In Lira, or in Euros?

Even if it is a debatable question whether or not the Iraq war is bogged down in a quagmire, Italy's economy evidently is. And no-one has even gotten round to offering a plan 'b', not even Tony Blair himself. So the silence is deafening, and this simply leads to increased speculation. Berlusconi only pronounced publicy on the issue last Tuesday, nearly three weeks after Maroni's referendum call. Latest on the list of those taking a long hard look is Bloomberg's Mark Gilbert, who has dug out an old paper by legal expert on international financial systems Hal Scott.

The key points:

``Countries have kept their own payment systems, government debt instruments, central banks, and the lion's share of their foreign-exchange reserves,'' wrote Hal Scott, professor of international financial systems at Harvard Law School, in a 1998 paper. ``It is almost as if the EMU countries have hedged their bets on EMU by retaining the key institutions needed to re- establish their own currency and monetary policies if need be.''

Scott's paper, titled ``When the Euro Falls Apart,'' went on to ask ``would foreign law, if applicable, such as the law of the U.S. or Germany, enforce the re-denomination or provide instead that the contracts must be honored in euros or are breached if not honored in euros? This is far from clear given the lack of precedents.''

As Gilbert notes:

"The thing about sovereign debt, though, is that the sovereign can do just about anything it likes on its domestic debt, because it enacts the laws that govern those securities. That's how Russia was able to stop paying the $40 billion it owed investors in 1998, and Argentina could default on $95 billion of bonds in 2002 and settle its accounts at 25 cents on the dollar."

Stephen King, head of global economic research at HSBC Holdings Plc in London, togave the following analysis to Bloomberg reporter Sebastian Boyd earlier this week:

"For Italy the choice is increasingly stark. The first choice would be an aggressive tightening of fiscal policy, large tax increases followed by cuts in public spending, and I don't really see the political will for that at the moment. The second choice would be some kind of bond default. The third choice would be an implicit bond default, by creating a system under which it could leave the euro. That would be very difficult to do.''

More or less I agree with this outline. My guess is that choice one will be tried and found to fail. Maybe then some attempt will be made to have a go at number 2. This failing, as it would, we will finally get round to option three.

I watched Argentina systematically from the late 90's on. In Argentina terms my best guess is that we are more or less in 1998 (the default came in 2001). The count down has commenced.