A week ago, we seemed to be on the verge of a second euro crisis with a populist mood threatening to sweep Italy out of the single currency. By the end of the week a coalition government was in place, the markets had cheered up and the newspapers were worrying about other things.

The market’s twin fears - of a Eurosceptic, Paolo Savona, being appointed as finance minister and of an early election which might have ended up as a referendum on the euro – have been averted. An Italian exit from the euro, a “Quitaly”, looks much less likely now than it did a week ago.

The scare has passed, but the underlying causes of last week’s turmoil remain, and with it the potential for further euro crises. Last week’s events highlight the problems of running a single currency across diverse, sovereign nations.

They include some of the richest and poorest countries in the developed world. GDP per head in Denmark for instance is three times higher than in Greece while Denmark’s unemployment rate is one sixth of Greek levels.

Such differences means that a single interest rate and exchange rate will not be right for all member states all the time. So, in early 2011 the Greek economy was a staggering 10% smaller than a year earlier while, German economy was booming with an annual growth of over 5.0%. The policy needs of the Greek and German economies were completely different. Instead they had the same interest rate and exchange rate and, in theory, the same rules for controlling government borrowing.

The Greek crisis showed how sustained economic weakness in one member state fuels tensions with the euro area and its dominant member state, Germany. These tensions were on display last week, with the European Commission president, Jean Claude Juncker, reproaching Italy, saying it needed “more work, less corruption, seriousness…don’t play this game of loading with responsibility [on] the EU”.

Last week’s crisis abated with two radical, populist parties, the Northern League from the right and the Five Star Movement from the left, forming an improbable coalition. Some Italian politicians play up their reservations or outright hostility to the euro, but it is hard to detect serious appetite among the Italian public for leaving the euro. The real point of difference with the European Central Bank (ECB) and Germany is that many Italian politicians want to be able to borrow and spend more and believe the ECB should to do more to support troubled banks.

Germany fears that it would foot the bill for such policies, exposing Germany to instability, higher borrowing costs and the risk of having to bail out other governments. For German policymakers the solution to Italy’s problems lie in economic reform and improved competitiveness – matters which are squarely in the hands of the Italian government.

Germany wants Italy to sort itself out. Italy’s populist parties seem to want looser rules for borrowing and for Germany to assume a bigger role in ‘risk sharing’ (which means Germany being more exposed to risk in other member states).

This is the big divide within the euro area, one rooted in the hopes that attended the birth of the single currency and the experiences of different member states since 1999.

The architects of the euro saw it lowering barriers to trade, speeding integration and raising Europe’s growth rate. By handing control of interest rates and the exchange rate to the ECB, national governments would no longer be able to resort to devaluation and inflation to boost competitiveness. They would have to get to grips with the inefficiencies and failings of their own economies.

Germany embraced reform, most notably with a sweeping set of controversial changes to labour market regulations in the early 2000s. Successive German governments have kept a tight rein on public spending and debt. In Italy, economic reform has been more modest and public borrowing has soared.

The period of euro area membership has been a good one for Germany, less so for Italy.

Since the inception of the single currency in 1999 German’s economy has expanded by 30%, Italy’s by 8%. 

Successful labour market reforms have helped Germany to move from 14th to 5th position in the World Economic Forum’s Global Competitiveness League table. Italy’s ranking has fallen from 39th to 43rd place.

German unemployment has more than halved, to just 3.6%, since 1999 while Italy’s remains at 10.9%, the rate at which Italy entered the single currency. Despite a marked acceleration in euro area growth, youth unemployment in Italy stands at 32%.

Government debt account for 60% of Germany’s GDP, a figure unchanged since 1999. Italy’s has risen sharply to 130% of GDP, the third highest, after Japan and Greece, amongst 34 OECD economies. 

Italy today has the lowest growth potential of any major EU economy. A surge in debt-funded government spending, as the new coalition wants, would boost activity, but it’s hard to see it improving long term growth prospects and it would play very badly with nervous bond investors.

The German and Italian positions are very different, as are their experiences in the euro. So what happens next? 

If Italy’s new coalition enacted its earlier commitments in full public spending and debt will surge. Italy is already running a debt to GDP ratio of 130%, way above the 60% ceiling set by the euro area rulebook. This rule has been so frequently broken, at least 165 times since 1999 by several countries, that it has lost much of its bite. If Italian debt levels shoot up, pressure from financial markets, rather than enforcement action from the EU and the ECB, are likely to act as the real discipline. 

Germany and Italy want Italy to stay in the single currency. But they have different views about how the euro area should be run. The German response to President Macron’s proposals for greater integration and risk sharing in the euro area, so far, has been cautious. Without a more cohesive euro area there will be more ups and downs of the kind we saw last week over Italy.


PS: Last Friday, the US levied tariffs on imports of steel and aluminium from the EU, Mexico and Canada with all three announcing they will retaliate. Professor Greg Autry, a strong supporter of Donald Trump, pointed out that China sets the global price of steel, producing over half of the world’s output. As steel is bought at a global spot price regardless of its origin, any US action on China involves insulating its domestic steel industry from the global market, which also makes Europe, Britain and other US allies inadvertent victims of the tariffs. Separately, the Trump administration announced more measures targeted at China, most notably 25% tariffs on $50bn worth of Chinese exports.  

The FTSE 100 ended the week down 0.5% at 7,702.