The search for scapegoats

Economic troubles are always someone else's fault

SOME of the ills that have made Italy the new "sick man of Europe" may be beyond its control. The present government certainly likes to suggest that they are. Ministers point out that the whole of the EU, and especially the euro zone, has also been struggling economically, especially since the terrorist attacks on America of September 11th 2001. Italy's finance minister at the time, Giulio Tremonti, was quick to blame the terrorists for Italy's sluggish economy.

When he returned to his old job two months ago, after the sudden resignation of Domenico Siniscalco, Mr Tremonti soon found two new scapegoats at which to point an accusing finger: the euro and China. The political subtext was none too subtle. It was the opposition leader, Romano Prodi, who as prime minister in 1998 took Italy into Europe's single currency; and who as a former president of the European Commission could be charged with favouring globalisation and opening up the European market to Chinese imports.

Certainly the macroeconomic background of the past few years has been unhelpful to Italy. A near-stagnant, ageing Italian population has done little for domestic demand. Fiscal policy has of necessity been constrained: the previous government had to cut the budget deficit sharply in order to qualify for the euro, and the present one has had its hands tied by the EU's stability and growth pact. In its early years the European Central Bank's monetary policy has, arguably, been too restrictive for countries such as Italy and Germany, reflecting the difficulty of setting a single interest rate to suit 12 hugely diverse economies.

But Italy's biggest weakness over the past few years has been its export performance (see chart 2). The country's largest market is Germany, whose domestic economy, and hence appetite for imports, has recently been far from hale and hearty, although its exports are booming. Italy suffers from the opposite problem: its domestic consumption is holding up reasonably well, but its competitiveness has been sliding, which has led to a fall in its share of world exports.

This is where the euro comes in, albeit not in quite the way that Mr Tremonti and some of his colleagues like to argue. Many Italians sincerely believe that the changeover from the lira to the euro triggered a burst of inflation that cut living standards and eroded competitiveness. These problems, they feel, were exacerbated because the euro rose against the dollar. Persuaded by this argument, some in the Northern League, notably Roberto Maroni, the welfare minister, are now saying that the lira should be brought back. Mr Maroni has even tried to collect enough signatures for a referendum on the matter. Mario Monti, a former European commissioner and now president of Bocconi University in Milan, points out that the Northern League has performed a complete about-turn. In the mid-1990s it was so enthusiastic about the single currency that it wanted the north ("Padania") to join alone if the country as a whole found itself unable to meet the conditions.

In reality the euro has not been nearly as bad for Italy as the critics suggest. Inflation, which came down sharply ahead of Italy's entry into the fixed-exchange-rate regime in 1999, has remained low; indeed, this has been one of the key benefits of euro membership. The switch to euro notes and coins three years later had a negligible effect on the general price level, according to Italy's generally reliable statistical office. Admittedly the price of a few everyday goods and services rose steeply as some tradesmen exploited the confusion at the time of the switch-over. Restaurants and bars were certainly guilty of cashing in: hence the often-heard complaint that the price of a cup of coffee doubled overnight. The government should have done more to stop such profiteering. But this sleight-of-hand does not support the argument, which even senior politicians like to trot out, that many Italian businesses chose to convert all their prices at 1,000 lire to euro1, not the correct rate of 1,936 lire to euro1.

A different model

What is undeniable is that the euro has perforce broken Italy's habit of frequent devaluation. In effect, membership of the single currency has forced Italy to change its entire economic model. Instead of relying on high inflation, high budget deficits and currency devaluations, it has had to learn to live with low inflation, low budget deficits and a fixed single European currency. It is not surprising that such a massive adjustment has been painful, and so far remains incomplete - notably because wage and price inflation are still higher than in other euro-zone countries.

Does that mean that Italy should have made a different choice? Mr Maroni and his allies like to point to Britain to show that a country can thrive inside the EU but outside the euro. Yet the comparison is misleading. Britain has not followed a path of high inflation, a high budget deficit and frequent devaluation outside the euro, and nor would it have been possible for Italy to do so. The sharp devaluations of the lira in 1992, and again in 1995-96, brought furious responses in other European countries, especially France. Had Italy persisted with its previous practice, it is hard to see how the single European market could have survived.

Don't cry for me, Italia

More dramatically, Italy might have come a cropper too. For there is another, more unnerving example of a country that has preferred to go its own way: Argentina. The worrying parallel is not that Argentina is a country with a strong Italian heritage, or that it was once rich but has become relatively poorer, but rather that it adopted an extreme variant of the old Italian model: high inflation, high public spending, high budget deficits and frequent devaluations. All this came to a halt in 1991, when Argentina adopted its "convertibility" plan to fix the peso against the dollar, the equivalent of Italy's decision to join the euro in 1998. Yet in Argentina, inflation, high public spending and budget deficits persisted. The result was a loss of competitiveness and a wrenching recession - and, in January 2002, the sudden demise of the convertibility plan as Argentina simultaneously devalued and defaulted (which, incidentally, proved costly for Italian savers, many of whom were heavily invested in Argentinian debt).

It makes a grim story, and there are plenty of gloomy analysts who predict a similar fate for Italy. Yet the analogy with Argentina might have been closer still had Italy retained the lira, and thus been subject to the same sort of speculative pressure that eventually broke Argentina's link to the dollar. For example, an Italy outside the euro would not have escaped relatively unscathed from the recent resignation of Mr Siniscalco and the associated controversy over the governor of the Bank of Italy (see box in the next article).

Indeed, it is membership of the euro that has made Italy's public-debt burden bearable by cutting its servicing costs sharply. Mr Siniscalco declares that, when he was finance minister, he thanked God every day for the euro, without which his job would have been even more impossible than it was already. Most Italian businesses also strongly support Italy's continuing euro membership.

This implies, however, that to remain competitive without recourse to devaluation, Italy must introduce structural reforms to boost productivity and hold down costs, as well as sorting out its public finances. The euro has, in effect, exposed Italy's true weaknesses, which are microeconomic in nature. They include rigidities in product and labour markets and insufficient competition. These structural problems are to some extent shared by all countries in the euro zone, but in Italy they often seem worse. They will be discussed in more detail in the next article.

If nothing is done, might Italy end up on the same track as Argentina, forcing it to leave the euro, devalue and perhaps default? In a country that is a member of the rich G7 club, such an event would be cataclysmic, which may be why financial markets do not seem to expect it. The spread of Italian debt over German debt remains relatively small. But it has widened in the past year or so, and credit-rating agencies have begun to sound the alarm over Italy's government debt, the third-biggest in the world. Italy remains highly unlikely to leave the euro, voluntarily or otherwise. Even so, the country should pay heed to the warnings it is starting to get from the markets.

Paradoxically, although euro membership has made it more urgent for Italy to deal with its structural faults, it may also have made it easier to avoid doing so, by cutting interest rates and eliminating exchange-rate crises. As the OECD puts it in its most recent report on Italy: "It is somewhat ironic that EMU membership...may, in effect, have relaxed the perceived need for structural adjustments on both the supply and fiscal sides."

Something similar happened in Argentina after it adopted its convertibility plan: people started to believe that biting the bullet of a permanently fixed exchange rate was enough, on its own, to cure the economy's problems. In both countries, the new fixed-exchange-rate regime came to be seen as the end point of the reforms, rather than a prelude to broader structural adjustments. The need for these in Italy is now greater than ever.

Article forms part of a survey of Italy. Article says that economic troubles are always someone else's fault in Italy.

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