Sunday, May 27, 2018
Italy will work hard to avoid crashing out of the euro
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

It is comforting when normal service is resumed, by which I mean that Italy has taken its rightful place as the number one worry for the eurozone. The formation of a wacky coalition of the anti-establishment Five Star Movement and the right-wing, anti-immigration League, under an unknown and untested prime minister, Giuseppe Conte, is a little extreme even by Italian standards. But the fact of a populist Italian challenge to living under the eurozone yoke should not be a surprise.

Indeed, when I used to write and talk about the eurozone in the distant days before the financial crisis, I used to say that while the euro would survive it was unlikely to do with all its constituent parts intact and the country I picked as the most likely drop-out was Italy. Traditionally inflationary and fiscally-undisciplined Italy made a strange bedfellow for Germany, which was the opposite of those things.

Then, however, the global financial crisis led on to the eurozone crisis and, rather than Italy, other countries hovered near the euro exit door. Ireland was substituted for Italy in the original “pigs”, Portugal and Spain had their very nervous moments. Greece came within a whisker of crashing out in 2915. Italy was not immune from the crisis’s effects, far from it, but had a background role.

Now Italy is once again firmly in the foreground. Its new government wants to increase public spending and cut taxes, cocking a snook at the eurozone’s deficit rules. Even an Italian president of the European Central Bank, Mario Draghi, is outraged by suggestions that the Italian debt bought by the ECB under quantitative easing be written off. Italy, “too big to fail but too big to bail”, is in the spotlight.

Italy’s economic woes are not new; the peak of Italian post-war economic optimism was probably half a century ago in the 1960s. Its performance since the lira was shoehorned into the euro at its birth in 1999 has, however, been strikingly poor.

Based on full-year figures, in 2017 Italy’s gross domestic product (GDP), in real terms, was just 6.3% above its 1999 level, which averages out at growth of 0.3% a year, equivalent to prolonged stagnation; almost two “lost” decades.

By comparison, German GDP over the same period has risen by 27.4%, more than four times as much, underlining the difference between the eurozone’s haves and have-nots. Britain, which sensibly decided to stay out of the euro, puts both of them to shame, having recorded a 38.9% rise in GDP over the same period.

If Italy’s GDP performance looks terrible, bear in mind that it is smaller than the rise in population – 6.5% between 1999 and 2017 – over the same period. GDP per capita has therefore done even worse.

The unemployment rate, which averaged 10.9% in 1999, at the dawn of the euro, was 11.2% last year and 11% in March this year. The unemployment rate among under-25s is a staggering 31.7%, which is only exceeded by Greece and Spain. Italy’s legendary black economy may mop up some of the people officially measured as unemployed but not enough to seriously diminish what is a huge problem.

So why does not Italy just leave the euro, which has clearly been bad for growth, living standards and has done nothing to alleviate a chronic unemployment problem? Why does it not go the whole hog and follow Britain out of the EU, an Italexit? Italy has a justifiable gripe with the EU because it has had to carry the burden of refugees from North Africa and the Middle East, very large-scale immigration, without much help or even sympathy from the rest of the EU.

EU exit remains a very long shot, but what about an exit from the euro? After all, if I thought Italy was the most likely single currency faller a few years ago, before others intervened, it must surely be a very strong candidate to leave now.

Actually, I now think it much more likely than not that Italy will stay in the euro, for three reasons. The eurozone crisis displayed a considerable determination on the part of the authorities to hold it together and, while Italy is a bigger proposition than Greece, with an economy ten times the size – the third largest in the eurozone and the 9th biggest in the world – we will see the same determination, if it comes to it, again. The domino effect, if one member goes others will follow, is still feared by the EU. The euro may be a flawed project but a considerable effort will go into saving it.

As well as this, and despite the woes inflicted on them by euro membership, public opinion in Italy still favours continued membership. The latest Eurobarometer poll showed that while Italians have a low opinion of EU institutions, supported by just a third of people (one of the lowest proportions in the EU), there was 45% to 40% backing for continued euro membership. It is like a Roman version of the Stockholm syndrome; Italians have grown close to their captors. If nothing else, Italians see that as a founder member of the EU and one of its biggest economies, being in the euro is their right.

Most of all, Italian citizens and businesses know that, however tough life in the single currency is, by leaving the euro they would be shooting themselves in the foot. A new Italian lira would become a currency to dump by the foreign exchange markets, rather as the Turkish lira has recently.

As big a reason as that would be the effect on Italy’s borrowing costs. In joining the euro in 1999, despite government debt being almost double the supposed Maastricht ceiling of 60% of GDP, Italy’s enjoyed an instant benefit. Its borrowing costs, government bond yields, converged on Germany’s removing its budget deficit problem at a stroke. Its budget deficit, 7% of GDP in the mid-1990s, came down to 2% or below and has remained generally well behaved since.

But the debt has nevertheless increased as a result of the years of weak growth, and is 130% of GDP. The fear of political instability pushed Italian 10-year bond yields close to 2.5% last week, which is still low by historical standards. A sharp rise in Italy’s borrowing costs would follow exit from the euro, plunging the country’s public finances into deep crisis. It was a different era but in pre-euro days in the 1990s Italian government bond yields were are high as 14%. Italy’s troubled banks are struggling while inside the euro; departure would expose them to the serious risk of collapse.

None of this means that keeping Italy in the euro with a populist government offering a new kind of politics will be painless. None of it should mean, either, that there are not issues around the way the eurozone operates that need to be addressed. Germany, with its large trade surplus and tight fiscal policies, imposes a huge burden of adjustment on other countries, including Italy. That needs to change if that euro exit door is not to swing open.