Markets have shrugged off their worries over Italy. They may want to think again.
While Italian bond yields have dropped back to more normal ranges after a spike earlier this week, the underlying tension in the euro zone has not abated one bit. Germany continues to be the big winner from the common-currency zone. Italy remains one of the biggest losers.
The accompanying chart shows the problem. After decades in which economic output per head in the two countries grew in lockstep, a great divergence in prosperity began just before the financial crisis and has gaped wider and wider ever since. Germans are doing splendidly, thank you very much. Italians? Not so much. Their country’s gross domestic product is less than it was in 2008.
It’s difficult to see how any economic union can survive if a major partner in the union believes it’s being taken for a ride. Without reforms to the European Union, more conflict seems all but inevitable. In a worst case, Italy may decide to bolt the euro zone. And that should concern all of us, since Italy is one of the largest sovereign debt issuers in the world and the euro ranks second only to the U.S. dollar as a trading currency. A breakup of the euro zone would shake the global financial system to its roots.
“Italians are at the end of their rope after close to 10 years of brutal austerity, economic stagnation and a surge in migrants and economic refugees from all over Eastern Europe and beyond,” a very well-informed but publicity-shy investment professional wrote to me this week, to explain why he is so concerned about the situation. It’s one reason why, for the first time in his life, he’s building a significant cash position in his personal portfolio.
On this side of the Atlantic, commentators often blame Italy’s plight on a Mediterranean aversion to efficiency or the country’s long history of operatic politics. But neither explanation really convinces. As the chart shows, Italy was capable of growing just as rapidly as Germany for decades. Its relative economic decline began only in the early years of this century.
The obvious culprit was the introduction of the euro, beginning in 1999. It changed everything by removing a built-in buffer against economic shocks.
Before the euro was introduced, countries with their own currencies could devalue their money to offset bad developments. A country that was faced with dwindling competitiveness, for any reason, could cushion the pain by reducing the value of its currency to the point where its exports could once again lure buyers on international markets. In most cases, this would buy time for its economy to bounce back.
Euro zone countries no longer had that option once they were locked into the euro yoke. The hope was that the common currency would leave European countries with no choice but to focus on improving the efficiency of their economies. Instead, it’s resulted in a widening gap between winners and losers.
Germany, for instance, thrived by deliberately restraining wages beginning at the end of the 1990s. This reduced Germans’ buying power, and hence their demand for products from other European countries, while helping to make German exports supercompetitive in those other countries.
Other countries found themselves with limited options as they confronted this economic assault. They could, of course, try to undercut the German export machine. However, doing so was tough, especially after the financial crisis, when growth was painfully low anyway.
Regaining competitiveness involved a slow, grinding, politically explosive process of actually cutting wages, instead of the previous alternative of adjusting through currency depreciation. Of course, cutting wages also made the cost of servicing existing debt loads that much more onerous.
None of the problems came as a great surprise to people who had followed along. “A lack of [currency] flexibility makes it more likely that a member-state will lose competitiveness, and makes it extremely hard to reverse that loss of competitiveness,” warned Simon Tilford of the Centre for European Reform in a prescient 2006 paper titled Will the Eurozone Crack?
So what can be done? At the moment, the European Central Bank is doing the heavy lifting, by acting as a buyer for Italian bonds and those of other euro zone countries, and thus keeping rates low.
A better option would be to turn the euro zone into a true federation, in which rich countries would help subsidize poorer ones until they get back on their feet, just as Canadian provinces assist each other through bad patches.
Another notion would be for governments across the currency bloc – but especially in Germany – to open their spending taps, with the goal of encouraging faster growth. If German wages were to start growing at 5 per cent a year in a fast-expanding economy, other countries could regain competitiveness by holding wage increases to, say, 2 per cent.
But both options are politically radioactive, especially in Germany, which views its current prosperity as just reward for tough choices made years ago. This suggests the current truce in Italy is just a respite. Barring a sudden resurgence of growth, more conflict seems assured.
To its credit, Italy has major strengths, including a surprisingly robust current account surplus. But, as my correspondent points out, it’s difficult to shoulder a large debt load when your economy is barely growing. He’s worried about what comes next. And with good reason.