European View

Italy unfit for the Eurozone?

by Paul De Grauwe

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Italy’s economic performance since it joined the Eurozone has been dismal. GDP per capita of Italy is now lower than at the start of the Eurozone in 1999. This means that the Italian population as a whole is now poorer than when the country joined the Eurozone.

The contrast with the evolution of per capita GDP of the euro area as a whole is a stark one. The other countries of the Eurozone saw their GDP per capita increase by 15% since 1999. In other words they have become richer by 15%. Not terrific, but surely much better than Italy. No other Eurozone country has done worse. Even Greece has done better than Italy.

Unemployment in Italy has not fared much better. It remains stubbornly at a high level of about 12%. Yes, there are two countries that have a higher rate of unemployment, Spain and Greece, but these two countries have seen their unemployment decline significantly since the Eurozone started to recover in 2004. No such decline has occurred in Italy.

While since 2014 the government debt-to-GDP ratio has started to decline in the Eurozone, no decline has occurred in Italy. The public debt of Italy remains stuck at more than 130% of GDP. Only Greece has a higher public debt level.

Why is it that Italy’s economic performance is so dismal? Has the euro something to do with this? These are questions that many people ask themselves. The answer to these questions is of great importance for the political and economic future of Italy.

There can be little doubt that being in the Eurozone has not worked well for Italy. This can be seen as follows. Many countries in the South of Europe (including Ireland, not really in the South) experienced strong deteriorations in their competitiveness from 1999, when the Eurozone started, until the financial crisis that erupted in 2008. Ireland saw its unit labour costs increase by 45% relative to the other Eurozone countries, Greece by 35%, Spain by 28%.

Thus these countries experienced a massive loss of competitiveness that hurt their exports and led to large current account deficits. Italy came third with a loss of competitiveness of almost 30%. Like in these other countries this inflicted large losses on Italian exports.

The big difference between Italy and these other countries occurred since 2008. Ireland, Greece and Spain started a process of “internal devaluations.” By that economists mean that these countries followed policies aimed at reducing wages and prices relative to other Eurozone countries.

They were very successful. Ireland, Greece and Spain experienced internal devaluations that restored their competitiveness to the levels enjoyed at the start of the Eurozone. No such adjustment occurred in Italy. The internal devaluation of Italy since 2008 (measured by a decline of relative unit labour costs) amounted to less than 10%. As a result, Italy is saddled with a loss of competitiveness that seems to be stuck at 20%. In other words Italy’s unit labour costs relative to the other Eurozone countries are now 20% higher than they were when the Eurozone started.

In a monetary union it is crucial that when a country is hit by a loss of competitiveness there exist a mechanism that will restore competitiveness. This mechanism seems to have worked in countries like Ireland, Spain and Greece. It is a very painful one, and often leads to much resistance of the people that are hit by declines in their wages. Yet in a monetary union it is also an inevitable one. Countries like Ireland, Spain and Greece seem to have overcome the resistance against internal devaluation.

The striking fact is that Italy has failed to introduce a mechanism that will restore its competitiveness. As a result, the massive and uncorrected loss of competitiveness continues to erode Italy’s capacity to export. If not corrected, large parts of the Italian export sectors will disappear. All this leads to the inability of Italy to start growing again and to reduce its debt overhang.

I conclude from all this that Italy does not seem to have the political institutions that will force internal devaluations. Of course, as argued earlier such an internal devaluation is very painful and leads to much resistance. Yet it is necessary to remain in a monetary union. The experience of other Eurozone countries, that had seen their competitiveness decline dramatically, shows that it is politically possible to engineer painful internal devaluations. This does not seem to be possible in Italy.

The inevitable conclusion seems to be that Italy cannot function well in a monetary union. Its political institutions makes it unfit to be in the Eurozone. If these political institutions are not changed fundamentally, Italy will be forced to leave the Eurozone. It cannot stand still and see its economic fabric deteriorate further.

Prior to the start of the Eurozone, when Italy had its own currency, it often lost competitiveness because of high inflation rates. It always restored its competitiveness by devaluations. This led to an economic model with frequent foreign exchange crises and high inflation rates.

Not a great model. But at least it was a model that was consistent with weak political institutions. In the absence of stronger political institutions Italy should prepare itself for an exit from the Eurozone in the foreseeable future.