Tuesday, April 11, 2006

Devaluation Would Not Solve Italy's Problems

Following up on my recent post on Italy's election, which seems to have been as even as an election can be,with Romano Prodi's left-wing bloc winning 49.8% of the votesversus 49.7% for Silvio Berlusconi's right-wing bloc, I will now analyze the claim, made by both Berlusconi (seeking to deflect blame for the problems from himself) and various Friedmanite floating-exchange rate advocates, that the main cause of Italy's economic problems are its entry into the euro-zone, and the related claim that Italy's economy would regain its strength were Italy to re-introduce the lira and then use this to try to inflate and devalue its way.

It is sometimes claimed that the root cause of Italy's problem is that unit labor costs (wages adjusted for labor productivity) have risen 10% versus the Euro-zone average since 1999 (when the euro was introduced, while Germany have seen its unit labor costs fall 10% versus the euro-zone average, meaning that unit labor costs have risen 20% in Italy relative to Germany. Yet the economy need not be damaged by a relative rise in unit labor costs as long as it is driven by market factors, as this will increase purchasing power of the domestic economy and strengthen domestic demand, helping to offset the weakening trade balance. This effect is re-inforced in a monetary union, where the higher domestic price inflation will imply lower real interest rates, womething which will further boost domestic demand.

This fact is clearly demonstrated by the economic trends in other euro-zone countries. One would have thought that the advocates of "unit labor cost trends determine economic performance"-theory would be somewhat shaken in their beliefs when they cite the relative trend of unit labor costs in Italy relative to Germany. Germany have had as low level of economic growth as Italy despite the sharp decline in relative unit labor costs. Meanwhile, unit labor costs in Ireland, Spain and Greece have risen as much or more than in Italy, yet they have been the three fastest growing economies of the old 15 EU countries.

If higher unit labor costs were really the cause of Italy's problems, then surely we would have expected Ireland and Spain to experience weak growth too, but in reality they outperform all other Western European economies. And we should also if that theory were correct expect Germany to boom, but Germany's growth have been as weak as Italy's.

Instead the root cause of Italy's problems is as I've stated before a combination of a highly burdensome level of regulation that in particular inhibits the growth of the private service sector, a very old and rapidly aging population which in combination with´a low retirement age is a very heavy burden (already state pensions costs 14% of GDP, far higher than elsewhere) and also the bad luck of having a export structure concentrated in areas like clothing, shoes, white goods, machine tools and other goods where China and other super competitive East Asian and Eastern European economies have their strenghth. These are problems which would have existed with or without the euro.

But, someone might object, even if the euro weren't the root cause of Italy's problems wouldn't a re-introduction and heavy devaluation of the lira solve at least the last problem, that of Italian exporters getting out-competed on the world market by the Chinese?

Well, if the devaluation were big enough (we're talking about a really big devaluation now) it would indeed help Italian exporters regain lost marketshare. But even setting aside the damage such a devaluation would inflict on other countries, this would come at a very heavy cost as it would sharply reduce domestic purchasing power and thus damage the domestic economy.

Moreover, the success of such a move would depend on the Italian government and also private debtors being able to in effect default on their debts by re-denominating their debt in euros to the much lower valued liras. Given that the loans were issued in euros and the fact that euro would continue to exist, the legality of a move to re-denominate them into much lower valued liras (and in effect steal from creditors) would be dubious. If such a move failed and debts taken in euros would remain nominated in euros, it would imply a sharply increased real debt burden, something which would cause mass bankruptcies among private debtors and also increase Italian government debt to intolerably high levels, all of which would send Italy's economy into a crisis as deep as that seen in East Asia in 1997-98.

Italy did try the Friedmanite solution to devalue its way out of troubles in 1992, and while this boosted exports, overall growth continued to lag behind the rest of Europe as the devaluation damaged the domestic economy. The failure of devaluation to solve Italy's problems in 1992 illustrates that devaluation would fail again now and that the only thing that could solve Italy's economic problems are dealing with the statist policies that inhibits re-structuring of Italy's economy.


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