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Why Italy Is Flirting with Euro Exit and Spain Isn’t

Why Italy Is Flirting with Euro Exit and Spain Isn’t

Italy and Spain got new governments last week. But while Italy’s change of leadership led markets on a roller coaster, Spain’s was met with a yawn. The reason: Their economies have followed different paths, and so have their attitudes to the euro. The populists who make up Italy’s new government have toyed with exiting the common currency, whereas all of Spain’s major parties are committed to staying in.

This isn’t what you would have predicted six years ago; Spain suffered far more than Italy during the euro crisis. But it also reformed its economy much more and has enjoyed a much stronger recovery; gross domestic product is now above its precrisis peak. By contrast, Italy’s economic problems long predate the euro, and its failure to fix them has left GDP 5% below its prior peak and voters receptive to radical economic prescriptions.

Both Spain and Italy had a history of high inflation and currency devaluation to keep their exports competitive, which forced them to pay more to borrow. Once they joined the euro, that penalty disappeared and both saw bond yields drop to German levels.

In Spain, like in Ireland, that sparked a massive housing bubble and a huge inflow of capital from Germans and other foreigners. Spain’s current-account deficit, which includes trade and investment income, soared. In Greece the inflow of German savings went to finance government, not private, debt. The consequences were largely the same, though: When the crisis began, the inflows suddenly stopped, bond yields shot up, and all three economies fell into deep recessions.

Under conservative Prime Minister Mariano Rajoy, Spain responded to the crisis by liberalizing its labor market, such as making it easier and cheaper to fire employees or change working conditions; forcing banks to recognize bad loans, consolidate and recapitalize, and slashing public spending to contain deficits. GDP, which fell 9%, began recovering in 2013.

The Euro’s Consequences
The euro sparked a borrowing and asset bubble in Spain, but not Italy, and Spain’s post-crisis recovery has been stronger.

Sources: Haver Analytics (bond yields); OECD (housing prices); IMF (current account, per capita GDP)

There is considerable debate about whether Mr. Rajoy’s reforms fueled this growth or more conventional factors did, such as declining wages and prices that bolstered competitiveness. Unemployment remains stubbornly high. But the recovery is an important reason euroskepticism has never gained a foothold in Spanish politics. Mr. Rajoy, dogged by accusations of corruption, was ousted Friday in a no-confidence vote but his successor, socialist Pedro Sanchez, has promised to keep his budget.

Italy, like Spain, lost the ability to boost its competitiveness via devaluation when it joined the euro. Andrea Montanino, chief economist of Confindustria, Italy’s employer association, says Italy’s large, world-class exporters “restructured, reorganized, and penetrated foreign markets.” But small and medium sized enterprises, which dominate the Italian economy, didn’t, and couldn’t compete without devaluation.

Italy had no private borrowing binge like Spain or government borrowing binge like Greece, thus the inflow of foreign capital was much more moderate, and the growth crunch during the crisis less severe. Italy didn’t need a bailout for its banks, or undergo savage austerity: It ran bigger budget deficits than the eurozone average, notes Daniel Gros, director of the Centre for European Policy Studies.

But Italy entered the crisis saddled with structural problems that predate the euro: low productivity growth, a low birthrate, and rigid labor markets. Since Italy didn’t accept a bailout, it was slower to clean up its banks. Labor-market reforms were less ambitious than Spain’s. Its most important fiscal reform was to reduce the burden of public pensions via a less generous benefit formula and higher retirement age. But the changes are deeply unpopular and the new populist government has promised to repeal them.

Meanwhile, Mr. Gros says, on corruption, rule of law and government effectiveness Italy still ranks far behind the rest of the eurozone and has made little progress in recent years.

Previous ‘Outlook’ columns

Italian politics have always been unstable, reflecting the plethora of parties and deep divisions between the prosperous north and poorer south. Voters like “simple solutions to complex problems,” says Roberto Perli, an Italian-born economist and policy analyst at Cornerstone Macro in Washington. He said that mind-set explains the appeal of populists such as Silvio Berlusconi, repeatedly elected prime minister despite his governing failures and numerous scandals. It is also why support has surged for the 5 Star Movement and the League, which formed Italy’s new government. The two populist parties have no unifying ideology other than disdain for the establishment, including the European Union.

Their original candidate for finance minister was Paolo Savona, an economist who has advocated a “Plan B,” euro exit, to recover the tools Italy has previously used to revive growth: devaluation and deficit spending.

Last week, blowback from the markets and opposition by the Italian president forced the coalition to replace Mr. Savona with a pro-euro finance minister. Voters, who generally want to stay in the euro, were probably more attracted to the coalition’s promises of a crackdown on immigration, universal basic income and a flat tax. But those proposals would bust the budget and thus be blocked by the EU, says Mr. Perli. The government could tap resulting anti-Europe sentiment to legitimize leaving the euro, he says. Thus, the debate over euro exit may “only be postponed rather than abandoned.”

League party leader and new Interior Minister Matteo Salvini, right, and Undersecretary Giancarlo Giorgetti arrive at Quirinale Palace in Rome on Friday. Photo: massimo percossi/EPA/Shutterstock

Write to Greg Ip at greg.ip@wsj.com

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