Italy Looms on the Eurozone’s Horizon

By Adriano Bosoni – Re-Blogged From Stratfor

The skies may not be clear, but these days Europe’s leaders are more relaxed than they were when the year began under foreboding clouds. Economic growth is gaining momentum and unemployment is slowly going down. More important, voters in France rejected candidates opposed to the European Union, and moderate forces will remain in power after September’s general elections in Germany. But while things are relatively calm in the eurozone’s two main economies, the next big challenge for the currency area will come from its third-largest member, Italy. The country has to hold general elections by May, and the vote will take place amid discontent with the status quo, which in many cases includes skepticism about the euro. Given the size of the Italian economy and the depth of its problems, the country’s politics could have consequences far beyond Italy’s borders.


Italy was one of the founding members of the eurozone in the late 1990s, and its decision to join the bloc was controversial both at home and abroad. Some observers argued that Italy was not prepared to enter the currency area, while others warned that abandoning the lira, which Italian governments would often devalue to regain competitiveness in times of crisis, could adversely affect the economy. More optimistic commentators said eurozone membership would force the Italian authorities to be more fiscally disciplined. In the end, Rome made the geopolitically driven decision to be among the currency area’s founders, in the same way it had been for the European Communities in the 1950s.

The years that followed the euro’s introduction were tough for Italy. In the 1990s, the country’s economy grew by an annual average of 1.6 percent, a rate similar to that of Germany and France. By the 2000s, Italy’s annual average growth was 0.4 percent. Growth is even more elusive these days, as the Italian economy is smaller now than it was at the start of the decade. In addition, unemployment remains stubbornly high (around 11 percent, compared with 9 percent for the eurozone), while Italian banks are dealing with high levels of nonperforming loans. Italy’s debt-to-GDP ratio is above 130 percent, the second-highest ratio in the eurozone after Greece. To make things worse, the Italian government is under constant pressure from the European Commission to reduce its deficit. Even if Rome and Brussels usually reach compromise solutions for their disputes, amid low economic growth Rome has little choice but to repeatedly cut spending to keep its deficit under control.

Against this backdrop, it should come as no surprise that many Italians are not particularly excited about the euro. According to a Eurobarometer survey, only 53 percent of Italians support the common currency, the second-lowest level of support after Cyprus. Italy’s economic decline is explained by multiple factors, including the country’s struggle to introduce structural reforms, the presence of strong vested interests, an intrinsically unstable political system, a large gray economy and an aging population. But at a time when many Italians have little hope that things will improve, blaming Italy’s economic decay on the euro (in addition to blaming inefficient leaders and pervasive corruption) is a narrative that resonates with many voters.

This explains why three of the four largest political parties in Italy — the anti-establishment Five Star Movement, the far-right Northern League and, to a lesser extent, the center-right Forza Italia — are critical of the European Union in general and of the eurozone in particular. The Euroskeptic camp is divided, however, and a government coalition that includes all of them is unlikely to form after the next elections. But in a way, they already have won. Under pressure from its rivals, the center-left Democratic Party, Italy’s main pro-Europe force, has become more critical of the European Union on issues such as immigration and deficit targets.

A Referendum to Leave the Euro?

Disliking the euro doesn’t necessarily mean wanting to abolish it. Many Italians who oppose the common currency are concerned about the financial and economic implications of getting rid of it. This contrast puts Italy’s Euroskeptic parties in a quandary. On one hand, criticism of the euro is an important part of their populist and nationalist agendas. On the other, they know that the prospect of leaving the eurozone scares away many voters. The Five Star Movement offers an example of this predicament: While members of the party often speak in favor of holding a referendum on Italy’s membership in the eurozone, they have not added the idea to their party’s electoral platform. Something similar happened to France’s National Front, which struggled to find a balance between attacking the euro and reassuring moderate voters that their savings were not in jeopardy. As a result, the party’s position on the euro was inconsistent and often contradictory.

There is another complication: The Italian Constitution does not allow binding referendums on international treaties. For Italy to leave the eurozone, it first would have to amend its constitution. Given Italy’s political fragmentation, it’s doubtful the government that assumes power after the coming elections could secure support in Parliament for a constitutional change. Consequently, some members of the Five Star Movement have spoken in favor of a nonbinding referendum to test the popularity of the common currency before planning their next steps.

Referendum or not, events simply spinning out of control could precipitate Italy’s exit from the eurozone. An electoral victory by Euroskeptic parties could lead to a run on Italian banks as savers fearful of an eventual return to the lira move their money outside the country. A Euroskeptic government could also introduce a parallel currency (an idea the Northern League, the Five Star Movement and Forza Italia have toyed with), demand a renegotiation of the country’s sovereign debt, or withdraw from the European Union’s fiscal treaties. These scenarios probably would put Italy on the brink of needing financial help from the rest of the European Union — help a Euroskeptic government could decide not to seek, preferring instead to let the entire system collapse.

Naturally, many things could happen before Italy reaches a point of no return. Internal and external pressures could cause a Euroskeptic government to give way to a more cooperative administration. This is what happened in 2011, when the center-right government led by former Prime Minister Silvio Berlusconi resigned and was replaced by a technocratic administration in charge of passing emergency measures. But social and political conditions in Italy have changed since 2011, and in a future crisis, the electorate may be more willing to jump into the void than it was at the start of the decade.

A Matter of Leverage

Italy’s actions cannot be understood without considering the size of its economy and, by extension, the scope of the damage it can do to its neighbors. An Italian exit from the eurozone would be painful for the country, to be sure, but it also would create the risk of contagion across the Continent, not least because of the billions of euros in Italian sovereign debt other banks in the eurozone hold. While the currency area could have survived a Greek exit two years ago, it may not survive an Italian one today.

The size of the Italian economy influences the country’s behavior in at least two ways. For one, it gives politicians reason to believe they have leverage when demanding concessions of their EU partners. For another, it allows Euroskeptic leaders to promise voters there is a brilliant future for the country outside the eurozone. Thus Italy is different from smaller economies such as Greece or Portugal, where leaders had little leverage when negotiating with their international lenders. Even during the height of their crises, most members of the Greek and Portuguese establishments (and a majority of the electorates in each country) thought leaving the eurozone would make their countries poorer and more isolated. In Italy, the promise to “make Italy great again” seems easier to sell to voters.

Finally, Italy’s situation will be an important factor in the upcoming talks on reforming the eurozone. After German elections in September, Europe’s governments and institutions will start discussing ways to make the currency area more resilient to future crises. France, Spain and other eurozone members already have issued proposals to address the fact that the eurozone is a monetary union without a fiscal union — its members share a common monetary policy set by the European Central Bank but have individual fiscal policies — and to increase economic convergence among member states, including greater transferences of resources from the bloc’s core to its periphery.

Questions of whose money will be spent, how and where are central to these negotiations. Most of the plans to boost spending throughout the European Union and introduce risk-sharing measures come from Southern Europe. Not surprisingly, the wealthiest economies in the north are wary of plans to spend their money somewhere else. Southern European countries often play the solidarity card, arguing that for the European Union to be a true “union,” risk and resources should be shared among its members. Northern European countries, meanwhile, play the moral hazard card, arguing that they will agree to compromise their wealth only if the southerners commit to fiscal responsibility.

The negotiations will expose the different views that Germany and France have about the future of the eurozone, but they also will raise the awkward question of what to do with Italy. Germany and France understand the need for a stable and prosperous Italy. Paris also sees Rome as an important partner when pushing for reforms that are in line with the interests of Mediterranean Europe. But each side wrestles with some degree of mistrust. Germany is concerned about Italy’s political instability and financial fragility, and Rome’s recent decision to bend EU rules to rescue a handful of ailing banks has done little to change Berlin’s perceptions about Italian leaders. Italy, in turn, is critical of Germany’s political pre-eminence in the European Union and is frustrated by France’s lack of cooperation in dealing with migrants reaching Italian shores.

Italy’s discomfort with the status quo in Europe should not be taken lightly. Facing meager economic growth and high unemployment, many Italians are dissatisfied with their present circumstances and worried about their future. Most of their anger is focused on domestic issues, but anti-euro sentiments are part of the mix. The accumulation of EU-related distress, whether with regard to austerity or immigration, will continue to create fertile ground for nationalism, populism and Euroskepticism in Italy, creating significant challenges for the European Union in the process.

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