Would Italy be better off without the euro?

With Sunday’s election of President Emmanuel Macron, voters confirmed that France remains a bedrock of the euro area, buttressing the region’s financial markets. But political risks to the euro have not disappeared. In coming months, concerns probably will turn to Italy, where the leader of one popular party has called for a referendum on leaving the euro area, and where parliamentary elections must be held before 20 May 2018.

From an economic perspective, Italy stands on a knife-edge. The economy is smaller and less productive than it was in 2001, while government debt has jumped by 30 percent. As long as interest rates remain low, and the government continues to run a primary budget surplus, the situation is only mildly unsustainable (with the debt/GDP ratio creeping higher). But even a small problem at home or abroad could drive funding costs higher and expose Italy’s precarious state.

Is this situation a consequence of Italy’s membership in the monetary union? In theory, a country that has its own currency can engineer an unanticipated inflation that reduces the real burden of outstanding debt. It also can depreciate its currency in real terms to improve external competitiveness. All of this looks appealing for a country where gross government debt is 130% of GDP and rising, higher than in any advanced economy except for Greece and Japan (see chart), and where exports of goods and services account for a substantial 30 percent of GDP.

Gross general government debt (Percent of GDP), 1998-2016

Would independent Italian monetary policy, controlled by the Banca d’Italia in Rome, be sufficient to bring Italy back from the precipice and promote economic growth? We doubt it. In the long run, the most effective way to ensure debt sustainability is to implement growth-enhancing structural reforms. Nothing about Italy’s membership in the monetary union prevents this. The problem is a lack of political will.

Years of calm in financial markets have encouraged complacency about Italian debt. The IMF currently projects that the economy will grow and the debt ratio will decline in coming years. This assumes a big rise in the primary budget surplus from about 1¼ to 3½ percent of GDP. If the Fund is right, the debt will be sustainable so long as Italian interest rates don’t once again rise above 6%, as they did in late 2011.

If, however, fiscal fatigue sets in—as it has in the past—there are big risks. A rise of interest rates to something close to pre-crisis levels would prompt a further jump in the debt ratio. Such contagion could arise (as it has before) from developments elsewhere in the euro area. Or, depending on the prospects for the next Italian elections, it could result from fears of a currency redenomination, triggering a run on the debt (and on Italy’s banks).

What if Italy were to exit the from the euro area? Could a rejuvenated Banca d’Italia, with the power to set domestic monetary policy, generate an unanticipated inflation sufficient to lower the real value of Italy’s debt, even as the government needs to borrow more amid a recession? Perhaps. But it is far more doubtful that the central bank could then suddenly revert to the kind of credible, stability-oriented monetary policy that is needed to deliver price stability and strong long-run growth.

The same credibility challenge also would apply to the value of the new currency itself. One purpose of exit would be to lower the real value of the lira sufficiently to boost competitiveness while allowing for fiscal tightening. However, to prevent (or, more likely, limit) a bank run, an exit from the euro would have to come in the dead of night, with no prior announcement, and be accompanied by capital controls. (The process of a euro-area breakup was described by Eichengreen as “the mother of all financial crises.") Once applied, capital controls could take years to remove, making foreign investors wary. And, even as the new lira circulates, many people would still choose to opt to make payments in euro.

Assuming the formidable logistical challenges of introducing a new currency can be overcome, a key issue is whether Italian authorities will have sufficient credibility to engineer the real (or inflation adjusted) depreciation necessary to make Italy competitive. If, instead, recipients of new lira lack confidence in the government’s (and central bank’s) willingness to limit the volume of the new currency, high inflation will limit that real depreciation.

How big a problem are we talking about? How much would a new lira have to fall in real terms to make Italy competitive with other euro-area countries? Since the inception of the euro in 1999, Italian unit labor costs have fluctuated substantially, but are now a bit higher, while the German equivalent has fallen by more than 18 percent (see chart). In other words, competitiveness has deteriorated by nearly 20 percent. This divergence reflects in part Germany’s successful labor market reforms in the early 2000s that stand in stark contrast to Italy’s inaction. While redenominating Italian wages into newly depreciated lira could drive down labor costs (relative to those of foreign competitors) in the short run, it does nothing to improve labor market flexibility and spur productivity growth over time.

Unit Labor Costs, 1Q 1999 = 100.

Source:  Harmonized competitiveness indicators , European Central Bank.

Source: Harmonized competitiveness indicators, European Central Bank.

Ultimately, economic stagnation is the real challenge. Today, Italy is an unattractive place to do business – it currently ranks 50 out of 190 countries, behind Mexico, Serbia and Thailand, in the World Bank’s Doing Business rankings. The government is large, so taxes are high (including a total tax rate on profit of 62%, according to the World Bank, compared to 49% in Germany and 44% in the United States). Rigid labor markets lead to high youth unemployment. Pensions are generous and burdensome. There is little R&D. So, any lasting improvement of living standards will require major reform.

Will needed reforms be easier inside the euro area than outside? Put differently, does the common monetary policy and the mutual fiscal surveillance under Maastricht boost pressure for change? Perhaps, but it is difficult to know for sure. Since 1999, these factors have neither boosted Italy’s position in competitiveness rankings relative to other euro-area countries nor halted the upward creep in its government debt ratio.

In any case, we don’t view this issue as the key one for judging whether Italy should stay or go. The reason is that an Italian exit from the euro would cause deep financial harm at home and abroad. Italy’s economy is the world’s eighth largest. Cutting off its financial system from the rest of the world could trigger a crisis as serious as the global one that started a decade ago. That can't be good for anyone, least of all Italy.