The eurozone’s Italian Achilles’ heel

If there is one thing about the Eurozone on which most economists can agree, it is that Italy’s economic performance since the Euro’s 1999 launch has been appalling. If there is another thing on which consensus can be found, it is that an over-indebted Italian economy needs a coherent and reform-minded government to get the country quickly onto a higher economic growth path.

Sadly, in the run up to next year’s Italian parliamentary elections, which is most likely to take place in March 2018, the prospects do not appear to be promising that Italy will get itself such a government. This does not bode well for either Italy’s long-term economic growth prospects or for the long-run survival of the Euro.

The highly unsatisfactory nature of Italy’s economic performance since the start of the Euro can best be illustrated by comparing Italy’s economic record with that of Germany. Whereas since 2000, German per capita income has increased by around 20 percent, that in Italy has actually declined by 5 percent. Talk about two lost economic decades for the country. Similarly, whereas German unemployment has now declined to around 5 ½ percent, that in Italy remains stuck at over 11 percent.

At the heart of the economic performance disparity between Germany and Italy is the very different labor productivity performance in these two countries. Whereas year-in year-out, the efficient German economy manages to improve its productivity performance, the same most definitely cannot be said of the sclerotic Italian economy. As a result, since the Euro’s inception, Italy has managed to lose as much as 25 percent in international competitiveness to Germany.

Having given up its own currency within the constraints of Eurozone membership, Italy no longer has been able to depreciate its way to improved competitiveness as it had done so often in the pre-Euro days. Instead, now within the Euro straitjacket, if Italy is to get itself onto a higher economic growth path, it has to find ways improve the country’s labor market productivity performance towards German levels. It has to do so through major economic reforms, especially to its very rigid labor market, just as Ireland so successfully did in the immediate aftermath of the Eurozone sovereign debt crisis.

With the European Central Bank (ECB) already starting to wind down its government bond purchasing program, there would seem to be great urgency for Italy to get its economy moving again. Not only is rapid economic growth needed to bring down the Italian government debt substantially from its currently dangerous 133 percent to GDP level; rather it is also needed to put Italy’s fragile banking system back onto a firmer footing.

Italy’s serious economic challenges, especially in the context of the ECB’s likely shift to a less accommodative monetary policy stance, would seem to underline the importance of the country’s forthcoming parliamentary elections. Those elections will determine whether the country is capable of undertaking serious economic reforms before it is too late or if it will continue to muddle along in a way that will not reduce its economic vulnerabilities.

Sadly, the results of the recent Sicilian local elections do not augur well for a reform minded Italian government emerging from next year’s national parliamentary elections. Rather, they suggest that Italy could very well land up with a majority right wing coalition government comprised of three very strange bedfellows – Silvio Berlusconi’s Forza Italia, the anti-European Northern League, and the extreme right Brothers of Italy party. It is difficult to see how such a disparate government would find common ground for serious economic reform.

Alternately, Italy could find itself saddled with a minority government led by Bepe Grillo’s populist Five Star Movement. It would also be difficult to envisage such a government as likely to be the agent for major economic reform that the country so desperately needs.

It is often said that being the Eurozone’s third largest economy, Italy is simply too big to fail for the Euro to survive in its present form. However, it is also said that being roughly ten times the size of the Greek economy, a troubled Italian economy would be too big for Germany to save.

One has to hope against hope for both the Italian and the global economies that cooler minds prevail in next March’s Italian parliamentary elections than was the case in the recent Sicilian election. In particular, one has to hope that the Italian electorate gives a resounding mandate to a reform minded government.

Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund’s (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.