”
If all that’s true, the euro zone could unravel far more abruptly than most people are imagining.