Is Italy ready to commit economic suicide?

Late last month, defeated Italian Prime Minister Silvio Berlusconi raised the possibility that Italy's post-election crisis could lead to the resurrection of the political career of the 87-year-old Giulio Andreotti, a former premier who once stood trial for alleged collusion with the Mafia. The proposal drew this caustic response from a senior Brussels economic policy official: "Italy as a nation is not in touch with reality; it is deluded."

On this view, rather than a return to its tainted past, what Italy really needs now is a strong government which is prepared to start tackling the economic problems that it has evaded since the birth of the euro.

Instead, some Italian politicians seem to believe that they can short-circuit the painful reform process by exiting from the single currency, a move which, according to Otmar Issing, the European Central Bank's chief economist, would be tantamount to "economic suicide".

To understand why leaving the euro would cripple, not save, the Italian economy, you have to look at the implications of such a move and the scale of the economic challenges Italy faces.

In a report late last year, Standard & Poor's, the international credit rating agency, analysed the implication for Italy of abandoning the euro. It argued that such a move could allow Italy to depreciate and regain lost competitiveness and generate growth. "The danger, however, would be that this would lead to higher inflation and drive up wages and prices, consequently eroding competitiveness and growth once more. The real [inflation adjusted] yield on Italian bonds would rise, damaging public finances and private sector cost competitiveness," it said. The report concluded that Italy would find it hard to establish a new currency because "individuals and companies might try to circumvent 'lirafication' of their incomes and assets". As an EU official points out, Italy would need capital controls, normally ineffective after a time, to make a new currency regime work.

Since the launch of the euro in 1999, Italy's real economic growth has averaged a smidgeon over 1.2% a year, this in spite of the "boom" years of 1999-2001, when growth averaged more than 2%. In the past three years, including last year's mild recession, output growth has been 0.5% a year. Even Germany has done (slightly) better.

Part of the reason for this economic stagnation has been a dramatic collapse in Italy's competitiveness. Figures from the Organisation for Economic Co-operation and Development (OECD) show that whereas through the 1990s Italy's share of world exports was consistently around 4.5%, a little higher at the start of the decade, by last year this figure had slumped to only 3.7%.

This drop in global market share of almost one fifth in the space of six years, which shows no sign of reversing, underscores a harsh reality. Not only are Italy's businesses producing too many goods that China and other emerging market economies can make more cheaply, its workers are being paid too much.

Since 2003 workers' compensation in Italy has been rising at around 5% a year, making the country's' structural international competitiveness problem worse. Over the same period, German workers' compensation barely increased at all. And its export industries are making products which the world, even China, wants to buy.

This slow-burning Italian economic crisis is so worrying for Brussels officials that some of them are talking about the day when Italy, like Argentina, might have to effectively default on its debts or even turn to the International Monetary Fund for moral support in implementing an economic clean up.

In its last Economic Outlook, the OECD took issue with the Italian government's economic forecasts and suggested that the budget deficit would be 4.3% in 2005 (well above the Stability and Growth Pact's mandated 3% maximum) and would remain virtually unchanged in 2006.

Standard & Poor's has projected that, even on quite optimistic growth forecasts, Italy's debt to gross domestic product (GDP) ratio could rise to almost 110% in 2007, from 106.6% in 2004. The Maastricht Treaty limit is 60%.

Remove those growth assumptions and assume zero growth, but coupled with strong (if implausible) efforts to keep the budget deficit stable at 4% of GDP and the debt ratio would still soar to 116% of GDP by 2010, Moritz Kraemer, Standard & Poor's credit analyst for Italy says.

But now let's assume that somewhere in Italy today, in the utmost secrecy, lawyers, civil servants and banks are busily preparing the re-introduction of the lira.

It requires only a cursory look at the tables at the back of the OECD's bi-annual Economic Outlook to see what might happen. Long-term interest rates on government bonds today in Italy are around 4%, for the lira they were 12.2% in 1995, before the convergence process required by the looming single currency began to bring rates down.

Higher interest rates meant that Italy was paying almost 11% of GDP to service its debt in 1995 compared with 4.3% now. Indeed the decline in interest rates with the birth of the euro has been one of the principal factors behind the decline from double digit levels in the early 1990s in the government's budget deficit as a percentage of GDP.

Before concluding that this is an unrealistically pessimistic scenario, think how foreign-exchange markets might view the new lira, given that it would only come into existence in the midst of a horrendous political and economic crisis.

Remember, too, that businesses and consumers would be paying far higher interest rates for their loans than the government and that a run on the new currency could trigger a banking crisis. Any payoff from the effective devaluation of the Italian currency by returning to the lira would, by the way, take time to come through.

The first effect would be to make imports more expensive, long before any rise in exports surfaced. Economic suicide, indeed.

Major analysis feature in which the author explains why he thinks that the idea floated by some Italian politicians that the country should abandon the euro to overcome its economic problems, would amount to economic suicide.

• Primary Source