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

It is a very bad idea to go for brain surgery when you have a tummy ache

di Charles Wyplosz

(solvod - Fotolia)

5' di lettura

Italy’s economy has a lot of problems, but the euro is not one of them. Its economic growth has been nil since 2001, just after the euro was adopted, but it is plain wrong to believe that this disastrous result is the consequence of having given the lira up. Like many other countries, Italy can thrive within the Eurozone, provided it solves its problems. Like many other countries, Italy can shrivel outside the Eurozone, as long as it turns a blind eye on its problems. This does not mean that the euro is an optimal arrangement and that the Eurozone cannot be improved, but linking Italy’s poor economic performance to Eurozone membership is plain wrong and quite possibly hurtful.

Upon joining the Eurozone, a country gives up its monetary policy and, therefore, its exchange rate. In the good old times, monetary policy in Italy was soft, inflation exceeded foreign levels, which eroded external competitiveness. Periodically, the lira was devalued, restoring competitiveness, but inflation did not decline and external competitiveness was eroded again until the next devaluation. The lira simply fluctuated between being overvalued and undervalued. Not helpful, in fact quite an annoyance.


This is not surprising. If devaluing a currency could durably improve competitiveness, all countries would play the same game. In fact, this is the game that was played in the 1930s after the Great Depression. Competitive devaluations, also known as beggar-thy-neighbor policies, left such a bad taste – rising nationalism and protectionism– that the Bretton Woods agreement of 1944 prescribed fixed exchange rates for all countries. Eventually, this system too was abandoned in 1971, because it imposed tight limits on the use of monetary policy. Many central banks, including the Banca d’Italia , went for inflation and repeated devaluation, an acknowledged failure (1).

Abandoning the euro could be justified if Italy’s underperformance since 2001 was due to an overvalued exchange rate. This is simply not the case. Measured by unit labor costs – how much it costs to produce €1 of GDP in comparison to what it costs on average in 24 partner countries – Italy’s exchange rate is not overvalued, according to European Commission’s data (AMECO). In fact it is 5% lower than it was on average over the whole pre-euro period 1960-1998. Italy’s problem lies elsewhere, in the stagnation of productivity. This is purely homemade, the result of insufficient productive investment and slow adoption of frontier technology by a majority of firms, big and small (2).

Maybe leaving the euro could serve as a boost to embark on productivity-enhancing investments? It could if such investments were hampered by excessive borrowing costs, but interest rates have been at historical lows for many years now. Borrowing has been sluggish largely because Italian banks do not lend sufficiently. They starve firms for credit because too many of them have made bad loans for very long. Once again, the sorry condition of Italian banks is a homemade problem. Would leaving the euro make it easier to fix the banking system? It could if rapid inflation were to set in and erode debts. However, inflation is a tax which hurts people’s purchasing power, and it affects mostly the less affluent people who do not have the resources to play the game (3).

The other big Italian problem is its big public debt. It could even get higher if the government were to throw money at sick banks, which a European rule presently forbids, for good reason. Leaving the EU would only make things worse, much, much worse. For a start, if the government borrows money to rescue sick banks, it is great news for banks and their shareholders but the debt is on citizens. The European rule has been invented precisely to protect the citizens and to encourage banks to act more rigorously. Furthermore, keep in mind that the public debt is in euros. If a lira is created and devalued, the debt is likely to still be in euros. Indeed, there is considerable ambiguity on whether a conversion into lira is legally acceptable. It depends on the details of the debt contract and litigation is likely to last for years. The combination of a debt in euro and of wages in devalued liras, the burden on taxpayers increases in exact proportion with the devaluation. The government might default on its debt, which would hurt the people who hold it, starting with the banks that are already in poor shape. Crucially, were the government to default, it would become an international pariah for several years to come.

Leaving the euro is a bad idea, but that does not mean that staying in the Eurozone is a good idea. Eurozone membership acts as a straightjacket as it seeks to impose monetary and fiscal policy discipline. Discipline always is a straightjacket. Were Italy to leave the euro, it should impose its own discipline on the Banca d’Italia and on its governments. Although its track record over more than a century is not good, it can be done. But then, what would be gained from leaving the euro? Devaluing the lira? If this is used as a tool to gain unfair competitiveness, Italy’s trading partners will be very upset. There is an internationally agreed-upon principle of “currency manipulation” which allows for international sanctions. In this domain, no country is fully sovereign.

The Eurozone is a brand new experiment by historical standards. It is obvious that its current shape is far from perfect and that it will evolve over time. The Stability and Growth Pact is a disgrace: it has not worked and it constrains governments when they need some leeway. The ECB is too easily subject to national pressure. The Banking Union is half complete. The way Greece was dealt with is shameful (4). All of that, and more, will need to be fixed. It will be, even if it takes years or decades.


1) Giavazzi, Francesco and Alberto Giovannini (1989) Limiting Exchange-Rate Flexibility: The European Monetary System, MIT Press.

2) OECD (2017) “Reforms are Paying Off but Challenges Remain,” Economic Survey, OECD.

3) Lucas, Robert E., Jr. (2000) “Inflation and Welfare”, Econometrica. 68: 247–274;
Barro, Robert J. (1972) “Inflationary Finance and the Welfare Cost of Inflation,” Journal of Political Economy 80(5): 978-1001.

4) Wyplosz, Charles and Silvia Sgherri (2016) “The IMF’s Role in Greece in the Context of the 2010 Stand-By Arrangement,” Background Paper 16-02/11, Independent Evaluation Office, IMF.

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