Italy is currently in crisis but would have to undergo a period of austerity if it restored its currency and renegotiated all Euro debts into the New Lira (that is, defaulted) because investors would be reluctant to purchase Italian government debt.
Answer: False
The answer is False.
Once the Italian government reinstated its currency sovereignty and allowed the New Lira to float freely then it could choose whatever net spending position it desired irrespective of the desires or otherwise of the private investors for its debt and the assessments of the ratings agencies.
To get to that point it would have to renegotiate all Euro-denominated public liabilities but Argentina showed in 2001-02, the defaulting nation in this case holds all the cards.
For its own citizens it could also exchange New Lira for euros (at some fair rate) for those who wanted their wealth to be preserved in the local currency.
Please read my blog post - Exiting the Euro? - for more discussion on this point.
The Italians would have to then take measures - such as reforming their tax base to ensure stable growth was achievable. That is, with the significant leakage into the cash economy, the effectiveness of fiscal policy in attenuating demand growth is reduced. So whether they stay in the Eurozone or leave, tax reform is required as a matter of urgency.
As noted in the blog, the tax reform, would have nothing to do with increasing the capacity of the Italian government to "raising funds" to allow it to spend. Once they exited the EMU the Italian government would be sovereign again and face no revenue-constraints on its spending. Rather, the tax reforms would give it more flexibility to control aggregate demand and align it better with real output capacity.
It is likely that bond markets would retaliate and boycott Italian government debt issuance. The Government would then have two options - both of which would be completely within its power.
First, it would have to reform the central bank arrangements to ensure that the elected government restored influence on monetary policy. One of the pre-conditions placed on nations desiring to enter the EMU was that requirement that the central bank was made completely independent. Independence on steroids was how one commentator at the time described the arrangements.
So with new legislation, the elected government could instruct the central bank of Italy to manage the yield curve should the bond markets boycott the issues.
Second, more sensibly, the Italian government could ignore the rating agencies altogether and dispense with the unnecessary practice of issuing any debt. This would give it some more scope for improving employment and welfare within the inflation constraint.
An exit and resulting flexible exchange rate would also allow the nation to realign its traded-goods sector with those of its trading partners without having to scorch the domestic economy and impoverish its workforce.
Many would predict that a fairly substantial depreciation of the newly-introduced New Lira would occur.
But that is unlikely to happen in the short-term because there would be no volume of New Lira in the foreign exchange markets initially.
People would be scrambling to get it to ensure they could meet their tax obligations to the state and would be selling euros to fulfill that aim.
That act combined with the short supply would likely push the exchange rate up initially.
Eventually, once volume rose in the foreign exchange markets the currency would move according to trade and capital flow volumes. It might depreciate somewhat against the euro (if the euro survived an Italexit) to adjust for productivity differences between Italy and Germany.
But then a growing economy would also attract foreign direct investment (capital inflow).
Any subsequent depreciation would reduce the capacity of Italians to purchase foreign goods and would add some price pressure (albeit finite and small) to the Italian economy. But the inflationary impact is not likely to be substantial if managed correctly.
This should ease the worries that some people have who think that the depreciation would be inflationary. As I explained in this blog post - When you've got friends like this ... Part 3 - there is "no mechanical link between the exchange rate and the inflation rate" (Source: Bank of England's inflation outlook).
It is clear that any depreciation would drive a once-off adjustment to the terms of trade and so imported goods (like military equipment) would become more expensive. This doesn't necessarily result in inflation if the consequences are sequestered from the distributional system and the nation takes the "real" cut in living standards that is implied.
This real cut can be attenuated by increased government provision of non-traded goods. Further, the domestic non-traded goods sector suffers no negative impacts and goods and services emanating from that sector form the bulk of private consumption anyway.
Further, the real cut via the depreciation is likely to be of a much smaller magnitude than the austerity plan they have in place at present.
Finally, the improving terms of trade will make the Italian export products including its tourist and shipping industries more attractive and net exports would likely be boosted adding to domestic growth.
So upon exit, the Italian government would become responsible for maintaining aggregate demand and could increase employment and income without having to engage in a drawn out and very damaging austerity program.
There would clearly be ructions associated with leaving the EMU but the government would be better placed to attenuate them.
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