Italy and the future of the Euro

people in st peter s square
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Italy is currently struggling to form a government, after its elections of 4 March have been won by the country’s two main populist parties, the League – formerly Northern League – and the Five Star Movement (M5S). The xenophobic League is demanding mass deportations of foreign migrants and M5S a basic income for everyone. The center-left Democratic Party and the center-right Forza Italia are the main losers of the election.

While the outcome of the coalition negotiations is open, any government will have to live with the fact that a majority of deputies in both houses of parliament will belong to either the League or to M5S. This will make governing Italy even more difficult than usually.

The election result reflects voter fatigue with years of slow growth, which amounted to 1.5% in 2017 and to on average 1% in the preceding three years. Low growth was caused by restrictive budgetary policies designed to bring Italy’s public debt under control. The latter amounts to 132% of GDP, a ratio only surpassed by Greece.  Unemployment stands at 11%, of which for people less than 25 years old close to 40%.

Given the election result, it will be difficult for any government to ensure a parliamentary majority for a policy which continues even the gradual budget consolidation course of the past years. In this case, interest rates on government debt, which are currently below 2% for 10-year bonds, could rise again, making the continuation of policies to reduce debt even more difficult, and thereby making another EU rescue program necessary.  

But Italy being Italy, it is also possible that a deal will be struck which will permit a continuation the present course of gradual debt reduction. For example, the League’s support could be ensured by a harsher policy stance vis-a-vis migrants and fiscal concessions to Northern Italy, the League’s base of support.  

Greece and Portugal are in a similar predicament as Italy, with high public debt levels representing a brake on economic growth. Spain has lower debt but, at 17.2% in end-2017, even higher unemployment than Italy. France, which is pursuing restrictive fiscal policies in order to avoid joining the club of highly indebted countries, is paying for the privilege with slow growth – 1.8% in 2017. Its unemployment rate – 9.4% in end-2017 – is higher than Portugal’s 9.0%.

This is not how an economic upturn should look like. There is one measure that would help all these countries, including France: the abandonment of the Euro and the introduction of national currencies.

While an own currency will not per se tackle high public debt levels, structural problems or political gridlock, it will do one thing: make it possible to initiate export led-growth through a devaluation. At present, Eurozone countries suffer a decline in competitiveness if their wages, minus differences in productivity growth, rise more than in the countries with the lowest wage growth (which we will call low wage countries). The classic low wage country is Germany, whose powerful export industry is arguing that without wage restraint, exports and thus the alleged heart of the German economy will suffer. But restraining wages leads to low consumption and low growth.

With own currencies, countries can accelerate growth not only via consumption and exports but also via increased investments, which in a low-wage environment are withheld due to weak consumption. It is not by chance that Germany suffers from weak investment activity and that, in consequence, its GDP growth rate has been mostly below the average for the Eurozone in the past. And in almost every year since the introduction of the Euro in 1999, economic growth in the Eurozone was lower than in the rest of the EU. This is, among others, a consequence of the fact that none of the EU members outside the Eurozone had to adopt such radical bailout programs like the one currently in place for Greece.

In conclusion, It has become clear that the experiment of a joint European currency has failed. It impairs growth by tying everyone to the low wage-ideology of Germany’s export industry. Low growth is hindering indebted countries to outgrow their imbalances. To avoid EU sanctions for overshooting deficit targets, these countries have to cut domestic demand, which in turn keeps unemployment high. And EU bailout programs become, when they become unavoidable, deeply unpopular in both recipient countries, where they are widely regarded as unfair, and in surplus countries, where they are decried as a waste of taxpayers’ money. In short, the Euro is leading to pain and political polarization.

However, it is hard for a single country to abandon the Euro, because such a unilateral step might lead to a collapse in investor confidence and seriously disrupt the economy. This is why Greece shied away from adopting its own currency at the height of its debt crisis in 2015. On the other hand, an EU-wide program charting the course for member states to exit the Euro – while retaining EU membership – and involving guarantees to assure markets, would avoid these pitfalls.

Admittedly, such a program would make it more difficult for Germany, the Netherlands and other low-wage countries to maintain their export competitiveness vis-a-vis EU countries with national currencies. Even more importantly, the Euro is likely to appreciate in case it will be used by low-wage countries only, which will further impede the latter’s competitiveness.

But Germany and the Netherlands are anyway running high external surpluses so they have plenty of room to cede some export shares to deficit countries and to absorb more of their imports.

More importantly, the low-wage countries should look at the bigger picture. Economically as politically, the most important achievements of

European integration are the common customs area and the single market, where goods, services, people and capital can flow freely between member states. All EU members, including Germany, should cooperate to protect these achievements from the corrosive effects of the Euro – for their own sake.

27 March 2018

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