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[...]We suspect that Italy will compromise and remain in the eurozone in the short run, if only to avoid the damage a full-scale rupture would cause. In the long run, however, the country could increasingly be tempted to abandon the single currency.
Since Italy returned to the European Exchange Rate Mechanism in 1996 – after withdrawing from it in 1992 – it has surrendered its monetary sovereignty to the European Central Bank. In exchange, it has enjoyed much lower inflation and borrowing costs, resulting in a dramatic reduction in interest payments – from 12% of GDP to 5% – on its massive public debt.
Still, Italians have long been uncomfortable with the lack of an independent monetary policy, and that sense of lost control has gradually overshadowed the advantages of euro membership. The adoption of the euro has had massive implications for the millions of small and medium-size enterprises that once relied on periodic currency devaluation to offset the inefficiencies of Italy’s economic system and remain competitive.
The inefficiencies are well-known: labor-market rigidities, low public and private investment in research and development, high levels of corruption and of tax evasion and avoidance, and a dysfunctional and costly legal system and public bureaucracy. And yet several generations of Italian political leaders have cited “external constraint,” rather than domestic necessity, when pushing through the structural reforms required for euro membership – thereby reinforcing the sense that reforms have been imposed on Italy.
The loss of monetary sovereignty means there are effectively two chains of political command in Italy. One extends from the German government, through the European Commission and the ECB, down to the Italian presidency, treasury, and central bank. This “institutional” chain of command ensures that Italy meets its international commitments and maintains strict adherence to EU fiscal rules, regardless of domestic political developments.2
The other chain of command starts with the Italian prime minister and extends through the government ministries that are responsible for domestic affairs. In most cases, the two chains of command are aligned. But when they are not, a conflict inevitably ensues. Hence the current crisis, which came to a head when the prime minister-designate tried to appoint the Euroskeptic economist Paolo Savona as Italy’s next economy and finance minister without first consulting the other chain of command. The appointment was duly rejected by the Italian president.
Let us return to the question of whether Italy will now choose to break free of its straitjacket. Despite the euro’s advantages, it has not delivered for Italy economically. Italy’s real (inflation-adjusted) per capita GDP is currently lower than it was when the euro experiment began in 1998, whereas even Greece has managed to register growth, despite its depression from 2009 onward.
Some would explain this poor performance by arguing that the eurozone is an incomplete monetary union, and that its “core” countries like Germany drain labor and capital from “periphery” countries like Italy. Others might counter that Italians failed to conform to the rules and standards, and to implement the reforms, upon which a successful monetary union is based.
But the real explanation no longer matters. The prevailing narrative in Italy holds the euro responsible for the country’s economic malaise. And political parties that have either openly or implicitly called for leaving the eurozone currently hold a parliamentary majority, and would likely retain it in another election later this year or in early 2019.
If Italians were confronted with the choice of retaining or abandoning the single currency, recent polls suggest that they would initially decide to stay, for fear of a run on Italian banks and public debt, as Greece experienced in 2012-2015. But the long-term costs of remaining in a club dominated by inherently deflationary, German-dictated rules might tempt Italians to leave. That decision could come in the midst of another global financial crisis, recession, or asymmetric shock that pushes several fragile countries out of the euro at the same time.
Like the United Kingdom’s Brexiteers, Italians might convince themselves that they have what it takes to succeed on their own in the global economy. After all, Italy has a large industrial sector that is capable of exporting worldwide, and exporters would benefit from a weaker currency. Italians might be tempted to think: Why not escape the euro before those industries fold or end up in foreign hands, as is already happening?
If Italians do eventually go down this path, the immediate costs will be borne by domestic savers, whose nest eggs will be redenominated in depreciated liras. And the costs would be still greater if an Italian exit precipitated another financial crisis with bank holidays and capital controls. Faced with these possibilities, Italians – like the Greeks in 2015 – might blink and stay. But they also might decide to close their eyes and take the plunge. [...]
Full article on Project Syndicate
Reactions to political turmoil in Italy:
S&Ds: Italy shows us that it is high time for a new Europe
Bloomberg: Italy’s New Prime Minister Unnerves Investors With ‘Revolutionary’ Agenda
Italian Prime Minister Giuseppe Conte pledged in his maiden speech that his government will push through populist measures ranging from a “citizen’s income” for the poor to tax cuts and curbs on immigration, as he called for a stronger, fairer Europe “to prevent its decline.”
Conte used a speech to the Senate on Tuesday to promise “a new wind of change” based on a program of fiscal expansion drawn up by the euroskeptic Five Star Movement and League that risks breaching European Union budget rules.
Financial Times: Italy, democracy and the euro cage
[...] Italy’s new administration has now promised to stay inside the cage for the foreseeable future. In fact, the coalition between the League and the Five Star Movement was only accepted by Italy’s president once the europhobic Mr Savona was blocked from taking up the even more sensitive job of finance minister. In a further sign that the League is backing away from its longstanding flirtation with leaving the euro, a road sign proclaiming “Basta Euro” that stood outside the party’s headquarters was painted over last week. [...]
This debate over whether the EU is anti-democratic is bound to resurface in Italy. Even if the Italian government steers clear of any effort to leave the euro, it still seems likely to clash with the EU authorities over both fiscal policy and immigration. Matteo Salvini, the League’s leader and Italy’s new interior minister, has promised to speed up deportations and detentions of up to 500,000 illegal immigrants — which could cause angst in Berlin, as well as potentially violating EU law.
The League also wants a flat tax of 15 per cent on income. Five Star, its coalition partner, has argued for a universal basic income. Those policies together are a recipe for blowing up the EU’s 3 per cent limit on national budget deficits.
If the government in Rome ignores the EU’s fiscal rules, the reaction from Brussels and Berlin will be harsh. When Italy then finds itself under pressure from the bond markets, the likes of Mr Varoufakis and Mr Savona will return to the argument that the EU elite is conspiring against the will of the people.
The crude version of this argument does not make much sense. The biggest constraint on Italy’s freedom to cut taxes and boost spending is the level of the country’s debts rather than the EU’s rules. Italy’s debt stock is over 130 per cent of gross domestic product. In absolute terms, it is the third-largest in the world, after the US and Japan. Any sense that Italy is giving up on fiscal discipline — or, even more dramatically, planning to return to the lira — would probably provoke an Italian debt crisis, regardless of the statements of the EU.
But there are other aspects of euro membership that really do restrict Italy’s freedom to run its own economy. By joining the euro, Italy lost the ability to devalue its currency to restore competitiveness; or to stoke inflation to erode the value of its debts.
Some would argue that these were bad habits that Italy needed to get rid of. But after a decade of weak economic growth, many Italians look back with nostalgia to the “bad old days” of inflation and devaluation.
However, those policies could only be returned to if Italy left the euro. And any effort to do that and return to the lira is likely to provoke capital flight from Italy — and a financial crisis. In that sense, the euro is a “cage”. But the cage is inherent in the original design of the currency. The EU’s fiscal rules are merely an additional feature.
What is more, the Germans are also locked in the cage alongside the Italians. While the German economy has clearly prospered mightily, compared with the economies of much of southern Europe, Germany’s future is inextricably bound up with that of its less fortunate neighbours. A financial crisis provoked by the break-up of the euro would not be contained to southern Europe. German banks and savers would swiftly find themselves at risk. The resulting economic conflagration might well destroy not just the single currency, but the EU itself — and with it more than 50 years of German foreign policy. [...]
Full article on Financial Times (subscription required)