The possibility of a populist, euroskeptic government coming to power in Italy has focused investors’ minds like few other events this year. The yield differential, or spread, between Italian and German bonds has widened sharply, indicating that investors view Italy as a riskier bet. And Italian equity prices have fallen – particularly in domestic bank shares, the best proxy of country risk – while insurance premia against a sovereign default have increased. There are even fears that Italy could trigger another global financial crisis, especially if a fresh election becomes a de facto referendum on the euro.
Even before Italy’s March election, in which the populist Five Star Movement (M5S) and the right-wing League party captured a combined parliamentary majority, we warned that the market was being too complacent toward the country. Italy now finds itself in more than just a one-off political crisis. It must confront its core national dilemma: whether to remain shackled by the euro or try to reclaim economic, political, and institutional sovereignty.
We suspect that Italy will compromise and remain in the eurozone in the short run, if only to avoid the damage a full-scale rupture would cause. In the long run, however, the country could increasingly be tempted to abandon the single currency.
Since Italy returned to the European Exchange Rate Mechanism in 1996 – after withdrawing from it in 1992 – it has surrendered its monetary sovereignty to the European Central Bank. In exchange, it has enjoyed much lower inflation and borrowing costs, resulting in a dramatic reduction in interest payments – from 12 percent of GDP to 5 percent – on its massive public debt.
Still, Italians have long been uncomfortable with the lack of an independent monetary policy, and that sense of lost control has gradually overshadowed the advantages of euro membership. The adoption of the euro has had massive implications for the millions of small and medium-size enterprises that once relied on periodic currency devaluation to offset the inefficiencies of Italy’s economic system and remain competitive.
The inefficiencies are well-known: labor-market rigidities, low public and private investment in research and development, high levels of corruption and of tax evasion and avoidance, and a dysfunctional and costly legal system and public bureaucracy. And yet several generations of Italian political leaders have cited “external constraint,” rather than domestic necessity, when pushing through the structural reforms required for euro membership – thereby reinforcing the sense that reforms have been imposed on Italy.
The loss of monetary sovereignty means there are effectively two chains of political command in Italy. One extends from the German government, through the European Commission and the ECB, down to the Italian presidency, treasury, and central bank. This “institutional” chain of command ensures that Italy meets its international commitments and maintains strict adherence to EU fiscal rules, regardless of domestic political developments.
The other chain of command starts with the Italian prime minister and extends through the government ministries that are responsible for domestic affairs. In most cases, the two chains of command are aligned. But when they are not, a conflict inevitably ensues. Hence the current crisis, which came to a head when the prime minister-designate tried to appoint the euroskeptic economist Paolo Savona as Italy’s next economy and finance minister without first consulting the other chain of command. The appointment was duly rejected by the Italian president.
Let us return to the question of whether Italy will now choose to break free of its straitjacket. Despite the euro’s advantages, it has not delivered for Italy economically. Italy’s real (inflation-adjusted) per capita GDP is currently lower than it was when the euro experiment began in 1998, whereas even Greece has managed to register growth, despite its depression from 2009 onward.
Some would explain this poor performance by arguing that the eurozone is an incomplete monetary union, and that its “core” countries like Germany drain labor and capital from “periphery” countries like Italy. Others might counter that Italians failed to conform to the rules and standards, and to implement the reforms, upon which a successful monetary union is based.
But the real explanation no longer matters. The prevailing narrative in Italy holds the euro responsible for the country’s economic malaise. And political parties that have either openly or implicitly called for leaving the eurozone currently hold a parliamentary majority, and would likely retain it in another election later this year or in early 2019.
If Italians were confronted with the choice of retaining or abandoning the single currency, recent polls suggest that they would initially decide to stay, for fear of a run on Italian banks and public debt, as Greece experienced in 2012-2015. But the long-term costs of remaining in a club dominated by inherently deflationary, German-dictated rules might tempt Italians to leave. That decision could come in the midst of another global financial crisis, recession, or asymmetric shock that pushes several fragile countries out of the euro at the same time.
Like the United Kingdom’s Brexiteers, Italians might convince themselves that they have what it takes to succeed on their own in the global economy. After all, Italy has a large industrial sector that is capable of exporting worldwide, and exporters would benefit from a weaker currency. Italians might be tempted to think: Why not escape the euro before those industries fold or end up in foreign hands, as is already happening?
If Italians do eventually go down this path, the immediate costs will be borne by domestic savers, whose nest eggs will be redenominated in depreciated liras. And the costs would be still greater if an Italian exit precipitated another financial crisis with bank holidays and capital controls. Faced with these possibilities, Italians – like the Greeks in 2015 – might blink and stay. But they also might decide to close their eyes and take the plunge.
Though Italy would be better off staying in the eurozone and reforming accordingly, we fear that an exit could become more likely over time. Italy is like a train whose engine has derailed; it might be only a matter of time before the cars behind it start coming off the track.
Copyright: Project Syndicate
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