ITALY: Euro debate obscures the need for reform

Analysis

Three government ministers, all from the Northern League, have called into question Italy's continuing membership of the euro-area. The party's small size and following reduces the alarming nature of its demands, but in the present state of nervousness over European integration and the future of the Stability and Growth Pact, such statements fuel political speculation and have the potential to unsettle markets. Further public pronouncements are due on June 19, when the League will unveil its ideas for tying a re-introduced Italian lira to the US dollar, and will call for a national referendum on the subject.

Electoral politics. The League's motive in raising the issue is essentially electoral. Prime Minister Silvio Berlusconi's government almost collapsed in April, following a disastrous performance in regional elections (see ITALY: Forced resignation weakens Berlusconi - April 21, 2005). The parties of the centre-right are anticipating a difficult campaign for the next general election, to be held in Spring 2006 at the latest. In pursuit of electoral advantage over both the Left and its own coalition partners, the League has now broken a long-standing taboo in Italian politics by proposing that Italy withdraw from a major element of the European integration project. It will be attractive to some for two main reasons:

1. Popular dissatisfaction. Support for the introduction of the euro has fallen from 87% in 2002 to 62% today, according to the latest Eurobarometer poll. There is a widespread public perception that the introduction of the euro had a serious inflationary effect in 2001. The official figures do not bear this out, but voters perceive certain high-visibility prices to have risen rapidly. Fear of unemployment and general economic uncertainty also work against the euro, at least for those voters who think devaluation might be a solution to the sluggishness of the Italian economy.

2. Blame Prodi. All parties in the coalition are willing to use the argument that Italy entered the euro at too high an exchange rate, and that responsibility for this lies at the door of Romano Prodi, who was prime minister in 1997, when the final decision was taken. After serving as President of the European Commission, Prodi has returned as leader of the centre-left opposition which will challenge Berlusconi in next year's election. Since President Carlo Azeglio Ciampi was Prodi's treasury minister at the time, the attack on the euro is also an attack on Ciampi.

   Since exchange rates were locked at market rates operating at the time, it is far from clear that the Italian government could have done anything to alter the rate, or that it would have been to Italy's benefit had it done so. Ironically, there is a consensus that Germany, Italy's major trade partner, also entered at an uncompetitively high rate. While Italy has lost competitiveness inside the euro area in the last decade, this is mainly due to subsequent developments (see ITALY: Poorly framed proposals may face setbacks - March 18, 2005).

Underlying realities. It is possible that more favourable real exchange rates against other member states would have made Italy more competitive than it has been in recent years. For this reason, there was at least a case for Italy not joining the euro at the outset. However, Italy also benefited hugely from the credibility associated with the euro, for example:

• Italian interest rates converged very rapidly towards the euro area average, despite the high stock of Italian public debt; while
• lower debt-servicing costs were unquestionably a boost to public finances, just as lower interest rates were a stimulus to the economy.

If those two advantages were removed, the freedom that the authorities would enjoy outside the euro area to effect a staged devaluation of the national currency against the euro (or other currencies) would be more than offset by the deflationary impact of far higher interest rates to reflect the Italian risk. The latter is high not only because of a large accumulated stock of debt, but also due to concerns about demographics and pension liabilities. There is also evidence that the political class lacks the will to introduce structural reform.

Competing necessities. Italy's problem is that it is locked into a circle of uncompetitiveness and low growth, generating weak public finances, and pressures from the EU's Council of Economic and Finance Minister (ECOFIN) for public-spending restraint. This then weakens business and consumer confidence, and cuts aggregate demand. A dash for growth by withdrawal from the euro area, even accompanied by euro-denominated public debt issuance, is unlikely to restore confidence.

One solution has been mooted to reintroduce the Italian lira for the real economy, associated by managed devaluation, but continuing to price Italian public debt in euros. The idea is that markets would be reassured and interest rates would not soar to reflect the Italian risk exposure. However, this is unlikely to work, given the underlying concerns about the lack of political will to address structural bottlenecks such as the labour market and welfare spending. The shock of Italy withdrawing from the euro would drive up interest rates, and indeed in recent months the spread between Italian and German bond rates has already started to widen a little, even in a context where there is no serious short-term prospect of a crisis.

Obscuring reform. The Treasury, the Bank of Italy, and the government coalition parties excluding the League all believe that there is no alternative but to stay with the euro if a crisis of overseas confidence is to be avoided. This view is shared by the main business organisations and the trade union movement, and also by the great majority of voters.

The Treasury's view is that slow and unspectacular public service and labour market reform, improved fiscal regimes, and continued spending rigour, will eventually begin to pay dividends, and Italian competitiveness will recover. However, the Italian authorities have been running this argument now for more than five years, and far from improving, the competitiveness position has deteriorated further.

Withdrawal from the euro is not the fundamental solution to that problem. The euro-area has lost competitiveness, and Italy will not recover until the area as a whole recovers. However, within the euro-area, Italy has fared worse than any other country. This will continue to feed a beguiling argument about withdrawal and the active use of exchange rate adjustment, and will distract attention from underlying structural problems.