TCS Daily

Italy in Argentina's Shadow

By Desmond Lachman - August 1, 2005 12:00 AM

On looking at Italy's present economic predicament, one has to wonder whether one has not been to this movie before. Indeed, one has to wonder whether that movie might not have been called "Argentina", which was set mainly in Buenos Aires and New York between 1999 and 2001 and which had market participants on the edge of their seats till the riveting end. For while the end-game in the present Italian sequel might not be quite as sudden or as dramatic as that in Argentina, all the plot's ingredients are pointing away from a happy Hollywood-style ending.

The most striking similarity between Italy and Argentina, other than the Italian origin of many of the protagonists, is the extremely rigid currency arrangements in which the two countries managed to lock themselves. As a reaction to its harrowing mid-1980s experience with hyperinflation, in 1991 Argentina nailed its currency to the Convertibility Plan cross. It did so at the "immutable" exchange rate of one peso to the US dollar. This was supposed to usher in a period of low inflation and to force upon the country the fiscal policy discipline that it had never known before.

In a similar effort to impose macro-economic discipline, Italy has also supposedly given up forever any room for exchange rate flexibility. It did so in 1999 by abandoning the lira in favor of the euro. Gone were supposed to be the days of high inflation and periodic lira devaluations. In were supposed to be the days of fiscal discipline and structural reform that were to allow Italy to thrive inside its exchange rate straitjacket.

Like Argentina before it, by abandoning the lira, Italy has given up all macro-economic policy flexibility to stabilize its economy. No longer having its own currency, Italy cannot engage in periodic exchange rate devaluations as it did in the past to rectify losses in international competitiveness. No longer having its own central bank, Italy has to accept the interest rates set by the European Central Bank. It has done so even though the interest rates set by the ECB might not necessarily conform to Italy's particular circumstances.

As if no longer having an independent monetary and exchange rate policy were not bad enough, under Europe's Fiscal Stability Pact, Italy is committed to strengthening its public finances at a time of cyclical economic weakness. For like Argentina of the 1990s, Italy's public finances are in a real mess. With a debt to GDP ratio in excess of 105 percent, Italy is among the most indebted of the industrialized countries. With a public deficit in excess of 4 percent of GDP and rising, Italy is in clear violation of Europe's Maastricht criteria that require member countries to limit their public deficits to 3 percent of GDP.

Italy's loss of macro-economic policy instruments would not be of such great moment if its economy were booming and if its industries were competitive. All too sadly, however, this is far from the case. Already over the past two quarters, the Italian economy has sunk into recession. And under the weight of high international oil prices, this recession is only likely to deepen. Any such deepening will make it all the harder for Italy to correct its excessive fiscal imbalances.

More disturbing still is Italy's present lack of international competitiveness. Over the past five years, Italy has lost around 15 percentage points of competitiveness to Germany as wage increases in Italy were not matched by productivity gains. At the same time, Italy's failure to modernize its industries has left Italy exposed to the full winds of Chinese competition in today's increasingly globalized economy.

As was the case of Argentina before it, the only real way out for Italy is far-reaching structural reforms, especially in the labor market, that would restore Italy's competitiveness. However, one needs to ask how much more likely are such reforms in Italy under an enfeebled Berlusconi government than they were in Argentina under Carlos Menem. This would seem to be all the more so the case given the short-term pain associated with such reform.

In the absence of real reform, the most likely scenario for Italy will be a prolonged period of economic stagnation and ever widening budget deficits. This will likely force the ECB to periodically bail Italy out notwithstanding the ECB's protestations that it remains committed to its "no bail out" clause. However, in the same way that Argentina made the mistake of forever counting on IMF goodwill to paper over its economy's weaknesses, Italy will be making a grave error if it postpones painful market reforms and relies instead on the indefinite indulgence of the ECB to keep afloat its rickety public finances.

The author is Resident Fellow, American Enterprise Institute.



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