The euro may soon collapse even though there is no fundamental reason for it to fail. Everything depends on Italy, because financial markets now fear it may be insolvent. If Italy must continue paying a 7 per cent interest rate, the country’s total debt will grow faster than its ability to service that debt. If investors expect that to persist, they will stop lending to Italy. At that point, Italy will be forced to leave the euro. The resulting “new lira” will reduce the price of Italian exports. Competitive pressure could then force France to leave the euro as well, bringing the monetary union to an end.
This need not happen, however. Italy can save both its own economic sovereignty and the euro if it acts decisively to convince financial markets that it will balance its budget and increase its growth rate, reducing the ratio of its debt to output in a steady and predictable way. If markets have confidence in that, Italy’s interest rate could fall to its pre-crisis 4 per cent level.
Italy is well-placed to do this. Starting with its “primary budget surplus” (tax revenues exceeding total non-interest outlays), it can eliminate its overall budget deficit if it cuts spending by just 3 per cent of gross domestic product in a budget that equals half of GDP.