Italy’s Currency Before the Euro: Unpacking the Lira and its Economic Legacy

Introduction

Has the Euro truly hampered Italy’s economic growth, as some Italian politicians suggest? While definitive answers are rare in economics, mounting evidence indicates that blaming the Euro for Italy’s sluggish performance over the past two decades is likely misplaced. Focusing solely on the Euro not only misdiagnoses the issue but also distracts from addressing the genuine factors hindering Italy’s potential for higher growth. Identifying and implementing these necessary measures is crucial for Italy’s economic future, a discussion for another time.

This article argues against the Euro being the root cause of Italy’s economic stagnation, based on nine key points:

• Italy’s economic growth has been minimal in the last two decades.
• Attributing this stagnation to the Euro is inconsistent with most economic models, where monetary factors rarely dictate long-term economic stagnation.
• The timeline of Italy’s growth decline doesn’t align with the Euro’s introduction.
• The initial years of the Euro saw unemployment improvement in Italy and other Eurozone countries, contradicting the idea of the Euro as a depressive force.
• Italy’s economic struggles are more pronounced than other Eurozone nations, especially Spain, a fellow Euro-periphery country, further questioning the Euro’s role as the primary cause.
• The Euro’s introduction led to lower real interest rates, potentially negatively impacting productivity growth in Italy and Spain initially.
• However, the extension of this negative productivity effect to overall real growth is debatable.
• Italy’s historical track record of managing its exchange rate is weak, making the loss of currency devaluation a potential benefit rather than a disadvantage.
• Numerous structural issues within Italy offer more plausible explanations for its long-term growth struggles, overshadowing the need to blame the Euro.

1. Two Decades of Italian Economic Stagnation

Since adopting the Euro (1999-2016), Italy’s average annual per capita growth rate has been a stark 0% (Table 1). In stark contrast, Spain experienced 1.08%, France 0.84%, and Germany 1.25% growth during the same period. This highlights Italy’s significant underperformance compared to these major European economies. Simply put, while other major Eurozone adopters grew by approximately 1% annually since the Euro’s inception, Italy’s economy has remained stagnant. This disparity suggests unique factors beyond the Euro are at play in Italy’s growth crisis.

Table 1.

2. Political Scapegoating: Blaming the Euro for Economic Woes

Politicians, more often than economists, have pointed fingers at the Euro as the culprit for Italy’s economic stagnation. For instance, in 2005, then Italian Interior Minister Maroni suggested a return to the Lira, citing the Euro’s inadequacy in addressing slow growth, competitiveness loss, and unemployment.

Similarly, former Prime Minister Berlusconi in 2014 advocated for a dual currency system, aiming to regain monetary sovereignty. He reiterated this in 2015, drawing historical parallels to Italy’s post-WWII dual currency system alongside the Lira from 1943 to 1953. Berlusconi proposed considering a national currency, even suggesting retaining the name “Lira,” with its exchange rate against the Euro determined by market forces.

However, economists like Alesina and Giavazzi emphasize the need for broader European debate on monetary union reform, cautioning against unilateral exits from the Eurozone. They argue that leaving the Eurozone and potentially the EU would isolate Italy in Europe.

Often, the debate around the Euro’s impact intertwines with austerity measures as causes for Italy’s stagnation. While austerity’s role is a separate discussion, it’s worth noting that Germany, a champion of austerity, has been a top-performing Eurozone economy with low unemployment in recent years. This article focuses solely on the Euro’s potential impact, leaving the austerity debate for another discussion.

3. Monetary Theory and Long-Term Stagnation: Why the Euro is an Unlikely Culprit

Economic theory challenges the notion that monetary factors like currency adoption are primary drivers of long-term economic stagnation. A fundamental economic principle, the neutrality of money, posits that in the long run, doubling the money supply only doubles prices, leaving real economic variables unchanged.

While this principle has qualifications, they don’t strengthen the argument against the Euro. “Super-neutrality” debates whether changes in money growth rates affect real variables – deviations are considered minor and not significantly impacting growth. The “hysteresis” hypothesis suggests recessions can have persistent negative effects on GDP levels, potentially even growth rates (super-hysteresis). Recessions, including those caused by monetary policy, can lead to long-term unemployment as workers lose skills, impacting the Phillips curve and worsening the unemployment-inflation trade-off.

However, hysteresis is unlikely to explain two decades of stagnation attributed to the Euro. Firstly, its growth impact, as opposed to level impact, is unlikely to last so long. Secondly, the Euro’s introduction wasn’t associated with an initial recession in Italy. If anything, it provided a positive macroeconomic shock, suggesting hysteresis should have prolonged favorable effects, not triggered stagnation.

4. Timing is Everything: Italy’s Slowdown Predates the Euro Crisis

To assess the Euro’s impact, we must examine if its 1999 introduction coincided with a significant growth downturn in Italy. Analyzing both real growth and unemployment trends provides a comprehensive view.

Figure 1. Real growth and unemployment in Italy (1960-2016).

Source: Ameco, WorldBank.

Figure 1 divides nearly 60 years of Italian economic data into three periods:

1. Pre-Euro: Before 1999.
2. Stability Period: The initial Euro years.
3. The Great Recession: Post-2008 financial crisis.

Key observations from Figure 1:

1. Long-term Growth Deterioration: A clear, decades-long trend of declining growth is evident.
2. Growth Instability & Moderation: High growth volatility pre-1980s contrasts with a “Great Moderation” until the 2008 crisis.
3. Deep Recession Trough: The 2009 recession saw the steepest growth decline since the 1960s.
4. Unemployment Trends: Unemployment worsened from 1970-1998, improved during the “Stability Period” to levels not seen since the early 1970s, and then worsened again during the Great Recession.

Crucially, Figure 1 doesn’t show a clear macroeconomic performance decline coinciding with the Euro’s introduction. The Euro period doesn’t show more negative deviations from the trend compared to pre-Euro years. In fact, the “Stability Period” shows more positive deviations.

Comparing Italy’s growth to other major Eurozone economies (Germany, France, and Spain) further clarifies the picture.

Figure 2. Real growth per head in the periphery (Spain and Italy) and in the core (Germany and France) of the euro-area.

Source: World Bank

Figure 2 uses the same time divisions as Figure 1 but adds a post-2012 period reflecting ECB President Draghi’s “Whatever it takes” speech, which spurred growth, especially in Spain. The figure shows that the long-term growth slowdown is not unique to Italy; it’s a trend across all four nations. The Euro’s adoption doesn’t mark a growth break for any of them; if anything, it coincided with higher growth in Italy and Germany in 2000 and continued high growth in Spain. A slowdown in all four occurs in 2002-2004, followed by recovery and then the Great Recession plunge. Germany and France recovered quicker; Spain took longer but rebounded strongly post-2012. Italy lagged behind all three in both recovery time and intensity.

In summary, no growth break coincides with the Euro’s introduction for Italy or the other major Eurozone economies. Italy’s poor growth requires a specific explanation, as other major Euro adopters, including peripheral Spain, didn’t experience such a downturn post-Euro.

Table 2 reinforces this, showing average growth rates across periods. The overall growth slowdown and Great Recession trough are visible in all countries, but Italy’s is particularly severe. Interestingly, unlike the other three, Spain’s growth accelerated between the “Second Pre-Euro” and “Stability Period.”

Table 2.

Figure 3 examines unemployment, revealing further inconsistencies with the Euro-depression theory. As seen in Figure 1, Italian unemployment nearly halved from over 11% in 1998 to just above 6% in 2007. Spain’s unemployment drop was even more dramatic, halving from nearly 19% to just over 8% in the same period, the lowest since the early 1980s. Germany and France also saw unemployment improvements in the Euro’s first decade, though less pronounced. These diverging growth and unemployment trends hint at productivity issues, explored further in the next section.

However, it’s important to note that during the Great Recession, Italy’s and especially Spain’s unemployment fared much worse than Germany and France. Only in the last 4-5 years have Italy and Spain started to recover, with Spain showing more decisive improvement.

Figure 3. Unemployment in the periphery (Spain and Italy) and in the core (Germany and France) of the euro-area (1983-2016).

The evidence on growth and unemployment doesn’t support a direct link between the Euro’s introduction and Italy’s post-1999 economic struggles. Key inconsistencies include:

• No clear growth break in Italy coinciding with the Euro’s introduction over a long timeframe.
• Initial growth increase in Italy in the first two years post-Euro adoption.
• Italy’s significantly worse growth performance than other major Euro adopters, particularly Spain.
• Substantial unemployment reduction in Italy, Spain, and other major Eurozone countries in the “Stability Period” before the Great Recession.

5. Exploring Deeper: Productivity, Real Interest Rates, and the Euro

To delve further into a potential Euro-growth link in Italy and Spain, more complex models are needed.

One intriguing theory, proposed by Cette, Fernald, and Mojon, suggests that the lower real interest rates following the Euro’s introduction may have reduced Total Factor Productivity (TFP) growth, potentially due to misallocation of capital spurred by cheaper borrowing costs. Giugliano and Odendahl echoed similar concerns. While Cette et al. empirically link real interest rates and TFP growth, they don’t fully extend the analysis to the TFP-to-GDP growth link. This link can be weakened by factors like unemployment changes, which affect GDP growth independently of productivity.

Establishing the Euro’s responsibility for Italy’s slowdown requires demonstrating a systematic chain of correlation, even causation, from the Euro to real rates, TFP growth, and ultimately real income growth. The Euro-to-real rates link is well-established. Cette et al.’s research also suggests a real rate-to-productivity link, especially pronounced in Spain and Italy between the mid-1990s and mid-2000s.

Figure 4 examines TFP growth in Italy, Germany, France, and Spain over seven decades.

Figure 4. Total factor productivity (TFP) growth in the periphery (Spain and Italy) and in the core (Germany and France) of the euro-area (1990-2016).

Figure 4 shows a general downward TFP growth trend across all four countries, with negative TFP growth in France, Spain, and Italy in the early 2000s. Consistent with Cette et al., a temporary TFP growth dip in Italy and Spain in the early 2000s roughly coincides with the lower real interest rates post-Euro introduction.

Table 3 further explores the real interest rate, TFP change, and real growth links in Italy, Spain, Germany, and France across the “Pre-Euro,” “Stability,” and “Great Recession” periods.

Table 3.

Table 3, while not a formal test, shows a general trend of decreasing TFP growth, real interest rates, and per capita growth across the four countries over time. However, some nuances emerge. All countries experienced significant growth during the “Stability Period” despite negative TFP growth (except Germany), indicating unemployment reduction’s role. Interestingly, real interest rates rose in Italy and Spain during the “Great Recession,” yet growth declined further, and TFP growth worsened in Italy. Conversely, France saw a real interest rate decrease and improved TFP growth in the same period.

Following Cette et al., we can conclude that lower real interest rates in the “Stability Period,” possibly Euro-induced, likely negatively impacted TFP growth in Italy and Spain. However, the causal chain from the Euro to low real rates, lower TFP growth, and lower real growth isn’t strong enough to definitively blame the Euro for the slowdown in the Euro-periphery, particularly Italy. This aligns with the standard IS-LM model, where lower real interest rates are typically expansionary. The impact of real interest rate changes on aggregate supply (long-term) may be opposite to its demand-side effect (short-term): higher real rates could boost long-term aggregate supply via productivity, but negatively impact short-term aggregate demand.

An alternative Euro-blame argument points to the Euro’s inflexibility during the financial crisis. This theory suggests the Eurozone framework, combined with the financial crisis amplified by Greece’s fiscal misreporting, prevented devaluation to offset Italy’s (and other periphery countries’) idiosyncratic shocks, forcing more painful internal devaluations. While the Maastricht Treaty lacked mechanisms for mutualizing idiosyncratic shocks, partially addressed by EFSF/ESM loans and ECB action during the crisis, the question remains: would devaluation have been a “savior” for Italy? To answer this, we must examine Italy’s pre-Euro experience with a weak currency.

6. The Lira Era: Not a Golden Age for Growth

From abandoning fixed exchange rates against the dollar in 1973 until Euro adoption in the late 1990s, Italy’s monetary history under the Lira was marred by high and volatile inflation and devaluation, without sustained improvements in growth or employment.

Figure 5 illustrates the Lira’s relentless devaluation against the Deutsche Mark from the 1970s Bretton Woods collapse until the Euro’s approach in the late 1990s. In the early 1970s, one Deutsche Mark bought 160 Lira; by the late 1990s, it bought around one thousand. This devaluation trend was accompanied by significant exchange rate volatility throughout the three decades.

Figure 5. Exchange rate between the Italian Lira and the Deutsche Mark (1965 – 1998).

Source: IMF-International Financial Statistics. Note: the exchange rate is bracketed by 2 standard deviations above and below it calculated over the previous three years.

This devaluation was accompanied by higher interest and inflation rates in Italy compared to Germany until Euro adoption approached in the late 1990s. This highlights that sustained low interest rates require sustained low inflation, necessitating rate hikes when inflation is unchecked. Despite contrary commentary, the Bundesbank proved more effective at maintaining consistently low interest rates than the Banca d’Italia.

Conversely, to prevent persistently low inflation and interest rates, rates sometimes need to be lowered to exceptionally low levels, as is the current situation.

Figure 6. Interest rate spread and inflation differential between Italy and Germany (1965 – 1998).

Source: European Commission, Annual Macro – Economic database (AMECO).

A key fact emerges: between Bretton Woods’ end and Euro adoption, Italy experienced a weak, volatile currency and high, variable interest and inflation rates. Abandoning the Euro risks repeating this unfavorable experience.

High and volatile inflation and interest rates, alongside a continuously devaluing and volatile currency, negatively impact welfare. Figure 7 examines Italy’s balance of payments and labor market performance during the Lira era.

Figure 7. Real exchange rate and the current account as percent of GDP in Italy (1970 – 2016).

Source: BIS.

Figure 7 reveals cycles of gradual competitiveness loss due to high inflation, leading to current account deficits, followed by sharp depreciations that restored current account surpluses – until the Euro’s introduction.

Regarding the labor market, Demertzis et al. analyzed Italy’s Lira era (1980-1999) and concluded that Lira devaluations weren’t associated with long-term labor market improvements. Instead, employment gains occurred during periods of exchange rate stability, not devaluation.

Figure 8 further explores the relationship between exchange rates, growth, and unemployment.

Figure 8. Real exchange rate, real growth and unemployment in Italy (1965-1999)

Source: Ameco, World Bank , BIS

Figure 8 shows that during Italy’s period without external exchange rate constraints (1973-Euro adoption), the economy suffered from a volatile exchange rate and two consistent negative trends: declining growth and rising unemployment. This suggests Italy struggled to manage its currency, and devaluations were consequences of flawed macroeconomic policies rather than effective adjustment tools.

This aligns with Fratzscher and Stracca’s findings:

• Political instability negatively impacts growth via financial variables.
• Italy has historically been less politically stable than most European countries.
• The Euro has shielded Italy from its political instability, reducing negative political events’ impact on financial variables.

7. Structural Issues: A More Plausible Explanation for Italy’s Slowdown

Numerous studies point to structural factors, not the Euro, as the primary drivers of Italy’s underperformance. While structural factors are relatively constant and might not immediately explain growth changes, their interaction with global shifts can illuminate Italy’s growth decline. Pre-existing structural weaknesses may have become more damaging when interacting with exogenous global changes.

This article doesn’t aim to fully explain Italy’s slowdown through structural factors and global shifts, but highlights the abundance of literature supporting structural explanations. Common structural impediments cited include:

• Inadequate Education
• Insufficient R&D Investment
• Specialization in Low-Growth Traditional Sectors
• Small Firm Size
• Weak Corporate Governance
• Low Social Trust
• High Corruption Levels
• Inefficient Public Administration and Judiciary
• Welfare System Focused on Job Protection over Worker Mobility
• Geographic Dualism Between Northern and Southern Italy

Exogenous global changes often emphasized include:

• Shifts in International Specialization and Comparative Advantage
• Globalization, with Emerging Economies (especially China) entering global markets with lower-cost traditional goods
• The ICT Revolution

Calligaris et al.’s firm-level empirical study highlights the interaction of structural factors and global changes leading to resource misallocation, a key immediate cause of Italy’s productivity slowdown and subsequent lower trend growth.

In conclusion, a wealth of evidence points to structural issues, not the Euro, as the main culprits behind Italy’s economic underperformance. Blaming the Euro is not only unproductive but also diverts attention from addressing the real, structural causes hindering Italy’s growth potential. Shifting focus from the Euro to these underlying issues is essential for formulating effective strategies to put Italy on a path towards sustainable and higher economic growth. A detailed examination of these structural causes is a topic for future discussion.

This post was written with the assistance of Pia Hüttl and Madalina Norocea.

[1] Author’s translation. The original is: “E’ l’ora di tornare alla lira: chiediamo un voto agli italiani”. Intervista a Repubblica . E allora, torniamo alla lira? “Io dico di non scartare questa ipotesi perché non è affatto peregrina. Anzi. Sono tre anni che l’euro, non per colpa sua ma per responsabilità di chi ha gestito il passaggio alla moneta unica, ha dimostrato di non essere adeguato di fronte al rallentamento della crescita economica, alla perdita di competitività e alla crisi dell’occupazione. Non è forse meglio tornare, temporaneamente, almeno ad un sistema a doppia circolazione?).”

[2] Author’s translation- The original is: “Io ricordo, dopo la seconda guerra mondiale, che c’era in Italia una seconda moneta che è rimasta di fianco alla lira dal ’43 al ’53 – ricordava Io non dico di uscire dall’euro, ma non ho trovato nessuna norma nei trattati Ue che vieti l’adozione di una moneta nazionale e noi abbiamo già un nome: si chiama lira, il cambio lo da il mercato con l’euro, perché non fare una prova?”

[3] http://www.corriere.it/opinioni/17_marzo_28/insensata-uscita-moneta-unica-1dedd6b4-1322-11e7-be9a-6ca09ed8307d.shtml?refresh_ce-cp. Author’s translation. The original is: “Un dibattito europeo su come riorganizzarne, anche radicalmente, la gestione andrà avviato, e presto. Ma il nodo della campagna elettorale che si è aperta non è questo. La questione sarà: vogliamo che l’Italia esca subito e unilateralmente dall’unione monetaria e in prospettiva dall’Ue divenendo un paria dell’Europa?“. March 27th 2017.

[4] P. Manasse. The roots of the Italian stagnation. 19 June 2013. VOX, CEPR’s Policy Portal. The author refers this accusation but clearly does not believe in it. The rest of the quotation is as follows: “ This column argues that while the severity of the downturn is clearly a cyclical phenomenon, the inability of the country to grow out of it is the legacy of more than a decade of a lack of reforms in credit, product and labour markets. This lack of reform has suffocated innovation and productivity growth, resulting in wage dynamics that are completely decoupled from labour productivity and demand conditions.”

[5] McCallum (1990) defined super-neutrality in such a way. See McCallum, B.T. (1990). Inflation: theory and evidence. In: Friedman, B.M., and F.H. Hahn (eds.), Handbook of Monetary Economics, Vol.2. North-Holland, Amsterdam, pp.963-1012.

[6] Blanchard, O. and Summers, L. (1986), Hysteresis and European Unemployment, in Fischer, S. (ed.), NBER Macroeconomics Annual, MIT Press, September, pp. 15-77.

[7] O. Blanchard, E. Cerutti, and L. Summers., Inflation and Activity – Two Explorations and their Monetary Policy Implications IMF Working Paper, Research Department.. November 2015.

[8] G. Cette , J. Fernald, B. Mojon, The Pre-Great Recession Slowdown in Productivity, Mineo January 15, 2015.

[9] F. Giugliano and C. Odendahl, Europe’s Make-Or-Break Country: What Is Wrong With Italy’s Economy? Center for European Reform. Policy brief, 19 December 2016.

[10] Was the € a good idea, Mark II?” March 21, 2017 in my Blog; Money Matters?.

[11] M. Demertzis, K. Efstathiou and F. Matera, The Italian Lira: the exchange rate and employment in the ERM. Bruegel Blog, January 13, 2017.

[12] M. Fratzscher and L. Stracca. Does It Pay To Have The Euro? Italy’s Politics And Financial Markets Under The Lira And The Euro, ECB Working Paper Series No 1064 / June 2009.

[13] Elias Soukiazis, Pedro André Cerqueira and Micaela Antunes. Causes of the decline of economic growth in Italy and the responsibility of EURO. A balance-of-payments approach. Mimeo. Paolo Manasse. The roots of the Italian stagnation. 19 June 2013. VOX, CEPR’s Policy Portal. Ashoka Mody and Emily Riley. Why does Italy not grow? Bruegel BLOG POST October 10 2014. Paolo Manasse, Tommaso Nannicini, Alessandro Saia Italy and the euro: Myths and realities. 24 May 2014, VOX, CEPR’s Policy Portal.

[14] Sara Calligaris, Massimo Del Gatto, Fadi Hassan, Gianmarco I.P. Ottaviano and Fabiano Schivardi. Italy’s Productivity Conundrum, A Study on Resource Misallocation in Italy. Discussion Paper 030 | May 2016. European Commission, Directorate-General for Economic and Financial Affairs.