Taboos prohibit even thinking about a particular action. While taboos play an important role in social interaction and most religions, economic policy, which requires a careful examination of all the options, should be exempt from them. Given the severity of Italy’s crisis and its systemic importance, one should not be deterred from asking: should Italy stay in the euro?
From Europhoria to Europhobia
When Italy chose to join the euro in the early 1990s, it opted to relinquish control over its unsound monetary and exchange rate policies in return for the price stability and low interest rates of Germany, and for the hope that a common currency with its most important trading partners would boost its trade.1 Until the outbreak of the financial crisis, the euro seemed to broadly fulfill its promises, but now that unemployment and interest rates have soared and all of Italy’s policy instruments—fiscal, monetary, exchange rate—are shackled, the euro’s reputation is suffering and a more dispassionate examination is needed. We will never know precisely what the euro’s impact has been since we cannot know what would have happened had Italy not adopted it. However, by comparing Italy’s performance before and after the euro, we can develop a sense of what it may have achieved.
Inflation and Interest Rates
In the pre-euro decades of the 1970s and 1980s, Italian inflation averaged more than 13 percent a year, but came down gradually to around 5 percent as the prospect of euro introduction became firmer in the 1990s. Today’s moderate 2–3 percent inflation is, so far at least, the euro’s greatest victory.
Interest rates on government debt present a more complicated picture. Excluding the extraordinarily volatile 1970s, real interest rates on ten-year Italian government bonds averaged about 4.5 percent from 1960 to 1995. Interest rates fell sharply with euro adoption and averaged a little above 2 percent until the outbreak of the crisis in 2008.
The European sovereign debt crisis has meant much higher interest rates. But even so, at around 3.4 percent, the current real interest rate remains well below the pre-euro average and is another euro victory. So long as inflation and interest rates can be maintained at current levels, then, on this score at least, Italy is better off than it was before the euro.
Competitiveness and Trade
The euro’s value reflects the competitiveness not just of Italy, but of all the other sixteen countries that have adopted it. If prices in Italy rise faster than in its eurozone partners, Italy becomes a less attractive place in which to do business.
Unit labor costs—wages adjusted for productivity—are a more appropriate indicator of competitiveness than consumer prices. Differences in unit labor costs are not easily arbitraged because labor does not move easily across European countries. Reflecting both rising wages and stagnating productivity, this measure reveals a severe competitiveness problem. From the end of 1998, when exchange rates were fixed, through the first quarter of 2011, Italy’s real effective exchange rate—based on unit labor costs—has risen by 26.7 percent. As the chart shows, Italy’s competitiveness position is clearly worse under the current arrangement.
This loss of competitiveness is reflected in the Italian trade deficit. Italy ran a healthy current account surplus in the years prior to euro adoption, but it has run deficits in recent years, culminating at -3.3 percent of GDP in 2010. Meanwhile, Italy’s export volume growth slowed from 4.4 percent annually from 1980 to 1998 to 2.9 percent from 1999 to 2007. Moreover, despite the common currency, Italy’s trade with the eurozone has fallen relative to its trade with both non-eurozone Europe and non-European economies.
Not all these adverse trends can be blamed on the euro. But there is no doubt that Italy’s inability to resort to devaluation in the face of rising labor costs and slow productivity improvements has contributed to the yawning competitiveness gap and slowing export growth.
Debt and Economic Growth
Italian government debt had been high and rising for decades prior to euro adoption, peaking at 122 percent of GDP in 1994. A combination of falling interest rates and an improving primary surplus (government balance excluding interest payments) then followed, allowing Italy to cut its debt to 104 percent of GDP in 2007.
Unfortunately, in the aftermath of the financial crisis, Italy’s public debt has returned to its pre-euro level. However, Italy’s debt deterioration during the crisis is much less than that of nearly all other advanced countries; furthermore, the IMF expects its debt level to stabilize in coming years. This suggests that Italian public debt dynamics are, if anything, better with the euro than before it.
Italian private debt levels, however, have been rising. According to a report by McKinsey, total Italian private debt rose from 196 percent of GDP in 1995 to 315 percent in 2009. Debt owed abroad by the private sector is also increasing—from 2002 (the earliest data is available) to 2011, external debt rose from 82 to 115 percent of GDP. These rising private debt levels are, however, far less dramatic than in, for example, Spain and Ireland.
Most worrisome, since the ability to raise living standards as well as to carry debt depends on the ability to grow, Italy’s GDP growth slowed sharply since the euro’s introduction. From 1980 through 1998, Italian GDP growth averaged 2 percent a year, compared to 1.5 percent from 1999 through 2007; including the 2008–2011 crisis period, growth in the euro era has been an abysmal 0.7 percent.
From all of this, one can draw the following conclusion: it is not unambiguously evident that Italy is worse or better off today than it was before it chose to join the euro. Lower inflation and interest rates are a big plus. However, the loss of competitiveness and slowing growth represent a huge challenge. So far, Italy’s debt dynamics remain difficult but manageable. In the end, much depends on interest rates remaining within reasonable bounds and Italy being able to continue to refinance its maturing debt.
What happens if things get worse?
One cannot ignore the possibility that, in a deteriorating international environment and given the deep political divisions in the eurozone and in Italy itself, Italy’s interest rates could rise further, and, like Greece, its economy could go into a downward spiral of surging debt and collapsing economic activity. Could Italy then envisage leaving the euro? As Barry Eichengreen has argued, exiting the eurozone entails incurring the ill will of European partners, as well as economic and transactional costs.
Transactional costs would be major but surmountable. Countries, which not so long ago turned their economies into arms production machines and fought a world war, are perfectly capable of minting a new currency, reprogramming computers, and limiting capital flight as that currency is introduced.
By contrast, the economic cost of a euro exit would be enormous. Reintroducing and devaluing the lira would only make sense if the devaluation was large enough to help restore competitiveness. But such a devaluation—amounting to say, 30 percent—would make it difficult for the Italian state and many firms to service their foreign (euro and dollar denominated) debts. At the end of the second quarter of 2011, Italy’s external debt—both public and private—totaled 1.9 trillion euros, or about 115 percent of GDP, of which the public foreign debt is 800 billion euros, or 52 percent of GDP. Introducing a devalued lira, would imply a 570 billion euro (36 percent of GDP) increase in the debts owed by Italians.
To be sure, some households and firms with assets abroad could stand to gain from devaluation. But the Italian state and firms that are net borrowers internationally would be exposed to large losses, and may default. Moreover, liquidity would dry up for banks and many others, even if their net investment positions are relatively balanced. A huge financial crisis and a decade of litigation would ensue.
Recent episodes in emerging markets have led to an average contraction of around 5 percent in the year following similar crises, though the decline was up two to three times sharper in Argentina and Russia. UBS estimates that euro exit could cost Italy as much as 50 percent of GDP. While the latter is almost certainly an exaggeration, even assuming that Italy’s GDP contracted by 10 percent after leaving the eurozone but its long-term growth accelerated from 1 to 1.5 percent, it would take 25 years for its GDP to regain its trend level.
To complicate matters, there is no guarantee that such a disaster would eventually give way to the long term acceleration of growth. The benefits of devaluation could turn out to be short-lived and offset by inflation.
In any event, Italy cannot choose between being the Italy of today or that of twenty years ago, before the euro. And even if it could, the choice to make is far from clear. What is obvious, however, is that Italy’s central challenge today is reestablishing competitiveness, improving productivity, and reigniting growth. And that is precisely where current Italian policies are falling short.
Uri Dadush is the director of Carnegie’s International Economics Program. Bennett Stancil is a researcher in Carnegie’s International Economics Program.
1. In practice, Italy—which maintains an open capital account—cannot control both simultaneously. As the Bank of Italy notes, the exchange rate was its major occupation in the 1980s, thus limiting its ability to freely conduct monetary policy. However, by adopting the euro, Italy sacrificed its ability to choose which dimension to manage and, in cases where it elected to float its exchange rate, lost the pressure release that can come from market depreciation.