June 6, 2018 / 2:09 PM / 6 months ago

Breakingviews - Hadas: Financial freedom is not what Italy needs

LONDON (Reuters Breakingviews) - Is it time for Rome to leave the euro in order to take back control of its fiscal policy? Both parties in the new Italian government have been flirting with that idea for some time. The right-wing League has nationalist reasons, while the radical 5-Star Movement has more nihilist motives. Does returning to the lira make any sense?

An Italian Army parachutist hoists Italian flag during the Republic Day military parade in Rome, Italy, June 2, 2018. REUTERS/Tony Gentile

Certainly not in the short term. As the British government is learning with regards to its planned departure from the European Union, hastily undoing long-term economic and political partnerships which involve thousands of strands of mutual dependency causes serious self-harm. At the very least, the rapid restoration of monetary independence would devastate Italian banks and savers, and destabilise financial markets.

Careful preparation might cut those problems down to a more manageable size. If greater Italian fiscal sovereignty makes economic sense in the long run, other euro zone members would find it hard to prevent the country from letting a new domestic currency find its equilibrium value, and running deficits beyond current European limits.

What would Italy gain from such upheaval? An independent monetary policy is one benefit. However, a newly autonomous Italian central bank would start with a big shortage of credibility. It probably could not get away with the European Central Bank’s current growth-friendly policies, let alone anything more stimulative. Interest rates would rise. With government debt at 132 percent of gross domestic product, that’s an invitation to a crisis.

A floating exchange rate might sound more appealing. Even with higher interest rates, the new lira would likely fall against the euro, boosting exports for a while. The trade balance, though, is not a big problem. Italy is expected to run a current account surplus of 2.6 percent of GDP this year, according to the International Monetary Fund.

More significantly, a temporary export-led boom would only delay the decline of structurally weak industries, while reducing the more helpful pressure to upgrade the quality of Italian exporters and the productivity of its workers. The country does not need any distractions from those increasingly urgent challenges.

The biggest supposed economic prize of a euro-free future is the freedom to run big fiscal deficits. Since joining the single currency the country has consistently run only a modest deficit – 2.3 percent of GDP in 2017 – and a surplus before interest expense on its debts. Leaving the euro zone would free Italy from European rules that restrict budget deficits, and require the country to bring down its national debt.

However, the new government can probably persuade the European authorities to allow a modestly larger deficit now, and at much lower borrowing costs than would be available in lira.

That does not mean a fiscal boost is a good idea, though. Undeniably, extra government spending and lower tax burdens can be invaluable for staving off a spiral of decline. All developed economies made use of that power after the 2008 financial crisis. Even conservative Germany ran a fiscal deficit of 4.2 percent of GDP in 2010 – the same as Italy in that year.

Now, though, there is little need. Europe’s economy is still expanding: the IMF predicts 1.5 percent growth for Italy this year. And the last thing still-fragile Italian banks need is being forced to buy large quantities of new government bonds.

Big fiscal deficits only help if there are economic gaps for the extra government money to fill. Otherwise, borrowing usually does more harm than good – as Italy’s own experience before joining the euro testifies. Persistent budget shortfalls contributed to undesirably high inflation, wasteful government spending and uncomfortably high levels of corruption. The main legacy is that huge government debt.

Fiscal flows also cannot solve structural problems in southern Italy. An Italian academic study shows government cash flows from 1951 to 2014 added the equivalent of a whopping 10 to 22 percent to annual GDP in the depressed region. The results of this largesse have been meagre. There has been almost no convergence with the wealthier north.

Of course, this time could conceivably be different. If the new government proves competent and disciplined, it could use a bigger deficit to fund policies which pay for themselves in sustained increases in employment, GDP and future tax collections.

Unfortunately, little in the initial programme and less in the past records of Italy’s new leaders give much reason for hope. The League and 5-Star Movement need to prove competence first, and perhaps then benefit from spending more later. For now, though, larger deficits are no more than an optional extra in any sensible Italian economic plan.

Chronic southern weakness is only one of a list of national economic problems which are more urgent than euro zone fiscal constraints. The tax, higher education and benefits systems all have serious troubles. Technologically sophisticated businesses are in short supply and organised crime is all too prevalent. Running a successful modern economy is complicated. Italy has many problems. The nation’s leaders would do well not to look for deceptively simple solutions.

Breakingviews

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