In the comments on an earlier article, Michele asked me about Italy leaving the Euro. Here’s her question:

i’m italian and a friend of mine claims that in order to solve all our economic problems we should exit the euro and devalue the currency.

he than claims that devaluating a currency doesn’t bring inflation…

note that i just want to refute the claim that devaluations don’t bring inflation, not his entire claim.

sadly i don’t have a competent guy in economics at hand and i really need a check on the whole thing.

i’d really like to read your take on this account.

thanks

Short answer: he may be right. But he is looking at only a small part of the big picture. Leaving the Euro will be a big mistake for Italy.

To understand what is going on in Italy, what exactly their problem is, see this article. Very short version: too much consumption, too little production.

To understand the role the Euro plays in Italy, see this one. Short version: Germany pays for all the wild Italian feasting and merrymaking.

Since Italy’s problem is too many parasitic jobs and too few productive jobs, playing around with the money, calling it Euros or Lira, will not change anything. The govt has to take a good hard look at all the ways it is harming the economy and stop doing them. Their guide should be: Does this cause less production? If yes, get rid of it.

In addition to the basic problem of not enough production to pay its bills, Italy has gotten itself into a deeper mess caused by their basic problem. Since Italians do not support themselves by producing things, they have borrowed a lot of money to pay for their high living, and now cannot afford to repay. This secondary problem, debt the Italians cannot repay, is the one Michele’s friend wants to solve. And his solution is elegant in its simplicity. Don’t repay, or at least repay with useless garbage.

To do this, Italy will have to stop using Euros as their currency and start using Lira. Then they will tell everyone that for every Euro they owe, they will repay with a Lira.

The only question that remains is, how will the Italians make sure the Lira will be useless garbage, money that has little actual purchasing power? Michele is worried that they will do it by printing a lot of these new Lira, so many that, by the laws of supply and demand, its purchasing power will go down. This is inflation for two reasons. First of all, the classical definition of inflation is increasing the money supply, printing new money. Which will happen, she fears. Second, the new definition of inflation is higher prices, which she also fears will happen. And if the govt does indeed print tons of Lira, she will be right on both counts.

But her friend may be right, and she may have nothing to fear. Perhaps the Italian govt will not print mountains of Lira. They may find that the Lira will become useless garbage very soon without massive printing. Since Italy has been producing less and less every year for decades, foreigners may soon see no point in possessing Liras. After all, the only use of Lira to a German is to buy Italian products, and if there are no Italian products, he will have no use for Lira. Why trade valuable foreign currency for something you cannot use? So that the Lira’s worth on the foreign exchange market will be very low.

Bottom line, maybe in time there will be no demand for the Lira. In other words, the Lira will turn into useless garbage not because the Italian govt will increase its supply, but because it is doomed to be worthless anyway. A currency that will not be able to buy anything, because almost nothing is made in Italy, will be useless garbage from the get go.

Now there is a difference between Michele’s way of ruining the Lira, by printing mountains of it, and her friends way, by relying on the new Lira’s becoming worthless from because there will be nothing to buy. Michele’s way will ruin the Lira for everyone, Italians included. When there is a lot of Lira in existence, it loses value for everyone. But her friend’s way might save the Lira within Italy. After all, people have to go shopping and pay their taxes, especially the latter. The govt will need Lira to pay its debts and to function. Foreigners will have no use for a Lira, but Italians certainly will.

But again, when Italy makes little to nothing, Italians will have to import everything. And then they will find, to their horror, that they cannot buy any foreign products with their new Lira, because foreigners have no use for them. In other words, prices of imported goods will rise under her pal’s scheme, as well. And since Italy makes very little, meaning Italians import almost everything, that means prices for almost everything will rise. So her pal may be saving Italy from monetary inflation, but the price inflation is sure to come.

As long as Germany is stupid enough and cowardly enough to pay all Italy’s bills, which they will do to keep Italy in the Euro [see above link], Italy is best off being smart enough and cynical enough to let them do it.