Italy in World Affairs
Italy and the Euro in the Global Economic Crisis
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Erik Jones
The global economic crisis hit Italy harder than expected and much harder than Prime Minister Silvio Berlusconi is wont to admit. According to data published in the July 2009 update of the International Monetary Fund’s (IMF) World Economic Outlook, real output growth in Italy contracted by 1 percent in 2008 and 5.1 percent in 2009. Italian policymakers were not the only ones caught by surprise, the 2009 figure released in July was 0.7 percentage points higher than the IMF had estimated the previous April.1 Economic performance is not the only thing that has suffered in Italy; public confidence has been shaken as well, particularly with respect to Europe. While policymakers awoke to the full extent of the crisis, popular concern about the effectiveness of the euro has risen and trust in the European Central Bank has declined. Many Italians remain committed to the euro as a symbol of European integration, nevertheless, their confidence in its effectiveness as a source of economic stability is weak.2 Indeed, when asked whether they would weather the crisis better with the vecchia lira than with the euro, 53 percent of Italian polling respondents agreed.3 Surprisingly, this fall in popular support takes place at a time when Italian politicians have been silent on the subject of euro membership.4 None of the major parties is complaining about the cost of the euro or the role of the euro in the financial crisis; popular support for the single currency has collapsed nonetheless. The purpose of this article is to explain why these attitudes are important. Given the fickleness of popular attitudes toward European integration, it is tempting to disregard such results as just another strange public opinion polling anomaly.
Erik Jones is Professor of European Studies at the SAIS Bologna Center of the Johns Hopkins University. Email:
[email protected]. Many thanks go to Brian Hoyt and Lucia Quaglia for helpful comments on a previous draft of this paper. Thanks also to Gabriele Tonne and two anonymous referees for their very generous comments and assistance. The usual disclaimer applies. 1 International Monetary Fund, World Economic Outlook Update, 2. 2 European Commission, Eurobarometro 70: Rapporto nazionale italiano, 20. 3 European Commission, Europeans and the Economic Crisis, 19. 4 Quaglia, ‘‘Response to the Global Financial Turmoil in Italy’’, 16. The International Spectator, Vol. 44, No. 4, December 2009, 93–103 ß 2009 Istituto Affari Internazionali
ISSN 0393-2729 print/ISSN 1751-9721 online DOI: 10.1080/03932720903351229
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Italians have a long tradition of being pro-European and are expected to remain that way. Even so, treating these recent polling results too lightly would be a mistake. These new trends in public opinion can have four important effects. They can make it easy for Italians to forget the tremendous efforts that went into joining the single currency in the first place and the benefits that made euro membership worthwhile. They can recast the influence of the euro on domestic economic performance and so obscure the importance of other factors. They can hide the consequences of the choices made by Italy’s economic policymakers in relation to other plausible alternatives. And they can create the perception among other important actors – like bond traders in international capital markets – that an Italian exit from the eurozone is at least plausible, if not exactly on the table. Each of these effects can impose a cost on Italian economic policymaking and performance that Italy would do well to avoid. By ignoring what they have already achieved, Italians are likely to underestimate what is possible. By misidentifying the challenges they face, they are likely to squander their efforts. By discounting (or overestimating) the alternatives, they may lose sight of what they have gained. And by embracing new possibilities, they may inadvertently convince others to adapt their behavior. If international bond markets start to give greater credence to the prospect of an Italian exit from the eurozone, Italians are likely to face higher premiums on their government debt instruments and a correspondingly tighter squeeze on government finances as a result.
Big efforts, big rewards
Most Italians associate participation in the eurozone with the changeover from the Lira to euro notes and coins in January 2002. Then, it is alleged, retailers and restaurants took advantage of the new currency denominations to raise their prices and so shift much of the cost of the changeover onto consumers while making a tidy profit at the same time. Much popular disaffection with the euro can be traced back to that event. And while Italians remain committed to the idea that economic policy should be coordinated at the European level, they remain sceptical that the euro has done anything to help fight inflation. The link between dropping the Lira and rising prices remains an open wound in the relationship between Italians and the euro. The Lega Nord, a right-wing regionalist party centered in the north of the country and currently aligned with Berlusconi, played on this scepticism in the 2006 parliamentary elections, when its leadership accused then opposition candidate Romano Prodi of being the ‘father of the euro’ because Prodi was in Brussels as European Commission president both when the eurozone was created and when the notes and coins were introduced.
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The Lega returned to that theme, albeit less prominently, in the 2008 elections when Prodi was prime minister. While the issue has not arisen since the Lega returned to government in 2008, the global financial crisis has done little to make the association of price rises and the euro go away: despite the sharp decline in economic performance in the Autumn of 2008, inflation remained the number one priority for popular concern.5 Economists familiar with Italy’s entry into the eurozone tell a very different story – one that focuses on the efforts made between 1992 and 1999, and not on the price effects that took place after 2002.6 This story starts with the exchange rate turmoil that hit the European monetary system in 1992 and that continued to buffet the Lira in 1993 and 1995. In each of these episodes, Italy was forced to devalue the Lira against the Deutschmark. As a result, Italian inflation increased relative to Germany’s, as did the relative interest rate that Italians paid on their long-term government bonds. Italians got less for their money and they paid more for their debt. Meanwhile, however, Italian trade performance improved as import growth slowed while export growth remained relatively constant. Successive devaluations may have preserved competitiveness, but they also cut into the real value of Italian incomes because while exports became cheaper in foreign markets, imports into Italy (including energy and raw materials) became more expensive. The turnaround came after the final bout of instability in 1995. Successive center-left governments, first under Prodi and then Massimo D’Alema, struggled to gain control over domestic inflation and government accounts. This involved considerable efforts to reform labour markets and the welfare state. These efforts did not solve all or even most of the country’s major institutional rigidities, but they did start moving things in the right direction. The guiding theme behind this collection of policies was the need to make a credible commitment to bringing Italy into the euro. The Lira appreciated against the Deutschmark as a result. Nevertheless, Italian trade surpluses continued to mount. This time Italy’s competitiveness took place through the favourable movement of relative labour costs rather than by relying on a Lira-depreciation to hold market ground. The payoff for Italy from having made a credible commitment to join the euro came in terms of an increase in foreign demand for Italian government obligations and a correspondingly lower premium charged on government debt. Whereas Italian long-term sovereign bonds paid an effective interest rate (or yield) more than six percentage points higher than those in Germany in March 1995, the yields 5
European Commission, Eurobarometro 70: Rapporto nazionale italiano, 18. This story is drawn from a range of sources. The data summarised in this paragraph is available either on request or from the author’s personal website: http://www.jhubc.it/facultypages/ejones. For a quick treatment of many of these issues, see Della Sala, ‘‘Hollowing Out and Hardening’’, Ferrera and Gualmini, ‘‘Reforms Guided by Consensus’’, Molina and Rhodes, ‘‘Industrial Relations and the Welfare State’’, Regini and Regalia, ‘‘Employers, Unions and the State’’, or Walsh, ‘‘Political Bases of Macroeconomic Adjustment’’. 6
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were essentially the same by August 2007. Over the same period, the Italian government had to issue less debt than it otherwise would have because it was paying out less in interest on outstanding debt, and foreign investors bought more of what was issued, taking pressure off domestic credit markets. Italy was able to pay less for borrowing money and Italians were able to use more of their own money for making profitable investments. Italy went into the eurozone with low inflation rates and a large surplus on its trade accounts. It was paying less on its government debt and had more resources to use in reining in the deficit as a result. Moreover, it escaped another round of exchange rate turbulence along the way. When the Russian economy went into crisis in the summer of 1998, the exchange rate between the Lira and the Deutschmark remained stable. Of course, Italy had much more to do in its welfare state and labour market reforms, but that should not be allowed to obscure the huge extent of its accomplishments. Few believed in the early 1990s that Italy would succeed in joining the euro; many were surprised when it actually did. Unfortunately, however, this story rarely appears outside of the scholarly literature and plays almost no role in popular debate – where the perception is widespread that things have gotten worse rather than getting better. Such perceptions do a disservice to the efforts that went into Italy’s euro membership. Worse, they make it easy to take up the nihilistic view that Italy is incapable of making any real progress at all.
Perceptions and performance
Since Italy joined the eurozone, its performance has not been outstanding and again it is worth reiterating that there is much to be done to improve things. The question is whether being inside the eurozone has made matters better or worse. Marcello De Cecco takes a strongly negative view, saying ‘‘statistics show without a trace of doubt that the first effects of EMU [economic and monetary union – meaning the euro] have been very negative for Italian industrial companies’’.7 To illustrate this point, he looks at Italy’s share in world trade. According to De Cecco’s figures, whereas Italy had 4.5 percent of world exports in 1995, it held less than 3 percent a decade later. Other major European countries like France and Germany were less affected over the same period. Then again, they did not depend so much on exchange rate flexibility for their competitiveness as Italy did. Therefore, so the argument runs, Italy’s inability to devalue its currency since the start of the single currency must be to blame. This argument about trade competitiveness and currency devaluation has a strong intuitive appeal and a broad international acceptance. Italy is the 7
De Cecco, ‘‘Italy’s Dysfunctional Political Economy’’, 773.
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stereotypical weak currency country, therefore it is hard to imagine the consequences for Italy when the currency is persistently strong. Belgian economist Paul De Grauwe used Italy to illustrate the challenge of adapting to adverse real exchange rate (meaning relative cost) movements in a monetary union in his classic textbook on the subject.8 British economist Simon Tilford made the same point in his 2006 pamphlet Will the Eurozone Crack?9 Nevertheless, there are four important reasons to doubt that Italian trade shares suffered because Italy was in the eurozone and therefore unable to see its currency depreciate or devalue. The first reason has to do with the data for relative market shares. De Cecco bases his argument on the comparison between the mid-1990s and the mid-2000s. A more reasonable test for the effects of euro membership on Italian competitiveness would be to compare the situation in 2000 with 2007. It would also be useful to dis-aggregate world export markets into separate markets for advanced economies and developing or emerging countries. Finally, it would be useful to keep track of the eurozone as a market on its own. This data is assembled in Table 1 (next page) from the Direction of Trade Statistics of the International Monetary Fund. What the data show is that Italy has lost only a very small amount of its world market share during the country’s participation in the euro – falling from 3.7 percent of world exports in 2000 to 3.6 percent in 2007. Moreover, this performance is consistent across both advanced economies and the emerging or developing world. While it is clear that German performance is superior, moving from 8.6 percent of world exports in 2000 to 9.6 percent in 2007, French performance is worse. France dropped from 4.7 percent of world exports in 2000 to just 4.0 percent in 2007; more importantly, French performance among the fast growing developing or emerging economies suffered particularly, bringing its market share in that part of the world down from 4.1 percent to just 3.0 percent – one-half a percentage point below the Italian share. Of course there is some evidence that Italy has suffered a loss of competitiveness within the eurozone, where its market share has deteriorated more than elsewhere. Yet, the French market share in the eurozone has fallen by five times as much. The market share data for Great Britain show the extent to which that country lost competitiveness despite being outside the single currency. The loss of British export shares in the eurozone has also been particularly severe – and more than accounts for the gain in market share in the eurozone garnered by China over the period. The second reason is that the euro was anything but a strong currency, at least during the first years of its existence and before the introduction of the notes and coins. The dollar exchange rate at the start of Europe’s economic and monetary union in January 1999 was $1.17. By September 2000, it was down to well below 8 9
De Grauwe, Economics of Monetary Union, 32–3. Tilford, Will the Eurozone Crack?
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E. Jones Table 1.
Export market shares
Percentage of Total
2000
2007
3.7 8.6 4.7 4.4 3.9
3.6 9.6 4.0 3.2 8.8
3.8 8.9 5.3 5.0 4.3
3.7 10.0 4.4 3.8 9.6
3.6 7.7 4.1 2.7 2.8
3.5 8.7 3.0 2.0 7.3
6.1 13.3 8.8 8.3 1.7
5.7 14.1 6.8 5.3 4.5
World Italy Germany France United Kingdom China Advanced Economies Italy Germany France United Kingdom China Downloaded By: [Jones, Erik] At: 15:30 22 March 2010
Developing/Emerging Economies Italy Germany France United Kingdom China Eurozone Italy Germany France United Kingdom China
Source: International Monetary Fund, Direction of Trade Statistics.
$0.90 – and stayed there until February 2002. Once the euro started to strengthen against the dollar, it took nine months to reach parity and another seven months to reach its launch rate. The euro only began to move systematically above $1.17 from October 2003 – which is not enough time for such dramatic effects from being locked into a strong currency to come about. Within the single currency, the situation is obviously different because the exchange rates are irrevocably fixed. Therefore, it is more appropriate to look at the movement of relative labour costs – and this is the evidence that has economists like De Grauwe and Tilford concerned. Starting with the year 2000, Italian labour costs relative to the rest of the eurozone have deteriorated while German labour costs have improved. Since these numbers are relative, the implication is that Italian labour costs have got higher (or worse) while German labour costs have got lower (or better). This puts Italian manufacturers at a relative disadvantage. The significance of that disadvantage, however, is hard to prove – and this is the third reason for questioning the impact of the euro on Italian competitiveness. If we look at relative labour costs over a somewhat longer period, a very different picture emerges. Italy loses ground relative to Germany during the eurozone period, but
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that is only a partial retreat on the relative cost improvement that Italy achieved during the run-up to the euro.10 Recent analysis of competitiveness within the eurozone by the European Commission confirms these results. Although admitting that relative costs have moved against the Italian economy, they find little evidence that exchange rates are to blame.11 Finally, there is the issue of interest rates and other input prices, like energy. Manufacturers rely on more than just labour for their production and the cost of these other elements plays a role in overall price competitiveness as well. The impact of the euro on interest rates and access to capital is unambiguous. Although large Italian firms could always access international capital markets for low cost financing, now the advantages of being able to do so extend down into the small and medium enterprise sector as well. By the same token, the strengthening of the euro against the dollar held down energy prices for all consumers during the rapid increase in oil prices that followed the onset of the Iraq war. These are advantages that most economists interested in competitiveness often neglect to mention. They are nevertheless significant advantages that emanate from the euro.
Choice and stability
Of course there were other choices that Italy could have made. One could have been to move away from manufacturing to embrace financial services, the other could have been to adopt a flexible exchange rate. Both of these things were tried in Great Britain – and the consequences are apparent today. Writing before the global financial crisis, however, De Cecco made it clear that the British alternative was never a real option: Italy ‘‘had no such advantages as an internationally spoken language, or a political, legal and educational infrastructure peculiarly appropriate for the new global system. Moreover, Great Britain’s financial system had for more than two centuries been at the center of international finance.’’12 No doubt De Cecco is right and Italy can never remodel itself as Great Britain. Nevertheless, it is worth wondering whether the British option would have been worth taking, had it been possible. The combination of a fast-growing financial services sector and a flexible exchange rate would certainly have implied a very different employment structure. This can be seen most easily if we compare levels of manufacturing employment. At the start of the 1990s, Italy and Great Britain started out much the same, with roughly 5.5 million workers engaged in manufacturing employment. By the time the European single currency was launched, the difference between the two countries had more than doubled from just over 300,000 more Italian than British manufacturing workers in 1990 to more than 10
Jones, ‘‘The Euro and the Financial Crisis’’, 42–4. European Commission, Quarterly Report, 39–40. 12 De Cecco, ‘‘Italy’s Dysfunctional Political Economy’’, 769. 11
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600,000 more Italian manufacturing workers in 1999. By 2008, the difference was 1.9 million: Italy had 5 million manufacturing workers and Great Britain just over 3 million.13 The decline of British manufacturing has moved in parallel to the rise of its financial services industry. Where manufacturing accounted for almost 16 percent of total British employment in 1999, it now accounts for fewer than 8 percent of total employment. By implication, manufacturing performance has little impact on the exchange rate. Instead, the value of the pound moves in line with financial transactions. Of course that is no different from anywhere else that government policymakers allow for capital market liberalization without fixing the value of the exchange rate in terms of foreign currency. As a general rule, governments can only control two of three factors – liberalized capital markets, autonomous monetary policy, fixed exchange rates – at any one time. Having opted for liberalized capital markets and an autonomous domestic monetary policy, the British government had no choice but to watch the value of the pound float freely with the ebb and flow of capital into the country. Specifically, the choice to remain outside of the single currency meant British policymakers had to accept that the pound would confront the whipsaw between the euro, dollar and yen. Hence it is not surprising that its export market shares would suffer. Having shifted from manufacturing to financial services, Great Britain also exposed itself to the risk that the financial service sector would fail, pulling down a substantial part of the British economy with it. That downside risk has come about. What is less obvious is that this was always likely to happen. Although many commentators bemoan the fact that the current recession was unforeseeable, economists have long cautioned that financial crises are recurrent. Some, like Hyman Minsky, maintain that they are endogenous to the behaviour of financial markets.14 Yet if that is the case, it would seem a dangerous sector in which to concentrate resources – not least because of the prospect that a collapse in the financial industry could precipitate a collapse in the national currency as well. This is precisely what happened to Great Britain. When the economic crisis struck, it not only had to deal with a sudden contraction of the financial services industry, but also a wild fluctuation in exchange rates. The pound has lost value relative to other major currencies and has seen the relative values of the euro, yen, and dollar gyrate as well. The yen strengthened as large financial institutions unwound their carry trades, selling high-yielding sterling-denominated assets to pay off yen-denominated loans; the dollar also strengthened against the pound as large American financial institutions sold sterling-denominated assets to consolidate their dollar accounts. Meanwhile, the euro has strengthened against the pound 13 Jones, ‘‘The Euro and the Financial Crisis’’, 45–6. An updated graph of this data is available upon request or from the author’s personal website. 14 Minsky, Stabilizing an Unstable Economy; Kindleberger, Manias, Panics, and Crashes.
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as well, but by substantially less. This has distorted trade relations with what is left of Britain’s manufacturing base, while offering little prospect of improvement in Britain’s current account. Recent data show a narrowing of Britain’s current account deficit from 1.7 percent of gross domestic product (GDP) in 2008 to just over 1 percent of GDP in 2012; Italy’s current account will remain close to 3.2 percent of GDP across the same period.15 Italy’s choice to enter the eurozone has saved it from exchange rate volatility without any obvious consequences in terms of the aggregate levels of manufacturing employment and only a slight loss in world export shares. Its current account balance will not improve as much as Britain’s, but it will retain many more manufacturing jobs and both countries will remain in deficit. Of course Italy’s politicians could have made other choices as well. But if Britain was the unobtainable ideal, then it is unclear what other models would have been better.
The price of possibility
Still it could be argued that Italians should at least consider other possibilities. The costs and benefits of leaving the eurozone could be debated and the relative merits of different solutions for correcting the problems of Italy’s competitiveness assessed. Indeed, this is being done, although it is not yet a coherent conversation. Some politicians, principally in the Lega Nord have been willing to raise questions about the euro; most others tend to ignore the euro because they are more broadly focused on the problem of performance and competitiveness. The problem is that an unfocused debate on the merits of participation in the eurozone can chip away at the commitment that undergirds its significant advantages. Debate about the merits and demerits of having adopted the single currency is in many respects a one-way street. Not only does it open the door for a worsening of popular perceptions, but it also gives legitimacy to those in international financial markets who would charge a premium on Italian government debt. Participation would be less popular and less advantageous as a result. It is at this point that the consequences of ignoring popular perceptions come to bear. The argument is not that politicians should never question the advantages of having joined the euro, it is that they should not do so lightly. And, once the issue is raised, it should be given full consideration. At the moment, both of these conditions are being violated. Some voices have been raised challenging the relative merits of the euro, others evidently have failed to provide a persuasive answer. The consequence in terms of public opinion has been to weaken the permissive consensus that surrounds all things related to ‘Europe’. This is what the public opinion polling data presented at the outset of this article indicates. Moreover, it is 15
IMF, World Economic Outlook, April 2009.
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not a uniquely Italian problem. During the period from October/November 2008 to January/February 2009, trust in the European Central Bank fell most sharply at the core of the eurozone – not in Italy, but in France, Germany and the Benelux. Yet, the loss of popular support for the euro is no less important for being general.16 As analysts of public opinion have shown, the more elites appear divided on the merits of European integration, the more the public opinion tends to move from support to opposition.17 In turn, any growth of opposition tends to raise the political salience of Europe as an issue and so increase the likelihood that new radical right political parties – like the Lega Nord – will campaign against it.18 So far this has not been the case. Where politicians like Umberto Bossi, Roberto Calderoli and Roberto Maroni were once open in their criticism of the euro, they now tend to be more muted. That does not mean, however, that they have forgotten the issue or that the Lega is somehow reconciled to it. In any case, public opinion and political campaigning are only part of the problem. Perceptions among the wider investment community are potentially more important. The principal advantages derived from joining the euro came in the form of increased access to international liquidity and a lower premium on sovereign debt. Both of these advantages could be jeopardised if international investors were to believe that Italy’s commitment to the euro could be reversed. So far there is no evidence of such a change in international perceptions taking place. On the contrary, two of the remarkable features of Italian performance during the recent crisis are that its long-term sovereign borrowing rates have not increased and its credit ratings have not deteriorated. Given the sharp contraction in gross domestic output and the corresponding increase in public sector net borrowing requirements, this situation could be much worse. Even Spain and Portugal, where ratings have fallen, have not seen the cost of long-term sovereign borrowing increase. Only the ease of acquiring liquidity within the eurozone can explain that resilience.19 Still there is no reason to take such stability for granted. One thing that the crisis has revealed is that the tight convergence of long-term interest rates is not permanent. The spread between German bonds and the weakest of the eurozone sovereign bonds was less than one half of one percent before the crisis; at the height of the credit crunch it was closer to three percentage points. While that difference has narrowed again, there is no guarantee that it will not widen in the future. Italy’s economic policymakers were surprised when they realised the full implications of
16
Jones, ‘‘Perceptions Matter’’. Gabel and Scheve, ‘‘Estimating the Effect’’; Hooghe and Marks, ‘‘Calculation, Community and Cues’’. 18 Anderson, ‘‘Consent and Consensus’’. 19 Jones, ‘‘The Euro and the Financial Crisis’’. 17
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the global economic crisis, if they are not careful to keep an eye on developments in public opinion, they may find other surprises in store.
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