How it could happen; why it would be horrible

By J.O. | LONDON

THE bond-market run on Italy has increased the chances of an eventual break-up of the euro, even if no one can be sure what the precise odds now are. If Italy is unable to finance itself at reasonable rates, and the resources of the rest of the euro zone cannot (in the case of the EFSF, the bloc's rescue fund) or will not (in the case of the ECB) stretch to a bail-out of such a big, indebted sovereign, then one of the attractions of euro membership (ie, low interest rates) is gone. That weakens the argument for staying in. If default is forced upon Italy, goes the argument, why would it not go the whole hog and create a new domestic currency?

That way, at least, Italy could write down its wages, prices and private debts at the same time as its public debts. All such contracts could be redenominated in a new lira, at a one-for-one exchange rate with the euro. The currrency would then "float" (ie, sink) to a discount to the departed euro on foreign-exchange markets. The size of that effective devaluation would measure the magnitude of Italy's default against its euro creditors. And the deeper cause of Italy's economic malaise, its chronic lack of cost competitiveness, would also then be addressed. A cheap new lira might even make Italian industry vibrant again.

Creating a new currency is not that difficult. A determined country could simply pass a law saying that all financial dealings should henceforth be conducted in the new lira (or drachma, or escudo, or whatever). Colleagues who have covered Argentina tell of how, in August 2001, the province of Buenos Aires issued $90m of IOUs to employees as part of their pay packets. These bills, known as patacones, were soon widely accepted in exchange for goods and services. McDonalds even offered a special “Patacombo” menu in exchange for a $5 denomination IOU. Argentina broke its "irrevocable" currency peg to the US dollar a few months later.

The technical challenges are not great. What is vastly under-estimated by advocates of euro exit is the financial and social chaos that would ensue both in the departed country and in the rest of the world. A euro break-up would not, as some seem to believe, be a slightly messier version of the ERM crisis of 1992-93. It would be a gigantic financial shockwave. Once departure by Italy were a serious prospect, there would be runs on its banks as depositors scrambled to move savings to Germany, Luxembourg or Britain, in order to avoid a forced conversion into the new weaker currency. The anticipated write-down of private and public debts, much of which is held outside Italy, would threaten bankruptcy of Europe's integrated banking system.

There would be runs on other countries that might even consider leaving. A taboo would be broken. Credit would collapse. There would be a dash for cash (those €500 euro notes would come in handy). Businesses short of it would go under. Capital controls and restrictions on travel would be needed to contain the chaos. Once the recriminations start, the survival of the European Union and its single market would be under question. It's all a frightening prospect. But that doesn't mean it won't happen.