The defeat of the European constitution in the French and
Dutch
referendums created a political crisis and provoked a slump in
the value of the euro. But the most serious threat to
European monetary stability is not the debate about the constitution;
it is the fact that Italy has slid back into recession because
of declining industrial competitiveness. There is a not insignificant
risk that Italy could be compelled to withdraw from the European
monetary union and the euro if it cannot revitalize its economy
with higher productivity growth.
Italy struggled to reduce its budget deficit during the late
1990s in order to join the euro. But while Italy improved its
public finances, it has suffered from membership of the monetary
union
because of declining productivity. Since joining the monetary
union, Italian unit labor costs have increased by 15 percent,
compared to a rise of three percent in France and a decline of
five percent in Germany.
During the past five years, German companies have ruthlessly
reduced unit labor costs by trimming employment, increasing the
workweek and maximizing productivity. Italian companies have
found it hard to keep up with German productivity because of
cultural differences and the high cost of firing workers. During
the past four years, German companies have reduced their employment
by six percent, while Italian
companies have shed only 0.7 percent. As a result, Italy’s
share of global exports has slumped by 25 percent during the
same period.
In the past, Italy always coped with competitiveness problems
by devaluing the lira. In 1993, for instance, Italy
enjoyed a burst of export-led growth by devaluing the lira by
34 percent. But as a result of monetary union, Italy has lost
this option. If Italy is to remain in
the euro, it will either have to boost
productivity or put the economy through a period of deflation
to drive down costs. It is difficult to imagine
deflation in Italy because the government has just announced
a five percent pay increase for civil servants over two years.
The risk is high that the increase will set an example for unions
in the
private sector.
Italy also has structural problems in meeting the challenges
of globalization. Italian exports are concentrated in
low-skill, labor-intensive sectors such as
textiles and shoes. In 2004, exports
of clothing, textiles, and leather accounted for 13 percent of
Italian
exports, compared to three to four
percent in Germany and France. Automobiles represent 16.8 percent
of
German exports and 13.1 percent of French exports, against only
7.7 percent for Italy.
Textiles account for 12 percent of Italian manufacturing jobs
compared to five percent in France and two percent
in Germany. Italian industry is also dominated by small companies.
Over 90 percent of all enterprises employ fewer than 10 workers.
The dominance of small businesses has inhibited spending on research
and development as well as on information technology, where
Italian spending is far below its main
European competitors.
Ministers of the Northern League, which forms part of the governing
coalition, recently called for abandoning the euro and reintroducing
the lira. That was a surprise, because in the 1990s the Northern
League welcomed the impact of the monetary union on Italian
borrowing costs the interest rate on Italian government
bonds fell from
double-digit levels to 3.5 percent and Italy’s government
debt servicing costs fell from 12.6 percent of GDP to 4.7
percent.
If Italy were to leave the monetary union, the interest rates
on Italian public debt would skyrocket back to double-digit levels.
The government would also have to address the difficult question
of whether to convert existing debt into liras or continue to
treat it as euro-denominated debt. As Italy produced large capital
gains for bond investors during the late 1990s by converting
lira debt into
euro debt, the odds are high that the Italian parliament would
pass a law declaring all the debt to be lira-denominated.
When Argentina devalued in 2002, its government converted both
public debt and utility contracts from dollars into pesos. It
then simply defaulted
on the securities that were still dollar-denominated. The only
time Italy has ever defaulted was when Mussolini did so during
the mid-1920s in order to
reduce the fiscal deficit and lower the level of public debt
from 75 percent of GDP to 50 percent. The conversion of euro
bonds into lira instruments would not be a technical default
but would still produce large capital losses for bond owners.
Since monetary union, Italy has taken advantage of falling borrowing
costs by doubling the maturity of its public debt to five years.
Italy should prepare for the risk of leaving the euro by attempting
to prolong the maturity of its debt even farther. Some Italians
will probably also favor large government debt sales to the Argentinians
in order to punish them for the billions of dollars of defaulted
Argentine securities owned by Italian investors.
When Italians are told their country could become a new Argentina,
they
naturally assume the reference is to their soccer team. But the
reality is that there are a growing number of economic
parallels between the Argentine crisis of five years ago and
today’s situation in Italy. Monetary union has given Italy
a fixed exchange rate which is steadily eroding the country’s
competitive
position. Italy has a public debt equal to 106 percent of GDP
and is once again running fiscal deficits of four to five
percent of GDP. The European Union will allow Italy a period
of grace to
reduce the fiscal deficits because of the downturn in the economy
but Brussels cannot do anything to restore Italy’s competitiveness.
Other European countries will do everything possible to help
Italy remain in the monetary union. They will give Italy additional
time to reduce its fiscal deficit. There will be strong pressure
on the European Central Bank to protect Italy by restraining
interest rates and limiting upward pressure on the common currency.
What remains to be seen is whether special treatment for Italy
will produce a counter-reaction in countries such as Germany
and the Netherlands. They were initially opposed to Italy’s
membership of the monetary union, and there could be a public
outcry if there is an
excessive accommodation of Italy’s fiscal irresponsibility.
The credibility of the ECB could also be at risk if it is widely
perceived that monetary policy is being targeted on keeping Italy
in the euro.
There are few signs that Italian politicians appreciate the scope
of the challenge that lies ahead. The Berlusconi government is
unpopular and thus
unable to propose any radical reforms. The opposition leader,
Romano Prodi, leads a left-wing coalition that includes the labor
unions. If Mr. Prodi’s coalition were to win the national
elections due in spring 2006, it would be reluctant to enact
legislation that might weaken
employment security or encourage
aggressive restructuring.
The inertia in Italy is distressing
because Germany is likely soon to elect a Christian Democratic
government that will probably accelerate the pace of
economic reform. France may also elect a more reform-oriented
president in 2007. If Germany and France restructure more effectively
and bolster productivity, the competitiveness problems of Italy
will intensify. By 2010, Italian unit labor costs could be 40
percent to 50 percent higher relative to Germany than they were
in 2000. In such a scenario, Italian industrialists could become
sympathetic to calls for restoring the lira in order to devalue
against the rest of Europe.
There was derision in the markets when the Northern League welfare
minister proposed reintroducing the lira, because of the potential
consequences for Italian interest rates. But while
leaving the monetary union would be a very high-risk policy,
the fact remains that membership will become increasingly high-risk
if Italy cannot improve its productivity. There is no simple
solution to Italy’s problem. At this point only one thing
is certain. Italy could
become the first country to leave the monetary union if there
is no improvement in its economic performance. As a result, the
yield on Italian government debt should be much higher than the
current 25-basis-point yield differential with Germany. In the
next few years, this yield gap is likely to emerge as a very
important proxy for investor confidence in Italy’s capacity
to reform its economy.
David Hale is an economist based in Chicago.
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