The introduction of the euro has been a contentious topic in Europe, and nowhere is this more evident than in Italy. Across Italy and the Eurozone, discussions about the single currency are often highly politicized. Empirical evidence is frequently selectively presented to support pre-existing viewpoints, creating a polarized debate.
On one side, proponents argue that the euro is essential to prevent economic instability in peripheral nations like Italy, acting as a bulwark against financial collapse. Conversely, critics blame the euro for a range of economic woes, including deindustrialization and persistent unemployment.
For economists, the crucial question remains: Has Italy, in balance, gained or lost from its adoption of the euro?
The Challenge of the Counterfactual
Determining the precise impact of the euro on Italy’s economy is inherently complex due to the challenge of establishing a credible counterfactual. In macroeconomic analysis, we often lack a clear picture of what would have transpired had a specific policy decision, such as euro adoption, not been made. As Antonio Fatas highlighted in “The Euro Counterfactual,” both euro enthusiasts and skeptics tend to cherry-pick examples – comparing countries with fixed exchange rates to those with floating rates – to bolster their respective arguments.
For instance, euro proponents might point to Ireland’s successful economic stabilization within the Eurozone compared to Thailand’s currency devaluation crisis. Euro-skeptics, conversely, may highlight Spain’s rising unemployment within the Eurozone against the backdrop of the UK’s relatively mild recession outside of it.
To mitigate such biases, a more rigorous approach is needed. This analysis employs a statistical method known as the ‘synthetic control’ to allow data to speak more objectively, minimizing the influence of subjective opinions.
The synthetic control method begins by identifying a group of countries that did not adopt the euro and whose economies, before the euro’s introduction, mirrored Italy’s economic performance. By creating a weighted combination of these ‘control’ countries, we construct a ‘synthetic Italy’ that represents how the Italian economy might have behaved without euro adoption.
This synthetic control then serves as a benchmark to assess the actual performance of Italy’s economy after joining the euro. For any given economic indicator, such as inflation, the algorithm calculates a weighted average of inflation rates from the non-euro countries, using weights designed to closely match Italy’s inflation rate before euro adoption. The difference between Italy’s actual inflation rate and the synthetic control’s rate post-euro provides an estimate of the euro’s impact.
This analysis considers January 1, 1999, when exchange rates were fixed, as the starting point, and also examines January 1, 2002, the date of physical euro circulation, to ensure the robustness of the findings. The control group includes EU member states that retained their national currencies (Bulgaria, Croatia, Denmark, Lithuania, Poland, UK, Czech Republic, Romania, Sweden, and Hungary) and non-European OECD members (Australia, Canada, Chile, South Korea, Japan, Switzerland, Iceland, Israel, Mexico, New Zealand, US, and Turkey). Eurozone countries and subsequent entrants are excluded from the control group.
It’s important to acknowledge potential limitations of this method:
- Contagion Effects: The euro’s influence might extend beyond member countries, affecting the control group economies.
- Confounding Effects: Simultaneous events unrelated to the euro could impact Italy and the control group differently, leading to misattribution of effects.
- Small Sample Size: The limited number of countries and time period requires cautious interpretation.
- Time Decay: The further we move from the euro’s introduction, the less reliable the synthetic control becomes due to increasing external shocks.
- Anticipation Effects: The euro’s impact might begin even before its official launch, for example, through reduced government bond yields anticipating the elimination of exchange rate risk.
Despite these caveats, the synthetic control method offers a more systematic and less biased approach compared to selective comparisons often seen in political discussions. This analysis applies this method to five key economic variables central to the euro debate: international trade, inflation, long-term government bond yields, labor productivity, and real per-capita GDP. In the following figures, the solid line represents Italy’s actual data, and the dotted line represents the synthetic control simulation.
Impact on International Trade: Italy Euro and Trade Flows
A primary goal of the euro was to stimulate trade integration by lowering transaction costs and removing exchange rate risks. We first examine the euro’s effect on Italy’s trade flows, specifically bilateral trade (exports and imports) between Italy and other nations. Figure 1 illustrates key trade flows.
Figure 1 Bilateral trade flows
As shown, trade flows between Italy and other European countries generally increased relative to the synthetic control, with the notable exception of trade with the UK.
The estimated increase in trade between Italy and its Eurozone partners, attributed to the euro, is substantial, around +38% compared to the control group. Importantly, this “trade creation” effect was not offset by a “trade diversion” effect that would have reduced trade with non-euro members. Total exports and imports as a percentage of GDP both increased relative to the synthetic control. On average, post-euro adoption, Italian exports exceeded the synthetic control by 0.5% annually, while imports exceeded it by 2%. The larger increase in imports compared to exports might reflect a decline in Italian competitiveness, as argued by Manasse (2013), where persistent high unit costs in Italian firms could no longer be mitigated by currency devaluation. Overall, euro adoption led to an increase in Italy’s trade, fulfilling one of the single currency’s intended objectives.
Inflation Control: Italy Euro and Price Stability
A key motivation for Italy joining the euro was to achieve greater control over inflation. Past experiences with monetary sovereignty had resulted in prolonged periods of double-digit inflation. However, public perception often holds that the euro’s introduction caused a significant price level jump. 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 spike following the euro’s introduction in 1999. Instead, the euro appears to have contributed to a temporary reduction in Italy’s inflation compared to its synthetic control. Between 1999 and 2009, the cumulative inflation reduction attributable to the euro is estimated at 3% (0.3% annually), with a significant portion of this effect occurring during the period of fixed exchange rates preceding the euro’s physical launch. Furthermore, inflation volatility (not shown) also decreased considerably after euro adoption.
However, these estimates might be influenced by contagion effects. If control group countries like Denmark and Sweden, who pegged their currencies to the euro, also benefited from lower inflation due to reduced import prices linked to the euro, the initial calculation could underestimate the euro’s true impact on Italian inflation. Repeating the analysis using only non-European countries in the control group shows that the cumulative inflation reduction attributed to the euro nearly doubles, rising to 0.7% per year between 1999 and 2009. Contrary to euro-skeptic claims, the euro demonstrably curbed inflation in Italy.
Government Bond Yields: Italy Euro and Interest Rates
Euro proponents frequently assert that the euro significantly lowered Italian government borrowing costs. This analysis examines the yield on ten-year government bonds (similar results were found for three-year bills and alternative interest rate measures in the original Italian report). Figure 3 compares Italian ten-year government bond yields with its synthetic control, which includes both European and non-European countries. Interest rates are normalized to 1 at the start to improve the pre-euro fit of the control.
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, potentially reflecting an anticipation effect as the risk of Lira-DM exchange rate depreciation diminished ahead of euro adoption. The reduction in the Italian ten-year yield attributable to the euro, relative to the control group, is estimated at a modest 2%. Applying this to an average Italian interest rate of approximately 4.5 percentage points post-euro yields an annual reduction of only about nine basis points (=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 risks resurfaced (Manasse and Zavalloni 2013). Second, contagion effects are again relevant. The control group includes countries like Denmark, Sweden, and Switzerland (along with the UK), which, by pegging to the euro, may have indirectly benefited from lower interest rates without formal euro adoption. Restricting the control group to non-European countries and excluding the post-2007 crisis period significantly increases the estimated interest rate savings to 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 – a considerable sum, though less dramatic than often claimed by euro enthusiasts.
Labor Productivity: Italy Euro and Economic Efficiency
Examining labor productivity, measured as GDP per hour worked (2005 base year, OECD data), reveals interesting trends. Figure 4 shows that Italy’s labor productivity growth slowed in the mid-1990s and stagnated after the euro’s introduction, while the synthetic control (including 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, which encouraged temporary employment, might have subsequently discouraged firms from investing in human capital, hindering productivity growth.
- Sectoral Shifts: The elimination of competitive devaluations with the euro might have increased the relative price of non-tradable goods compared to tradable goods. This could have shifted resources from the more productive tradable sector to the less productive non-tradable sector.
However, the latter explanation is somewhat inconsistent with the finding that Italian trade increased after euro adoption. A more plausible interpretation is that the euro, while promoting trade integration and eliminating devaluation as a tool for competitiveness, made structural reforms essential for Italy to enhance its competitiveness – reforms that were not adequately implemented. These explanations are not mutually exclusive and warrant further investigation.
Per-Capita GDP: Italy Euro and Comparative Growth with Germany
Euro-skeptics often portray the euro as a system designed by Northern European countries, particularly Germany, to exploit Southern European economies. But has Italy’s per capita GDP actually suffered relative to Germany’s with the euro? Figure 5 compares Italy’s real per capita GDP to its synthetic control (a combination of Sweden, Turkey, and the UK).
Figure 5 GDP Italy and Germany
The data suggests a small negative impact of the euro on Italian per capita GDP, with a cumulative loss of 3.7 percentage points compared to the counterfactual between 1999 and 2011. Repeating the analysis for Germany (whose synthetic control is primarily composed of Switzerland, Denmark, and Japan) reveals that German per capita GDP consistently underperformed its counterfactual, with a larger cumulative loss of 7.4 percentage points. Therefore, claims that Italy overwhelmingly benefited or was severely harmed by the euro, or that Germany significantly gained at Italy’s expense, are not supported by this evidence and appear to be largely unfounded myths.
Conclusion: Italy Euro – Evidence-Based Assessment
In conclusion, this analysis demonstrates that many arguments in the political debate surrounding the euro, on both sides, are either contradicted by the evidence or significantly exaggerated. The euro has, in fact, reduced inflation and fostered trade for Italy. Furthermore, German per capita GDP has been negatively impacted by the euro to a greater extent than Italy’s. While Italian interest rates did decrease after euro adoption, the resulting interest savings were not as substantial as often claimed.
This evidence-based assessment underscores the complex and nuanced reality of the euro’s impact on Italy, moving beyond simplistic narratives of either resounding success or catastrophic failure.
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
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Billmeier, B., & 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.
