Italy will Kill the Euro - Not Spain or Portugal

Berlusconi's restive and anti-European coalition partners are mulling a contingency plan to pull out of the eurozone and reinstate the lire. Italy is in worse shape than most members of the European Union (EU): at 6% of GDP, it has an ostensibly sustainable budget deficit, but its external debt (now close to 120% of GDP) is higher than that of the most egregious wastrels in the bloc, Greece and Ireland included. Italy's banking sector is over-exposed to borrowers in Central and Eastern Europe, a region habitually pendulating between recovery and economic calamity. If Italy goes Greece's and Ireland's way, the EU and the International Monetary Fund (IMF) - already over-extended by serial bailouts - will be unable to stem the red tide. Italy may actually effectively default even before Spain and Portugal do.

Reverting to its erstwhile and much-abused currency will allow the cash-strapped country to print money to meet its budgetary demands without the shackles and constraints imposed by membership in the club of 16 rich European economies that have adopted the euro as their currency in 2002. Italy cannot levy additional taxes on its faltering economy and would rather minimize its borrowing abroad, the yield on its bonds having soared together with the other PIIGS (the five eurozone members afflicted with systemic risk). Its only remaining option is to monetize its financing requirements by printing money and to erode its public debt by reinflating its economy.

If Italy pulls out of the eurozone, it would spell the end of the euro for all intents and purposes.

What went wrong with Greece and Ireland? More specifically, where did the euro go awry?

I. The History of Monetary Unions

"Before long, all Europe, save England, will have one money". This was written by William Bagehot, the Editor of "The Economist", the renowned British magazine, 120 years ago when Britain, even then, was heatedly debating whether to adopt a single European Currency or not.

A century later, the euro is finally here (though without British participation). Having braved numerous doomsayers and Cassandras, the currency - though much depreciated against the dollar and reviled in certain quarters (especially in Britain) - is now in use in both the eurozone and in eastern and southeastern Europe (the Balkan). In most countries in transition, it has already replaced its much sought-after predecessor, the Deutschmark. The euro still feels like a novelty - but it is not. It was preceded by quite a few monetary unions in both Europe and outside it.

What lessons does history teach us? What pitfalls should we avoid and what features should we embrace?

People felt the need to create a uniform medium of exchange as early as in Ancient Greece and Medieval Europe. Those proto-unions did not have a central monetary authority or monetary policy, yet they functioned surprisingly well in the uncomplicated economies of the time.

The first truly modern example would be the monetary union of Colonial New England.