Italy never should have joined the euro, and the ECB can’t rescue it from its next crisis

Italy wil plunge the eurozone into an unmanageable crisis

Italian financial tremors are again rumbling dangerously. Yields on the country’s 10-year government bonds, which briefly topped 3% when President Sergio Mattarella temporarily stopped the 5 Star Movement and the League from forming a government, appear primed to rise even higher, potentially plunging Italy and the eurozone in an unmanageable crisis. Italy is not just a deeply troubled country, it is also large. Its chaotic banking sector is the eurozone’s third largest, following those in France and Germany. The Italian government’s debt, at €2.5 trillion ($2.95 trillion), is about the same size as the debt owed by the French and German governments, and is larger than the combined government debt of Spain, Portugal, Greece, and Ireland, the four countries that needed financial bailouts. An Italian financial crisis would quickly break through the defenses eurozone authorities have constructed. This need not have been. In the 1990s, thoughtful observers understood that Italy did not belong in the eurozone. Italy could not give up its own monetary policy and currency, the lira. Over three decades, between 1970 and 1999, the lira had steadily lost over 80% of its value relative to the German mark. As the new millennium neared, Italy was being out-competed by emergent East European economies and even more dramatically by China. Unable to raise productivity growth, Italy would need more lira devaluations. However, Italy’s top economists and finance officials were keen, indeed desperate, to join the eurozone. They subscribed to the vincolo esterno (external constraint) proposition. They insisted that lacking the escape valve of an ever-depreciating lira, Italy’s political leaders would have no option but to enforce sound fiscal and structural policies to secure a better future for Italians. European Union scholars Kenneth Dyson and Kevin Featherstone say Mario Draghi, currently president of the European Central Bank and then director general of the Italian treasury, “believed in his soul” that the euro would enforce the discipline Italian governments needed. Hubris won the day, and Italy joined the eurozone at its inception on Jan. 1, 1999. But Italy’s fractious governments lacked the patience and durability to deal with the country’s endemic problems. The Italian economy fell into near-zero productivity growth, and despite the benefit of a buoyant world economy from mid-2003, the unemployment rate on the eve of the global financial crisis in 2007 was nearly 7%. Italian banks were eking out meagre profits, and the government’s debt was nearly 100% of GDP. The global crisis between 2007 and 2009, and then the 2011-2013 eurozone crisis magnified Italy’s pre-euro economic and financial fragilities. The euro’s central flaw now came to the fore: a single monetary policy could not work for the strong Germany economy and for an increasingly decrepit Italian economy. Making matters worse, the ECB adopted a much tighter monetary policy stance than either the U.S. Federal Reserve or the Bank of England. By mid-2011, amid over-the-top fiscal austerity demanded by eurozone authorities, Italy desperately needed easy monetary policy and a large euro depreciation. Instead, on July 7, 2011, the ECB made a catastrophic error by raising interest rates, sending financial markets into panic. Between mid-2011 and mid-2012, financial turmoil reigned through much of the eurozone, especially in Spain and Italy. Italy never recovered from that trauma. In July 2012, the ECB’s Draghi tried to heal the wounds with his dramatic promise to do “whatever it takes” to rescue eurozone countries. That led to the Outright Monetary Transactions (OMT) shield, which carried the promise that the ECB would buy unlimited quantities of a member country’s bonds. But although markets calmed down, Italian interest rates remained too high, which, combined with unremitting fiscal austerity, mired the Italian economy in recession.With the ECB continuing to deliver only niggardly monetary stimulus, the unemployment rate soared, reaching nearly 12% by early 2013. Even the jobs available were precarious, and, feeling a sense of hopelessness, large numbers of Italians stopped looking for work. For too many, the financial stress was acute. Anti-European sentiment spread. In the February 2013 elections, the anti-establishment and anti-euro 5 Star Movement emerged as a potent electoral force with a quarter of the vote.