July 25, 2005

Stephen Poloz

Guest Columnist

Should Italy abandon the euro?

European monetary union always seemed like a good idea, in theory. One currency for all would simplify things, reduce volatility and lead to better-functioning economies across the union.

Lately, though, there has been more than the usual amount of grumbling. Referenda in France and in the Netherlands have even rejected the proposed union-wide constitution, throwing doubt on the future of the entire project, at least in its political dimensions.

The turnaround has been especially sharp in Italy. Back in the mid-1990s the biggest issue around European monetary union was whether or not Italy could qualify for membership. In 1995-96, Italy’s fiscal deficit was over 7 per cent of GDP, a far cry from the requirement that members have deficits of less than 3 per cent of GDP. But Italy wanted very badly to be a member and came through, hitting deficits of 3 per cent of GDP in 1998 and under 2 per cent in 1999, the year that EMU took flight.

Fast-forward to 2005, though, and the Italian economy is languishing. In the first quarter of this year, economic growth was -0.2 per cent compared to the same period a year ago. This is far below the average for the entire Euro area, at 1.3 per cent, and forecasters are expecting more of the same. Many are blaming the strong euro, and there has even been a suggestion that Italy opt out of the euro and go back to using the beloved lira. But a short history lesson appears to be in order.

First, the euro is not actually strong. It was worth about US$1.20 at its inception in 1999. During 2000-2001 the euro fell to around US$0.85 because of weak global growth and U.S. dollar strength. But the global recovery fostered a rebound in the euro, too, and after overshooting to $1.35 it is now closer to $1.20, where it all began. With the world economy functioning much more normally today, this is the sort of value for the euro that Europeans will need to get used to.

Second, Italy is one of the countries that benefited the most from the monetary union. In 1995, the interest rate on 10-year Italian government bonds was over 13 per cent, while that on German bonds was below 8 per cent. That risk premium of 5 per cent was being paid by every Italian on their mortgages and credit cards. Today, thanks to monetary union, that risk premium is only 0.2 per cent.

Third, Italy’s economic performance has not really changed. Average growth in the six years since monetary union has been 1.4 per cent, and it was 1.5 per cent during the six years prior to 1999. Italy’s economic problems are mostly structural in nature, and dropping the euro would not change that.

Dropping the euro would, however, lead financial markets to worry about a return to high deficits and inflation, and ordinary Italians would pay the price through higher interest rates. The fact is that the rules of euro membership make it easier for politicians to take tough economic decisions.

The bottom line? European monetary union is still a pretty good idea, in theory, and Italy has benefited more than most. No one ever said that membership would be easy, just worthwhile.

Stephen S. Poloz is Senior Vice-President Chief Economist for Export Development Canada.

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