By William Rees-Mogg (THE TIMES, 17/04/06):
THE ITALIAN election result was a disaster for Italy and is a threat to the future of the euro. Romano Prodi’s coalition, which stretches from the hard Left to the soft centre, has a small majority in the lower house and a tiny majority in the upper house. Since joining the euro in 1999 the Italian economy has had very low rates of growth and rapidly declining international competitiveness.
Italy is now in the economic condition that normally preceded devaluation of the lira in the years before the single currency. So long as Italy remains in the euro system it will be impossible to devalue, yet it would be equally impossible for a weak left-of-centre coalition, with no real majority, to take the tough economic decisions that might, or might not, restabilise the economy.
Prodi, the incoming Prime Minister, can fairly be described as a euro fanatic. He took Italy into the euro; he was until recently the President of the European Commission. His core political beliefs are those of a social democratic European federalist. He is said to want to isolate Britain in Europe, because Britain is anti-federalist. He is likely to find that Italy is isolated by economic weakness and the reluctance of other European powers, inside or outside the euro zone, to bale out Italy’s debts.
When the euro was first planned many critics argued that a single currency could survive only if it was backed by a single European government. Inside the euro system different national economies would develop separately and would diverge over time. Each economy would have to adjust to unforeseen external shocks, such as the increase in the oil price or in Asian export competition, but the shocks would have different impacts on different countries.
With no recourse to devaluation, countries would have to take painful economic decisions that might prove to be politically impossible; we have recently seen that in France, where the students at the Sorbonne imposed their will on the Prime Minister. Sooner or later the weakest countries would be unable to stand the strain. Italy was often mentioned as the weakest of the largest European economies.
This is now being put to the test. The structural weakness of the euro is that it is a single currency that has 12 different economies, 12 different electorates, 12 different governments, 12 different budgets and 12 different systems of sovereign debt. In the debt market itself there are 12 different values for the euro. A table of “ten-year government bond spreads” shows that one euro bond can have a significantly different yield from another. This spread reflects the market assessment of the risk of the weaker nations being forced to leave the euro. Naturally investors expect a higher return on a bond that has a risk of default.
The German ten-year bond sets the standard. Currently it yields 3.95 per cent. The comparable French bond yields 3.99 per cent, not quite so good, but good enough. No one thinks that France will leave the euro, despite its government’s capitulation to student riots. Italy is another matter: the Italian rate is 4.27 per cent. Greece is even a little higher than that, but it has a smaller economy and is therefore less important. Portugal, another small economy, is also rather weak.
A number of factors influence the Italian euro bond market. No doubt it is managed to some extent by the Italian central bank, though the bank would aim at preventing a runaway decline in Italian bond prices. The Asian central banks do hold euros in their reserves, but they can be assumed to prefer high-grade German bonds to suspect Italian ones. A majority of Italian euro bonds are, in fact, known to be held by the Italians themselves.
Currently there is a yield premium on Italian euro bonds, and speculation is tending to raise that premium further. The market is not yet convinced that Italy will have to leave the euro system, but it has established a premium to take care of the risk. The real risk may be considerably higher than this premium suggests.
If Italy had to leave the euro the consequences would be quite sensational. A refloated lira might be devalued by between 30 per cent and 50 per cent, inflating Italy’s import prices, including oil. Italian debt and interest rates would both rise; perhaps interest rates would double. Initially, therefore, the Italian budget deficit would increase to alarming levels. The immediate effects would be very painful for Italy.
The euro itself would be expected to survive, but confidence would have been damaged. If Italy had to leave, who else might go in the future? One can expect every effort to prevent Italy leaving, both in Italy and in the rest of Europe. Even the US Federal Reserve would be worried. All uncertainty is bad for financial markets. If Italy leaves, it will be only after a lot more pain.
Yet seven years of the euro have left Italian industry dangerously uncompetitive in Europe and the world. The Italian economy is becoming progressively less competitive. There is no sign of a reversal of this trend. At some point, which might still be years away, that trend will have to be reversed. In economic terms, the only choice is between leaving the euro and a heroic stabilisation policy, which would involve sharp reductions in credit, Anglo-Saxon labour laws, cuts in public spending and serious budget surpluses. There is no third way out.
Signor Prodi passionately believes in the euro and will fight to defend it, but he does not have the political strength for a savage stabilisation programme. Signor Prodi’s incongruous coalition would explode if he attempted that. The Italians are not willing to be crucified upon a cross of euros.
In 1925 Winston Churchill returned Britain to the gold standard at too high a rate; in 1999 Italy joined the euro at what is now too high a rate. Britain left the gold standard in 1931, after years of economic misery. Will Italy learn from the British lesson?.