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.
But this need not happen. 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.
