The euro, a currency intended to unify Europe, remains a subject of intense debate, particularly in Italy. Following recent European elections, the discourse around the euro’s advantages and disadvantages in Italy and across the Eurozone has become increasingly politicized. Empirical evidence is often selectively presented to reinforce pre-existing biases.
Some argue passionately that the euro is essential, acting as the sole safeguard against Italy and other peripheral nations from economic collapse. Conversely, others condemn it as the root cause of Italy’s economic woes, pointing to de-industrialization and persistent unemployment.
Economists must move beyond partisan rhetoric to address a fundamental question: Has Italy’s adoption of the euro been economically beneficial or detrimental?
The Challenge of Counterfactual Analysis
Objectively assessing the euro’s impact on Italy is inherently complex. In macroeconomics, establishing a credible counterfactual scenario—what would have transpired had Italy not joined the euro—is notoriously difficult. This lack of a clear ‘what if’ scenario complicates policy evaluation. As Antonio Fatas (2012) highlighted in “The Euro Counterfactual,” both euro proponents and skeptics selectively use examples, comparing countries with fixed and floating exchange rates to support their respective arguments.
For instance, euro advocates might point to Ireland’s successful economic stabilization within the Eurozone, contrasting it with Thailand’s disastrous currency devaluation. Conversely, euro critics might compare Spain’s surge in unemployment within the Eurozone to the milder recession experienced by the United Kingdom outside of it.
To mitigate such biases and allow for a more data-driven analysis, we employ a statistical technique known as the ‘synthetic control’ method.1 This approach begins by identifying a group of countries that did not adopt the euro and then constructs a weighted combination of these countries to create a ‘synthetic’ Italy. This synthetic Italy closely mirrors the actual Italian economy’s performance before euro adoption.
This synthetic control then serves as our counterfactual. By comparing Italy’s actual economic trajectory after joining the euro with the simulated path of its synthetic counterpart, we can estimate the euro’s impact. For each economic indicator of interest, such as inflation, the algorithm calculates a weighted average of inflation rates from the non-euro countries. These weights are specifically chosen to replicate Italy’s inflation rate before euro adoption. The divergence between Italy’s actual inflation rate and its synthetic control’s rate after euro adoption indicates the estimated effect of the euro.
We have chosen January 1, 1999, the date when exchange rates were irrevocably fixed, as our starting point. To ensure the robustness of our findings, we also conducted the analysis using January 1, 2002, the date euro notes and coins began circulating, and the results remained consistent. Our control group comprises EU member states that retained their national currencies—Bulgaria, Croatia, Denmark, Lithuania, Poland, the UK, Czech Republic, Romania, Sweden, and Hungary—as well as non-European OECD members: Australia, Canada, Chile, South Korea, Japan, Switzerland, Iceland, Israel, Mexico, New Zealand, the US, and Turkey. Naturally, we excluded Eurozone countries and countries that subsequently joined the Eurozone.
Several potential caveats should be considered when interpreting the results of this analysis.
- Contagion effects: The euro’s influence might extend beyond Eurozone borders, affecting control countries that did not adopt it.
- Confounding effects: Simultaneous events coinciding with the euro’s introduction might disproportionately impact Italy and the control group, with their effects mistakenly attributed to the euro.
While the statistical model accounts for time-varying, unobservable differences between countries, the relatively small sample size necessitates cautious interpretation.
- Decreasing Reliability Over Time: The further we move from the euro’s introduction date, the less reliable the exercise becomes due to the increased likelihood of diverse economic shocks.
- Anticipation Effects: The euro’s consequences might manifest even before its official adoption. For example, government bond yields might decline in anticipation of reduced exchange rate risk.
Despite these limitations, we believe our synthetic control approach offers a more rigorous and less biased assessment compared to the selective use of counterfactuals often seen in political debates. We apply this methodology to five key economic variables central to the euro debate: international trade, inflation, long-term interest rates on public debt, labor productivity, and real per-capita GDP. In the following figures, the solid line represents the actual Italian data, while the dotted line depicts the counterfactual simulation generated by the synthetic control.
Impact on International Trade
A primary goal of the euro was to stimulate trade integration by lowering transaction costs and eliminating exchange rate volatility. Our analysis focuses on the euro’s effect on Italian trade flows.2 We first examine bilateral trade flows (exports and imports) between Italy and other nations. Figure 1 illustrates key trade flows.
Figure 1 Bilateral trade flows
Trade flows between Italy and other European countries, with the exception of the UK,3 have increased compared to the counterfactual scenario.
Our estimates indicate a substantial positive effect of the euro on trade between Italy and its Eurozone partners, approximately a 38% increase relative to the control group. Crucially, this ‘trade creation’ effect was not offset by a ‘trade diversion’ effect that would have reduced trade with non-euro members. Both total exports and imports as a percentage of GDP rose relative to the synthetic control. On average, in the years following euro adoption, Italian exports exceeded those of the synthetic control by 0.5% annually, while imports exceeded the synthetic control by 2% annually. The larger increase in imports compared to exports might reflect a decline in Italian competitiveness, as highlighted by Manasse (2013), where persistent high unit labor costs in Italian firms could no longer be mitigated by competitive devaluations. Overall, Italy’s entry into the euro was associated with increased trade, fulfilling one of the single currency’s key objectives.
Inflation Control
A central motivation for Italy joining the euro was to achieve inflation control. Decades of ‘monetary sovereignty’ had been marked by periods of double-digit inflation. However, public perception often attributed a significant price level jump to the euro transition. Figure 2 compares CPI inflation for Italy and its synthetic control.
Figure 2 CPI inflation (1991-2009)
Note: Counterfactuals: Australia (.295), Canada, Chile (.218), Denmark, Iceland, Israel, Japan, Korea (.009), Mexico (.010), New Zealand (.192), Norway, Sweden (.136), Switzerland (.132), Turkey, United Kingdom, United States.
The data reveals no inflationary surge following the euro’s introduction in 1999. Instead, the euro appears to have contributed to a reduction in Italy’s inflation compared to its synthetic control, although this effect was temporary. Between 1999 and 2009, the cumulative reduction in inflation attributable to the euro is estimated at 3% (0.3% per year), with a significant portion of this effect occurring during the period of irrevocably fixed exchange rates preceding the euro’s physical introduction. Furthermore, inflation volatility (not shown in the figures) also decreased substantially due to the euro.
However, these estimates might be influenced by contagion effects. If control group countries like Denmark and Sweden, which pegged their currencies to the euro, also experienced lower inflation due to reduced import prices, our initial calculation would underestimate the euro’s inflation-reducing impact. To address this, we reran the analysis using only non-European countries in the control group. Indeed, the cumulative reduction in inflation attributed to the euro nearly doubled, increasing from 0.3% to 0.7% per year over the decade 1999-2009. Contrary to euro-skeptic claims, the euro demonstrably curbed Italian inflation.
Government Bond Yields
Euro proponents often emphasize the euro’s role in significantly lowering Italian interest rates on public debt. Our analysis uses the yield on ten-year maturity government bonds (similar findings, detailed in the original Italian report, hold for three-year bills and alternative interest rate measures). Figure 3 presents the ten-year Italian government bond yield alongside its synthetic control, which includes both European and non-European countries. Interest rates are normalized to 1 at the beginning of the period to improve the control group’s fit in the pre-euro period.
Figure 3 10-year government bond yield (all counterfactuals)
Note: Counterfactuals: Australia, New Zealand, Sweden, Switzerland (.333), United Kingdom, United States, Denmark (.156), Japan (.51).
Both Italian and control group interest rates began declining in the mid-1990s. The Italian rate fell below the control group around 1996, well before the euro’s inception. This likely reflects an anticipation effect as the risk of Lira-DM exchange rate depreciation diminished. The estimated reduction in the Italian ten-year yield attributable to the euro, relative to the control group, is approximately 2%. Applying this to an average Italian interest rate of about 4.5 percentage points in the post-euro period translates to a reduction of only nine basis points per year (=4.5/0.98 -4.5) between 1999 and 2011.
However, this estimate is likely understated due to two factors. First, it encompasses the European debt crisis years (2008-2011), when the euro failed to shield countries like Italy from speculative pressures, and depreciation risk resurfaced in asset prices (Manasse and Zavalloni 2013). Second, contagion effects are again relevant. The control group includes countries like Denmark, Sweden, and Switzerland (plus the UK) that, by pegging to the euro, may have indirectly benefited from lower interest rates without formally adopting the currency. When we restrict the control group to non-European countries and exclude the post-2007 crisis years, the estimated interest rate saving becomes significantly larger, reaching 158 basis points per year. Applied to the average outstanding Italian government debt between 1999 and 2007, this translates to interest savings of €22.5 billion. While substantial, this figure remains considerably smaller than the often-exaggerated claims made by euro enthusiasts.
Labour Productivity
Examining labor productivity dynamics, measured as GDP per hour worked (base year 2005, OECD data), reveals a notable trend. Figure 4 shows that Italy’s labor productivity growth slowed down in the mid-1990s and stagnated after the euro’s introduction, while the synthetic control (including the UK, Turkey, Denmark, and Israel) continued to experience productivity growth.
Figure 4 Labour productivity
Several potential explanations exist for this productivity slowdown.
- Confounding Factors: Labor market reforms in the mid-1990s in Italy, promoting temporary employment, might have inadvertently reduced firms’ incentives to invest in human capital, subsequently hindering productivity growth.
- Sectoral Shifts: With the elimination of competitive devaluations under the euro, an increase in the relative price of non-tradable goods compared to tradable goods might have shifted resources from the more competitive and productive tradable sector to the less productive non-tradable sector.
However, the latter explanation appears inconsistent with our finding that Italian trade actually increased after euro adoption. WeLean towards the interpretation that the euro, while fostering trade integration and preventing competitive devaluations, eliminated an easy mechanism for Italy to enhance competitiveness, leaving structural reforms as the primary, but unaddressed, necessity. These explanations are not mutually exclusive and warrant further investigation.
Per-Capita GDP: Italy and Germany
Euro-skeptics sometimes portray the euro as a scheme designed by Northern European countries, particularly Germany, to exploit Southern European economies. But has Italy’s per capita GDP suffered relative to Germany’s since the euro’s introduction? Figure 5 compares Italy’s real per capita GDP to its synthetic control (a weighted combination of Sweden, Turkey, and the UK).
Figure 5 GDP Italy and Germany
The data indicates a slight negative impact of the euro on Italian per capita GDP, with a cumulative loss of 3.7 percentage points relative to the counterfactual between 1999 and 2011. Repeating the same analysis for Germany (whose synthetic control is primarily composed of Switzerland, Denmark, and Japan) reveals that German per capita GDP consistently lagged behind its counterfactual, resulting in a larger cumulative loss of 7.4 percentage points. Therefore, claims that Italy significantly benefited or suffered dramatically from the euro, or that Germany hugely profited at Italy’s expense, are not supported by our findings and appear to be largely myths.
Conclusion
In conclusion, our analysis reveals that many arguments surrounding the euro in political debates, on both sides, are either contradicted by the evidence or significantly overstated. For example, the euro demonstrably reduced inflation and stimulated trade, and it negatively impacted German per capita GDP more than Italy’s. While Italian interest rates did decline following euro adoption, the interest savings were not as substantial as often claimed. The true economic impact of the euro on Italy is nuanced and requires careful empirical analysis to disentangle from political rhetoric.
Authors’ note: This column is a revised version of a report for Link Tank, think tank of the Italian newspaper Linkiesta.it. The full report (in Italian) can be downloaded here: http://www.linkiesta.it/effetti-euro-italia.
References
Abadie, A., Diamond, A., & Hainmueller, J. (2010). Synthetic Control Methods for Comparative Case Studies: Estimating the Effect of California’s Tobacco Control Program. Journal of the American Statistical Association, 105(490).
Billmeier, S., & Nannicini, T. (2013). Assessing Economic Liberalization Episodes: A Synthetic Control Approach. Review of Economics and Statistics, 95(3).
Manasse, P. (2013). The roots of the Italian stagnation. VoxEU.org, 19 June.
Manasse, P., & Zavalloni, L. (2013). Sovereign Contagion in Europe: Evidence from the CDS Market. DSE Working Paper n 863.
Saia, A. (2013). Choosing the Open Sea: The Cost to the UK of Staying Out of the euro. mimeo, University of Bologna.
1. For more information on the methodology of synthetic controls, see Abadie et al. (2010). See also Billmeier and Nannicini (2013).
2. This part of this analysis is based on Saia (2013).
3. There is significant variation in bilateral flows: those with Austria and the Netherlands show the largest increases (49% and 47%, respectively). Trade between Italy and Germany and Italy and France grew substantially, by 38% and 37% respectively, as a result of the euro. Similarly, trade with Spain increased by 30%, while the effect for Italian-Portuguese trade is positive but smaller (17%).
