Under the sunlight: the academic debate about Italy and the euro

Is Italy better off without the euro?

by Stephen G. Cecchetti and Kermit L. Schoenholtz


4' di lettura

Italy is perched on a knife-edge. Today, 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, higher than in any advanced economy except for Greece and Japan, and exports of goods and services account for a substantial 30 percent of GDP.
Would independent Italian monetary policy, controlled by the Banca d'Italia in Rome, be sufficient to bring Italy back from the precipice and sustain prosperity in the long run? We doubt it.
Ensuring strong, sustainable and balanced growth—escaping the stagnation of the past 15 years—requires that Italy implement structural reforms and lower its debt ratio. On the first, today, Italy is an unattractive place to do business: it currently ranks 50 out of 190 countries, behind Mexico, Serbia and Thailand (1). High taxes are needed to pay for a big government. Rigid labor markets are leading to high youth unemployment. Pensions are generous to the point of being burdensome. And, there is little R&D. Any lasting improvement of living standards will require major reform that creates flexibility. Expanding the supply of goods and services in Italy requires less regulation in its product, labor, and real estate markets.
As for the borrowing, Italy's high debt is a drag on long-term growth (2). Getting Italian debt to a less troublesome level without a crisis requires sustained fiscal discipline that has been absent for decades. Most importantly, it means fiscal reforms that result in a smaller government—lower spending and lower taxes.
We are not talking about one-off reforms. Italy needs a flexible economic system that is able to adjust quickly to future challenges. Some of these are already predictable. How will Italy accommodate the millions of drivers whose skills become obsolete when vehicles are self-driving? Other changes are difficult to anticipate: we cannot know precisely which jobs will be replaced by artificial systems nor how many people that will affect.
While it is impossible to prove, we expect that the pressure for Italy to adjust will be somewhat greater inside the monetary union. This will come both from requirements imposed by European Union members and from Italy's participation in the euro area's integrated capital market. The latter brings benefits, including diversification for both domestic and foreign investors. And the risk premia that it imposes also will impose greater discipline than Italy would experience if it were to cut its financial markets off from the rest of the world.
Economic and financial integration of the economies in the monetary union is a clear benefit to all involved. There is more trade in goods and services, and there is more cross-border lending, borrowing and investing.
Aside from enhanced long-run growth prospects, there are other benefits from staying in the euro area. The most important is price stability. During the 40 years leading up to the inception of the euro in 1999, Italy averaged 7½ percent inflation per year. From 1973 to 1984, the average exceeded 15 percent. Surely, no Italian wants to return to the days of high and very volatile inflation.
Now, we realize that the common monetary policy, the easing and tightening of financial conditions by the Governing Council of the ECB, is aimed at stabilizing the entirety of the euro area. To the extent that future Italian business cycles are not synchronized with those elsewhere, an independent Banca d'Italia with its own currency could, in theory, do a better job of stabilizing Italian growth (even if didn't do so before the euro was introduced).
But at what long-run cost? Outside the euro area, pressure for structural and fiscal reform would likely be lower. Steady-state inflation would likely be higher. Trade in goods and services would be smaller. And, the financial sector would be more isolated. All in all, Italy is probably better off with the euro than without.

1. World Bank. Doing Business 2017. Washington, D.C., 2016.
2. Stephen G. Cecchetti, M. S. Mohanty and Fabrizio Zampolli, “The real effects of debt,” in Achieving Maximum Long-Run Growth, proceedings of the Federal Reserve Bank of Kansas City Jackson Hole Symposium, 2011, p. 145-196.


Stephen G. Cecchetti is Professor of International Economics at the Brandeis International Business School; Kermit L. Schoenholtz is Professor of Management Practice in the Department of Economics at the NYU Stern School of Business

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