European View

Reconsidering the Euro for Italy

by Martin Feldstein

24 Exclusive content for IT24

Although Italy was an enthusiastic adopter of the euro when the single currency began, the Italian experience of the past decade suggests that was a mistake. Real GDP in Italy is actually lower now than it was a decade ago. Italy’s unemployment rate exceeds 11% and the ratio of its government debt to GDP now exceeds 130%.

While it is impossible to know what would have happened if Italy had not joined the Economic and Monetary Union, it seems plausible that Italy’s economy would be in better condition today if Italy, like Britain, had decided to keep its own currency and therefore to be able to manage its own monetary policy and its own exchange rate.

Advocates of adopting the euro argued at the time that members of the Eurozone would be forced by market pressures to converge to a high common level of productivity and a corresponding level of real wages. That never happened. Instead, Germany powered ahead with rising productivity that has resulted in real per capita income 30% higher than Italy’s, an unemployment rate that is less than half Italy's and a trade surplus that is 8 % of its GDP.

The countries that adopted the euro never satisfied the three conditions for a successful currency union: labor mobility, flexibility of real wages, and a common fiscal policy that transfers funds to areas that experience temporary increases in unemployment.

Labor mobility in the Eurozone is limited by differences in language as well as by legal conditions like professional licenses and union memberships. Real wages adjust slowly and do not reflect differences in labor productivity. And the Eurozone never adopted an American style tax and transfer system that offsets cyclical changes in the GDP of individual states.

The combination of slow economic growth and large fiscal deficits caused Italy’s national debt to rise faster than its GDP. The rising ratio of government debt to GDP caused the interest rate on Italy’s long-term debt to rise rapidly, with ten-year bond rates reaching 7.5% in 2011. The high level of interest rates increased the budget deficit and caused the national debt to rise more rapidly. Financial markets became concerned about the rapidly rising debt, fearing a default on the national debt or an Italian decision to leave the euro.

Mario Draghi, president of the European Central Bank , famously came to the rescue in July 2012 with his promise to “do whatever it takes.” That was backed up by an ECB agreement to provide credit to any Eurozone country that presented an acceptable plan to resolve its budget problem.

Although neither Italy nor any of the other peripheral countries of the Eurozone did present such a plan, the potential availability of a rescue package was enough to cause long-term interest rates to decline sharply. By the end of 2014 the interest rate on ten-year Italian government bonds had dropped from over 7% to below 2%.

Although the Draghi promise and the ECB plan prevented an immediate crisis, the fall in the interest rate eliminated the market pressure that would otherwise have forced the Italian government to reduce its budget deficit. The Italian deficit and debt condition therefore continues to get worse.

Looking back to the time when the euro began, it is clear that the case for adopting the euro was more political than economic. While Jacques Delors had famously argued that a single market requires a single currency to function well, neither economic theory nor the experience of the European Union members who did not adopt the euro supports the idea that the single market requires a single currency.

The real driving force behind the creation of the euro was the idea that if the public had euros in their pockets instead of Italian lira or French francs they would be more likely to regard themselves as European, thereby advancing the cause of an ever closer European union. The experience since then has failed to show the public's increasing identification as “Europeans” rather than as members of their individual countries and the overall public support for the euro has declined.

If Italy were to leave the euro and adopt a new currency, wages and Italian prices in the new lira currency would be lower than they had been in euros, giving Italy an advantage in trade both within Europe and with the rest of the world. But at the same time Italian households would still have mortgages and other large debts denominated in euros, implying an increase in the value of their debts relative to earnings. This same effect would cause many Italian businesses to experience an increase in their debts relative to their earnings and assets.

If Italians had known what would happen in the years since the euro began, they might not have opted to join the monetary union. But the decision to leave now is complicated by conditions that would not have occurred if Italy had never adopted the euro.