William Hague once described the euro as a burning building with no exits, and the experience of Italy over the past 20 years has proved that the then Conservative party leader was absolutely right.
Joining the single currency was made easy at the end of the 1990s. As one of the original signatories of the treaty of Rome, Italy desperately wanted to be in monetary union’s first wave.
But there was no real examination of whether a country like Italy – with its inflationary tendencies – could actually cope with the rigours of single-currency membership. There was no equivalent of Gordon Brown’s five tests that the then chancellor said had to be passed before Britain could join.
On the contrary, when it became clear that Italy would not meet the criteria, the rules were bent to make sure it did. The result: two lost economic decades in which living standards have stagnated, which is why Italy has given up on mainstream politics. A coalition government of two populist and euro-sceptic parties – the Five Star Movement and the League – appears imminent.
Although neither wing of the coalition has any love for the euro, they have already discovered the truth of Hague’s words. Their draft policy agreement included the proposal that the EU should establish a procedure for countries to leave the euro where there was “popular will” to do so, but this has now been dropped.
It’s not hard to see why. Were the financial markets to think that the new populist government was serious about leaving the single currency, Italian government bonds would become riskier. Investors would demand a higher return for holding them and that would drive up market interest rates. The European Central Bank could help by buying Italian bonds, but would have little incentive to help a government in Rome intent on undermining – if not destroying – monetary union.
A financial crisis would envelop the new government. Italy’s shaky banking system would collapse and the country would descend into a deep recession. Unemployment would rise and the Five Star Movement and the League would be blamed. The populists would quickly become unpopular.
So the new Italian government is in the same position as all the other governments the country has had over the past two decades: membership of the single currency is a curse but trying to leave the euro would be even worse. Like Greece, Italy is discovering that it is a bit late to say that it would have been better to have constructed the euro with a few fire escapes. It is actually easier for Britain – with its own central bank and its own currency – to leave the EU than it is for Italy to leave the euro.
But even if Italy shies away from monetary independence, the new government still has plans for tax and spending that pose a challenge to the way the eurozone has been run hitherto. These involve a new citizens’ income, more generous pensions and lower taxes. Estimates suggest these measures will cost around €60bn a year – some 3.5% of Italy’s GDP.
This would drive a coach and horses through the eurozone’s fiscal rules, which impose strict limits on the size to which a budget deficit is allowed to run. It would also send Italy’s debt ratio – the size of the country’s public debt in relation to the size of its economy – up from just over 130% of GDP to around 150% of GDP.
The prospect of a marked loosening of policy scares the financial markets and won’t go down well in other European capitals either. But actually, the coalition’s fiscal policies make sense. The real problem lies with the eurozone’s absurdly deflationary fiscal rules.
As Dhaval Joshi of BCA Research has pointed out, Italy is in some respects similar to Japan. Both countries faced difficulties because their zombie banks proved incapable of lending to the private sector. Japan solved this problem by getting the public sector to do the lending, even though this meant a big increase in its debt ratio. Italy is in a worse position because the eurozone’s fiscal rules mean it has not been allowed to run bigger budget deficits.
Italy has lower total indebtedness – private and public combined – than Britain, France and Spain, but as far as the EU’s fiscal rules are concerned only public debt matters. Joshi notes: “Hence, the Italian government was prevented from recapitalising its banking system, and the Italian economy stagnated for a decade.”
Those in charge of the single currency know that as it stands the euro is an unfinished project. It could be completed by the reform package proposed by the French president Emmanuel Macron, which would involve fiscal union as well as monetary union, presided over by a eurozone finance minister.
There is not the remotest possibility that Macron could get the new government in Rome to sign up to his plan even if he could secure the full-throated backing of Germany.
One alternative to Macron’s scheme is to allow members of the eurozone more freedom to run fiscal policies that meet their own needs, which is what Italy’s populist coalition is demanding. At present, the rules mean that any struggling country can only make itself more competitive through internal deflation – cost cutting and austerity.
The other is to allow things to drift on as they are and hope for the best. This has seen the euro through one crisis – just – but would not see it through another. The risk is not that one country will jump out of the burning building but that the building will eventually collapse with everybody in it.