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

What the euro is doing for you

by Tarek Hassan


4' di lettura

Many of us have fond memories of the time before the euro. I was in a German high school in the late 1990s. I remember spending long days at the local lake and evenings with friends in beer gardens. I don't remember ever having to stress about exams, money or work. In my memories, it was a completely happy time. I have forgotten all the stress and anxiety of being a teenager, the economic crisis of the late 1990s in Germany, and the fact that many of my classmates were worried that they would never find gainful employment. I am even convinced that the weather was better back then.
Nostalgia about the Deutschmark and the Lira is very similar to nostalgia about the brick-sized mobile phones we were using at the time. Nice to remember but not something you want to go back to.
So what has the euro done for you?
The most tangible benefit of having the euro is lower prices for things you buy every day. When you give them a chance, firms like increasing their profits by charging different people different prices for the same product. For example, if a new toy is popular at your kid's school, the producer of the toy might want to make it more expensive there, but keep it cheap at another school where the cool kids are not yet hooked. This kind of price differentiation is much easier to do when people find it hard to compare prices in different currencies.
My colleague Brent Neiman and his co-authors have recently published a study comparing the prices of consumer goods from firms like H&M, Zara, and IKEA across European countries. They showed that these firms basically charge the same price for the same good in all Euro-area countries, but charge very different (and on average higher!) prices for the same goods in countries outside the euro like Denmark, Sweden, and Norway. Because people in Sweden have a hard time comparing prices in Swedish crowns with those in euros, H&M can take advantage of the fact people in Sweden might prefer black jeans to blue jeans, and charge them more for what they like better. On average, prices for hundreds of thousands of goods surveyed in the study are 16% higher in Sweden and 22% higher in Norway than in the Euro-area. That is the effect of the euro and the transparency it creates.
Some of my own research has focused on a similar effect of having a large currency area on borrowing costs. Because 340 million people use the euro, investors from around the world prefer to invest money and give loans denominated in euros than in currencies of smaller countries. In this sense, size brings stability: the euro and the dollar are regarded by investors as safer currencies than the Lira and even the Deutschmark ever were. Because it is a safer currency, the introduction of the euro has lowered ``risk-free'' interest rates (that is, interest rates corrected for the risk of default) in all participating countries by about 1.7 percentage points relative to the US dollar. Such lower borrowing costs make capital investment in the Euro-area more attractive, and more capital means higher wages for workers.
At the same time, lower borrowing costs make it easier for heavily indebted countries like Italy to finance their government debt. These huge effects of the euro are often overlooked, because politicians often focus on the difference in interest rates between euro member countries. Instead, the big-picture is that the euro has made it easier (some say too easy!) for all European governments to finance their debt. The idea that somehow Italy might be able to borrow more if it had its own currency is pure fantasy and has no basis in fact.
That said, the euro does make life harder for politicians. A once popular strategy of some Southern-European politicians was to borrow as much as they could (largely from their own populations), and then quietly default on them by printing money, creating inflation, and triggering a currency crisis. That is now no longer possible because the ECB has taken the ability to print money out of the hands of politicians. Instead, politicians now need to engage in the hard work of fixing the fundamentals of the Italian economy. That is no fun, but necessary to secure Italy's prosperity for the decades to come and to get young people back to work.
Regardless of how successful these political attempts will be, there is no scenario I can see in which Italy would be better off outside of the euro, even if it were somehow easy to leave. (In reality, any attempt to break up the union would have enormous political and economic costs that are beyond my 1000 word limit.)
Is everything great with the euro? Certainly not. There are some things that could and should be improved. For example, I believe that the ECB should raise its inflation target to 3% or maybe 4% to help Italy and other countries to “devalue,” that is to allow Italian real wages to fall relative to the rest of the Euro-area. A little inflation helps with such adjustments because it is very hard to cut nominal wages and prices (people hate doing that). Such an increase in the inflation target achieves all the same benefits of a nominal devaluation (that would happen if Italy had its own currency and that currency depreciated in value relative to the euro), but without having to provoke a currency crisis and all the upheaval and economic costs associated with it. In my view, this kind of adjustment through inflation would help a little in the short run. In the long-run the only remedy for Italy's problems are the structural reforms I mentioned above and that other authors have also advocated in this column.

Alberto Cavallo, Brent Neiman, and Roberto Rigobon (2014), “Currency Unions, Product Introductions, and the Real Exchange Rate,” The Quarterly Journal of Economics 129(2), pp. 529-595
Tarek A. Hassan (2013), “Country Size, Currency Unions, and International Asset Returns,” The Journal of Finance 68(6), pp. 2269-2308
Tarek A. Hassan, Thomas M. Mertens, and Tony Zhang (2016), “Not so Disconnected: Exchange Rates and the Capital Stock,” Journal of International Economics 99, pp. S43-S57
Carmen M. Reinhart and Kenneth S. Rogoff (2009), ‘'This Time is Different: Eight Centuries of Financial Folly,“ Princeton University Press

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