European View

The euro? More of a political creature than an economic one

by Luigi Zingales

24 Exclusive content for IT24

I would like to thank all those who contributed to the first phase of the debate on Italy and the euro, both those who did so following the rules I set out under the heading of my own column, as well as those who did it outside of these rule, in the rest of the newspaper.

The main conclusion is that the euro is a political, rather than an economic, choice. It is surprising therefore that economists are often called on to defend the euro as experts, when that task should really fall to political scientists.

The only two purely economic arguments for the euro were made by Tarek Hassan : a common currency reduces price variability, and reduces the yield of sovereign bonds because it makes them more liquid.

The quantitative dimension of these effects, however, is doubtful. These uncertain benefits are accompanied by high costs, especially for a country like Italy, with an inflexible price and wage structure. If continuous competitive devaluations can no longer be the solution to our problems, the lack of exchange rate flexibility forces our country to resort to internal deflation, which requires long periods of unemployment and recession. From 2008 to 2013 domestic demand in Italy fell by 16%; how much recession we still have to undergo to return to being competitive?

Given this analysis, it is not surprising that the almost unanimous support for the euro grew out of political considerations, as Ignazio Angeloni, a member of the European Central Bank’s Supervisory Board, said in his contribution . The political considerations laid out in support of the euro are of two types.

The first is idealistic: the euro is the first step towards a united Europe; the only remedy against the fratricidal wars that devastated Europe in the first half of the 20th century. The goal of avoiding another war obviously overshadows any mere economic calculation.

But the peaceful function of the euro is predicated on two hypotheses: that to be more united would prevent war, and that the euro would make us more united. Both of these hypotheses are questionable both from a theoretical point of view and (above all) from an empirical point of view. Do we really think that the Italians and the Germans feel closer today than twenty years ago when the euro was introduced? From what we can read in the pages of Il Sole 24 Ore-ItalyEurope24, it’s doubtful.

Most academics, from Cochrane onwards , support the euro for a different political motive: the “orthopedic” nature of the common currency. The euro is a “corset” that forces Italy to make economic policy choices that otherwise would not.

The economic need for an “institutional corset” is not new. For some time, economists have realized that constraints can overcome the time inconsistency of monetary policy (everyone would want to have low inflation, but in the short term it is politically convenient to stimulate the economy, with the effect of increasing inflation ).

But these constraints can be internal. The UK, which suffered high inflation in the 1970s, solved the problem without resorting to the euro. Proponents of the “orthopedic” vision claim (implicitly or explicitly) that Italians are not British nor can they hope to become like them. Italian democracy is so inefficient that it needs a “corset” imposed from the outside.
It is a plausible argument, but in economics the analysis of institutions is only at the primordial state. At this point it would be more useful to hear from political scientists. From an empirical point of view I can say that this was precisely why Argentina chose to be anchored to the dollar at the beginning of the 1990’s. The outcome was not good.

Not being a political scientist, I will limit myself to expressing two worries.

First, that the “corset” does not actually help to strengthen the muscles, but weakens them, as Italy’s former Prime Minister Silvio Berlusconi’s twenty years in power seem to demonstrate.

Second, the risk is that if the “corset” becomes too painful, the patient may rebel by ripping it off. This would be the worst of the possible worlds: on the one hand this violent action would cause damage; on the other, it would create the difficulty of living without “corset” and with weak muscles. The “patient,” Italy, would risk collapsing on the ground. My biggest worry is precisely to avoid this disaster.

From the debate it also emerged that it is not enough to simply state that the euro is irreversible. For Italy there is a risk of being thrown out (as was about to happen to Greece in 2015) or to be forced out in the midst of a severe economic or political crisis.

For this reason, regardless of our political views on the euro, it is important to understand not only what would be the costs of an Italian exit from the euro, but how these costs may differ depending on how the exit takes place.

The next contributions to the debate will look at this theme. On this matter, it is very important to understand the legal issues, so Hal Scott, a professor at Harvard Law School, will be the first to take the floor.