European Affairs

Summer 2005

 

European Perspectives

Could Italy Be First to Leave the Euro?

By David Hale

 

The defeat of the European constitution in the French and Dutch referendums created a political crisis and provoked a slump in the value of the euro. But the most serious threat to European monetary stability is not the debate about the constitution; it is the fact that Italy has slid back into recession because of declining industrial competitiveness. There is a not insignificant risk that Italy could be compelled to withdraw from the European monetary union and the euro if it cannot revitalize its economy with higher productivity growth.

Italy struggled to reduce its budget deficit during the late 1990s in order to join the euro. But while Italy improved its public finances, it has suffered from membership of the monetary union because of declining productivity. Since joining the monetary union, Italian unit labor costs have increased by 15 percent, compared to a rise of three percent in France and a decline of five percent in Germany.

During the past five years, German companies have ruthlessly reduced unit labor costs by trimming employment, increasing the workweek and maximizing productivity. Italian companies have found it hard to keep up with German productivity because of cultural differences and the high cost of firing workers. During the past four years, German companies have reduced their employment by six percent, while Italian companies have shed only 0.7 percent. As a result, Italy's share of global exports has slumped by 25 percent during the same period.

In the past, Italy always coped with competitiveness problems by devaluing the lira. In 1993, for instance, Italy enjoyed a burst of export-led growth by devaluing the lira by 34 percent. But as a result of monetary union, Italy has lost this option. If Italy is to remain in the euro, it will either have to boost productivity or put the economy through a period of deflation to drive down costs. It is difficult to imagine deflation in Italy because the government has just announced a five percent pay increase for civil servants over two years. The risk is high that the increase will set an example for unions in the private sector.

Italy also has structural problems in meeting the challenges of globalization. Italian exports are concentrated in low-skill, labor-intensive sectors such as textiles and shoes. In 2004, exports of clothing, textiles, and leather accounted for 13 percent of Italian exports, compared to three to four percent in Germany and France. Automobiles represent 16.8 percent of German exports and 13.1 percent of French exports, against only 7.7 percent for Italy.

Textiles account for 12 percent of Italian manufacturing jobs compared to five percent in France and two percent in Germany. Italian industry is also dominated by small companies. Over 90 percent of all enterprises employ fewer than 10 workers. The dominance of small businesses has inhibited spending on research and development as well as on information technology, where Italian spending is far below its main European competitors.

Ministers of the Northern League, which forms part of the governing coalition, recently called for abandoning the euro and reintroducing the lira. That was a surprise, because in the 1990s the Northern League welcomed the impact of the monetary union on Italian borrowing costs - the interest rate on Italian government bonds fell from double-digit levels to 3.5 percent and Italy's government debt servicing costs fell from 12.6 percent of GDP to 4.7 percent.

If Italy were to leave the monetary union, the interest rates on Italian public debt would skyrocket back to double-digit levels. The government would also have to address the difficult question of whether to convert existing debt into liras or continue to treat it as euro-denominated debt. As Italy produced large capital gains for bond investors during the late 1990s by converting lira debt into euro debt, the odds are high that the Italian parliament would pass a law declaring all the debt to be lira-denominated.

When Argentina devalued in 2002, its government converted both public debt and utility contracts from dollars into pesos. It then simply defaulted on the securities that were still dollar-denominated. The only time Italy has ever defaulted was when Mussolini did so during the mid-1920s in order to reduce the fiscal deficit and lower the level of public debt from 75 percent of GDP to 50 percent. The conversion of euro bonds into lira instruments would not be a technical default but would still produce large capital losses for bond owners.

Since monetary union, Italy has taken advantage of falling borrowing costs by doubling the maturity of its public debt to five years. Italy should prepare for the risk of leaving the euro by attempting to prolong the maturity of its debt even farther. Some Italians will probably also favor large government debt sales to the Argentinians in order to punish them for the billions of dollars of defaulted Argentine securities owned by Italian investors.

When Italians are told their country could become a new Argentina, they naturally assume the reference is to their soccer team. But the reality is that there are a growing number of economic parallels between the Argentine crisis of five years ago and today's situation in Italy. Monetary union has given Italy a fixed exchange rate which is steadily eroding the country's competitive position. Italy has a public debt equal to 106 percent of GDP and is once again running fiscal deficits of four to five percent of GDP. The European Union will allow Italy a period of grace to reduce the fiscal deficits because of the downturn in the economy but Brussels cannot do anything to restore Italy's competitiveness.

Other European countries will do everything possible to help Italy remain in the monetary union. They will give Italy additional time to reduce its fiscal deficit. There will be strong pressure on the European Central Bank to protect Italy by restraining interest rates and limiting upward pressure on the common currency.

What remains to be seen is whether special treatment for Italy will produce a counter-reaction in countries such as Germany and the Netherlands. They were initially opposed to Italy's membership of the monetary union, and there could be a public outcry if there is an excessive accommodation of Italy's fiscal irresponsibility. The credibility of the ECB could also be at risk if it is widely perceived that monetary policy is being targeted on keeping Italy in the euro.

There are few signs that Italian politicians appreciate the scope of the challenge that lies ahead. The Berlusconi government is unpopular and thus unable to propose any radical reforms. The opposition leader, Romano Prodi, leads a left-wing coalition that includes the labor unions. If Mr. Prodi's coalition were to win the national elections due in spring 2006, it would be reluctant to enact legislation that might weaken employment security or encourage aggressive restructuring.

The inertia in Italy is distressing because Germany is likely soon to elect a Christian Democratic government that will probably accelerate the pace of economic reform. France may also elect a more reform-oriented president in 2007. If Germany and France restructure more effectively and bolster productivity, the competitiveness problems of Italy will intensify. By 2010, Italian unit labor costs could be 40 percent to 50 percent higher relative to Germany than they were in 2000. In such a scenario, Italian industrialists could become sympathetic to calls for restoring the lira in order to devalue against the rest of Europe.

There was derision in the markets when the Northern League welfare minister proposed reintroducing the lira, because of the potential consequences for Italian interest rates. But while leaving the monetary union would be a very high-risk policy, the fact remains that membership will become increasingly high-risk if Italy cannot improve its productivity. There is no simple solution to Italy's problem. At this point only one thing is certain. Italy could become the first country to leave the monetary union if there is no improvement in its economic performance. As a result, the yield on Italian government debt should be much higher than the current 25-basis-point yield differential with Germany. In the next few years, this yield gap is likely to emerge as a very important proxy for investor confidence in Italy's capacity to reform its economy.

David Hale is an economist based in Chicago.

The opinions expressed in this article are entirely those of the author and do not necessarily represent the views of FedEE or its corporate members.