Italian Risks to

the Eurozone

DESMOND LACHMAN AND RYAN NABIL

F E B R UARY 201 8
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Washington, DC 20036
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A M E R I C A N E N T E R P R I S E I N S T I T U T E
Executive Summary
I taly, the eurozone’s third-largest economy, is due
to hold parliamentary elections on March 4, 2018.
The importance of those elections for both Italy and
the eurozone cannot be overstated. Italy is simply too
large an economy to fail for the euro to survive. How-
ever, it is also too large an economy for the eurozone
to save.
At the heart of Italy’s economic vulnerability is its
seeming inability to generate meaningful economic
growth or to improve its labor market productivity in
a euro straitjacket. Over the past decade, the lack of
economic growth has contributed to a continued rise
in the Italian public debt-to-GDP ratio to a dangerous
level. It also has prevented the country from materi-
ally improving the state of its shaky banking system.
1
Being locked in the euro, Italy’s lackluster productiv-
ity performance has resulted in a large loss in interna-
tional competitiveness.
The forthcoming elections seem unlikely to pro-
duce a coherent and reform-minded Italian govern-
ment that might decisively address the country’s
economic vulnerabilities. To date, markets have
turned a blind eye to these vulnerabilities in a favor-
able global economic environment of ample global
liquidity. However, it remains to be seen how forgiv-
ing markets will be when the external environment
takes a turn for the worse and when the European
Central Bank discontinues its large government bond-
buying program.
Italian Risks to the Eurozone
Desmond Lachman and Ryan Nabil
I taly, the eurozone’s third-largest economy, is due
to hold parliamentary elections on March 4, 2018.1
The importance of those elections for both Italy and
the eurozone cannot be overstated. Italy is simply
too large an economy to fail and for the euro to sur-
vive. Yet it is also too large an economy for the euro-
zone to save. For this reason, one has to hope that the
forthcoming elections produce an Italian government
much more committed to implementing far-reaching
economic reforms than previous Italian governments
have been.
At the heart of Italy’s economic vulnerability is its
seeming inability to generate meaningful economic
growth. This lack of economic growth has contrib-
uted to a continued rise in the Italian public debt-to-
GDP ratio to a dangerous level, and it has prevented
the government from materially improving the state
of its shaky banking system. While markets might
have turned a blind eye to these vulnerabilities in a
favorable global economic environment of ample cen-
tral bank liquidity, it remains to be seen how forgiv-
ing markets will be when the external environment
takes a turn for the worse and the European Central
Bank (ECB) discontinues its large government-bond-
buying program.
The Euro Was a Big Mistake for Italy
Judging by Italy’s poor economic performance since
2000, adopting the euro as its currency in 1999 was a
big mistake. Whereas German income per capita has
increased by around 20 percent since 2000, Italy’s has
actually declined by 5 percent (Figure 1). While Ger-
man unemployment has now been reduced to around
2
5.5 percent, Italy’s has been stuck at more than
11 percent.2 Worse yet, Italian youth unemployment
remains close to 20 percent.
The euro has hobbled the Italian economy by pre-
cluding the country from resorting to exchange rate
depreciation to either restore international com-
petitiveness or boost its economy by lower interest
rates when needed. This constraint has been par-
ticularly important in the aftermath of the 2008–09
financial crisis when Italy’s public finances were seri-
ously eroded by a deep economic slump. The need
to undertake severe budget belt-tightening in a euro
straitjacket contributed importantly to the country’s
triple-dip economic recession and to today’s Italian
economy remaining around 5 percent smaller than its
pre-2008 crisis peak.3
Looking ahead, continued euro membership will
likely constrain Italy to many more years of poor eco-
nomic performance for a simple reason. Italy, which
has consistently been a poor productivity performer,
has tied itself in a monetary union to an economic
powerhouse such as Germany, which has consistently
improved its labor productivity performance. This
disparity in productivity performance has resulted in
Italy losing around 20 percent in labor market com-
petitiveness to Germany (Figure 2).4 Unless Italy
were to undertake fundamental economic reforms to
boost its productivity performance, it will likely con-
tinue to lose competitiveness to its northern Euro-
pean economic partners.
While joining the euro seems to have been a sin-
gularly bad idea for Italy and seems to have clouded
its economic outlook, leaving the euro at this stage
does not seem to be a viable alternative for the coun-
try. Introducing a parallel currency, as former Prime
ITALIAN RISKS TO THE EUROZONE DESMOND LACHMAN AND RYAN NABIL

Figure 1. Divergent Trends in Economic Growth (GDP per Capita, Constant USD)

1.25
Germany
United States
1.20
United Kingdom

1.15
France

Spain
1.10

1.05

1.00
Italy

0.95

0.90
Q2
Q3
Q4

Q2
Q3
Q4

Q2
Q3
Q4

Q2
Q3
Q4

Q2
Q3
Q4

Q2
Q3
Q4

Q2
Q3
Q4

Q2
Q3
Q4

Q2
Q3
Q4

Q2
Q3
Q4

Q2
Q3
Q4

Q2
Q3
Q4

Q2
Q1

Q1

Q1

Q1

Q1

Q1

Q1

Q1

Q1

Q1

Q1

Q1

Q1
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Source: Organisation for Economic Co-operation and Development, “Quarterly Growth Rates of Real GDP, Change over Previous Quar-
ter,” https://stats.oecd.org/index.aspx?queryid=350#.

160%
Figure 2. Italy’s Increasing Uncompetitiveness (Quarterly Unit Labor Costs)

150% United Kingdom

Italy
140%

France
130%
Spain
United States
120% Germany

110 %

100%

90%
Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Source: Organisation for Economic Co-operation and Development, “Unit Labour Costs,” https://data.oecd.org/lprdty/unit-labour-
costs.htm.

3
ITALIAN RISKS TO THE EUROZONE DESMOND LACHMAN AND RYAN NABIL

Figure53. Net Government Interest Costs (Net Debt Interest Payments, % of GDP)

2
Percentage of GDP

–1

–2

–3

Un wit e n
ly
Hu ce

Po y
er e

l
Es k

Eu te s
C m

Ze d s

lO a
Au a

ia
G y

m a
ep a

Ice ry

an

Re a l
d

Ki and
d
Be ia

N d
he g

S w in
d

d
nia
De lic

Sl lic

D
it e om
ae

e
xe ore
ar

c
d
ali

an

n
It a
lan

lan

lan

n
a

et ur
iu

en
s tr

EC
ak ug

a
w

ar
e
an

S ed
Jap

ew lan
ub

b
a

Is r
ng

a
la
ala
nm

to

Sp
s tr

lg

N bo

Un n gd
m

re

pu

l
or
e c an

St
ov

it e ze r
Ire
Fin

ov P ort

ro
Fr

r
Au

d
G

ta
hR

To
d
Lu

N
Cz

Sl

Source: Organisation for Economic Co-operation and Development, “Economic Outlook Annex Tables,” http://www.oecd.org/
economy/outlook/economic-outlook-annex-tables.htm.

Minister Silvio Berlusconi has proposed in the past,5
would almost certainly raise the government’s bor-
rowing costs, which already rank among the highest
in Europe (Figure 3). A further increase in borrowing
costs would certainly encourage deposits to leave Ita-
ly’s shaky banks. That in turn could very well trigger
an Italian government debt default, which would have
major consequences not only for the Italian bank-
ing system but also for the eurozone as a whole. This
would seem to leave the country with little alternative
but to undertake major economic reforms to substan-
tially improve its productivity performance, which is
a necessary condition to get the euro to work for Italy.
Two Major Economic Vulnerabilities
Against the backdrop of the country’s poor economic
growth performance, the Italian economy remains
vulnerable to a change in the global economic envi-
ronment for two basic reasons. The first is that Italy
has made practically no progress in reducing its pub-
lic debt mountain. The second is that it has failed to
improve the parlous state of its banking system.
As an indication of Italy’s public debt problem,
the country’s public debt amounted to more than
€2.2 trillion in 2016 ($2.7 trillion), making it the
world’s third-largest government bond market.6
Meanwhile, Italy’s public debt-to-GDP ratio has
risen to 134.7 percent,7 which is the eurozone’s
second-highest such ratio after Greece (Figure
4). That the average maturity of this debt is only
around seven years heightens Italy’s vulnerability
to a change in global financial market conditions.8
This means that higher market interest rates would
feed through relatively quickly to the country’s pub-
lic finances. It also means that the country’s annual
gross government borrowing needs—at more than

4
ITALIAN RISKS TO THE EUROZONE DESMOND LACHMAN AND RYAN NABIL

15 percent of GDP—are high, which exposes it to any Political Headwinds

drying up in global liquidity.
The poor state of the Italian banking system’s bal-
ance sheet substantially constrains Italy’s economic
growth. Because of many years in economic reces-
sion, the banking system’s nonperforming loans
have risen to around 17 percent of its balance sheet.9
At the same time, pressured by the government,
the Italian banks’ holdings of Italian government
bonds have now risen to around €380 billion ($464
billion).10 This exposes the banks to any mishap in
Italy’s public finances. It also leaves them with little
room to increase credit to the private sector, which
would seem to be a necessary condition for Italy to
stimulate the sort of economic growth that might
allow the banks to grow their way out of their non-
performing loan problem.
Most economists would agree that Italy needs faster
economic growth if it is to resolve its public debt and
banking-sector problems in an orderly manner. They
would also agree that faster economic growth will
only be achieved if the country were to have a strong
government deeply committed to economic reform,
especially of Italy’s highly rigid labor market. There
also seem to be little disagreement that the last thing
that the country now needs would be a government
whose commitment to both the euro and the Euro-
pean Union seemed to be tenuous.
Sadly, the prospects appear poor that following the
March 2018 parliamentary elections Italy will receive
a strong and reform-minded government. Indeed, the
latest electoral polls suggest that support for the ruling

Figure 4. Italian Government Debt to GDP

160

140

120
Percentage

100

80

60

40

20
1861
1866
1871
1876
1881
1886
1891
1896
1901
1906
1911
1916
1921
1926
1931
1936
1941
1946
1951
1956
1961
1966
1971
1976
1981
1986
1991
1996
2001
2006
2011
2016

Source: Francese Maura and Angelo Pace, “Il debito pubblico italiano dall’Unità a oggi. Una ricostruzione della serie storica,”
Banca d’Italia, 2008; and Eurostat, “Government Finance Statistics (EDP and ESA 2010),” http://ec.europa.eu/eurostat/web/
government-finance-statistics/data/main-tables.

5
ITALIAN RISKS TO THE EUROZONE
Figure 5. Opinion Polls Show the Five Star Movement Is the Leading Party
50
45
40
35
30
25
20
15
10
0
April 8
Five Star Movement
Forza Italia
Free and Equal Party/Former Left-Leaning Coalitions
Source: Authors’ calculations.
Democratic Party, which is the country’s only main
pro-European political party, has slumped to under
25 percent of the vote. Meanwhile, the populist Five
Star Party, which is hardly known for its economic
reform or pro-European credentials, has now pulled
ahead of the Democratic Party in the polls (Figure 5
and Appendix A).11
The most likely political scenario is that the
March 2018 parliamentary election will produce a
weak Italian coalition government comprised of
strange bedfellows incapable of delivering the eco-
nomic reforms that the country so desperately
needs. A potential center-right coalition comprised
of Forza Italia, the Northern League, and Brothers of
Italy could achieve a parliamentary majority. How-
ever, one cannot exclude the possibility that the Five
Star Movement will find the way to form a coalition
government. If that were to occur, it is bound to
raise serious questions in the markets about Italy’s
6
DESMOND LACHMAN AND RYAN NABIL
April 14
Democratic Party
League
Brothers of Italy
commitment to economic reform and its continued
euro membership.
The commitment of the next Italian government to
the euro is likely to be more tenuous than was that of
the previous government. This is especially the case
considering that only 45 percent of Italians believe the
euro is a good thing for their country, comprising the
lowest rate of approval in any EU country (Figure 6).12
Berlusconi’s Forza Italia keeps talking about the need
for a parallel currency, while the Northern League is
even more robust in its opposition to the euro. For its
part, the Five Star Movement has recently toned down
its rhetoric on discontinuing Italy’s euro membership.
However, judging by its past performance, one cannot
exclude the Five Star Movement from switching back
to its anti-euro position following the election.
Beyond raising questions about Italy’s European
commitment, a new coalition government could cast
doubts on the country’s commitment to budgetary
ITALIAN RISKS TO THE EUROZONE DESMOND LACHMAN AND RYAN NABIL

Figure 6. Italian Sentiment Toward the EU Slides

80

75

70

65

60
Percentage

55

50

45

40

35

30
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Source: European Commission, “Public Opinion,” http://ec.europa.eu/COMMFrontOffice/publicopinion/index.cfm/Survey/

getSurveyDetail/instruments/FLASH/surveyKy/1092.

discipline. Particularly disturbing is the fact that the
Northern League, Brothers of Italy, and the Free and
Equal Alliance all want to introduce a more generous
pension system for Italians. Meanwhile Forza Italia
and the Five Star Movement want to introduce uni-
versal income support for the poor. At a time when
Italy’s debt-to-GDP ratio is the second highest in
the eurozone, the last thing Italy needs is a further
increase in its budget deficit and public debt.
These economic policies, along with uncertainties
about Italy’s future commitment to the euro, could
very well raise investors’ doubts as to the country’s
ability to stay the course. This would be particularly
the case should global liquidity conditions tighten as
the world’s major central banks move to normalize
their monetary policies. To date, Italy has benefited
importantly from the ECB’s bond-buying program
and from low European interest rates. However, the
ECB has already halved the monthly rate of its bond
purchases and intimated that it might end such bond
buying by September 2018.
Italy Is Not Greece
A struggling Italian economy could threaten the
euro because of its size. With Italy being around
10 times the size of the Greek economy and having
the eurozone’s third-largest economy, it is difficult to
imagine that the euro could survive in anything like
its present form if for any reason Italy were forced out
of the euro.13
Similarly, since Italy’s economy is significantly
larger than that of Greece, it is difficult to imagine
that Europe could come up with a sufficiently large
bailout package to keep Italy in the euro were it to
come under sustained speculative attack or experi-
ence a real bank run. This would particularly seem to

7
ITALIAN RISKS TO THE EUROZONE DESMOND LACHMAN AND RYAN NABIL

be the case considering German Chancellor Angela About the Authors

Merkel’s weakened position following her setback in
the September 2017 German parliamentary elections. Desmond Lachman is a resident fellow at AEI, where
Italy’s crashing out of the euro is certainly not pre- he focuses on the global macroeconomy, global cur-
ordained. However, absent real economic reform that rency issues, and the multilateral lending agencies.
might put the country on a faster economic growth Ryan Nabil is a financial services and global mac-
path, there is an appreciable risk that in time this roeconomy researcher with AEI’s Economic Policy
could happen. For this reason, one must hope for Studies department.
both Italy’s and Europe’s sakes that the forthcoming
Italian parliamentary elections produce a united gov-
ernment committed to serious economic reform and
making the euro work for the country.

© 2018 by the American Enterprise Institute. All rights reserved.

The American Enterprise Institute (AEI) is a nonpartisan, nonprofit, 501(c)(3) educational organization and
does not take institutional positions on any issues. The views expressed here are those of the author(s).

8
ITALIAN RISKS TO THE EUROZONE
Appendix A
Table A1. Italy’s Political Parties and Their Economic Agendas
PARTY
Democratic Party
• It leans center-left and is social democratic and pro-EU.
• It was founded in 2007 and has been in power since 2013.
• Paolo Gentiloni is the current head and nominee for 2018
election; the former prime minister and current Democratic
Party leader, Matteo Renzi, is also seeking reelection.
• It traditionally supports immigrant, but Renzi’s recent hawkish
rhetoric toward migrants has caused discontent in the party.
Five Star Movement
• It is populist, antiestablishment, and pro-direct democracy.
• It was cofounded in 2009 by comedian Beppe Grillo and is
now the main opposition party.
• “Five Star” refers to five key issues: public water, sustainable
transport, sustainable development, right-to-internet access,
and environmentalism.
• It is bipartisan—left-leaning voters support the Five Star
Movement for being pro-environment, anti-austerity, and
anti-capitalist. Right-leaning voters support the Five Star
Movement for being euroskeptic and anti-immigration.
• It previously sought reforms to euro and an end to fiscal
compact, but Luigi Di Maio, the party’s current leader, has
softened the party’s stance on Europe and euro membership.
Forza Italia (FI)
• It is center-right, liberal conservative, and pro-EU.
• It allied with traditional right-leaning parties—the Northern
League and Brothers of Italy—against the Democratic Party
and Five Star Movement.
• Former Prime Minister Silvio Berlusconi is back as the party’s
candidate for the election.
9
DESMOND LACHMAN AND RYAN NABIL
MAIN POLICY AGENDA
• Negotiate with the European Union to abolish the EU’s fiscal
compact, which requires Italy to run lower deficits and trim its
high debt levels.
• Raise the budget deficit above 3 percent of GDP to cut taxes
and increase investments.
• Continue Italy’s social and foreign policy, especially its current
membership of NATO.14
• Introduce universal income support to ensure a monthly
income of €780 ($953) for all Italians.
• Raise the budget deficit above 3 percent of GDP to cut taxes
and increase investments.
• Raise taxes on Italian banks and oil and gas companies.
• Renegotiate the Fiscal Compact.
• Repeal 2011 pension reform to allow earlier retirement and
2014 labor reform to make firing harder.
• Scrap unnecessary bureaucracy and design new
immigration policies.15
• Introduce a “parallel” Italian currency for domestic use while
using euro for international trade and tourism.
• Create a single rate flat income tax rate of 23 percent for
individuals and companies.
• Abolish housing tax, inheritance tax, and road tax on
most cars.
• Guarantee a minimum income of €1,000 per month ($1,222)
for all Italians.
• Block the arrival of new immigrants through treaties with
North African countries.16
ITALIAN RISKS TO THE EUROZONE DESMOND LACHMAN AND RYAN NABIL

Table A1. Italy’s Political Parties and Their Economic Agendas (Continued)

PARTY MAIN POLICY AGENDA

The Northern League (LN)
• LN was founded in the early 1990s as a separatist party, • Introduce parallel currency for domestic use while keeping
which campaigned for independence of Padania in the euro for international trade and tourism.
northern Italy. • Abolish Fiscal Compact and eventually leave the euro.
• It favors federalism and euroskepticism. • Introduce flat tax of 15 percent for individuals and companies.
• It is part of center-right coalition with Forza Italia and Brothers • Repeal 2011 pension reform to allow earlier retirement.
of Italy but has disagreed with Forza Italia on whether Italy • Crack down on illegal immigrations, send back migrant boats,
should leave the euro. and repatriate up to 100,000 immigrants per year.17
• It organized two autonomy referendums in Lombardy and
Veneto in 2017.
• It campaigned in the past for a referendum on EU
membership.
• It changed the party’s name from the Northern League to
the League to reflect its national—rather than regional and
separatist—ambitions.

Free and Equal

• The Senate president launched the alliance of left-wing
political parties and defectors from the Democratic Party in
December 2017.
• The founding parties of the alliance are associated with dem-
ocratic socialism and social democracy. However, they have
framed themselves as “the left” to avoid internal divisions.
• Repeal 2014 labor reforms to make firing harder.
• Soften 2011 pension reform to stop automatic increases in
retirement age.
• Increase spending on education, health care,
and infrastructure.
• Introduce free university education.18

Brothers of Italy
• It originated in 2012 to oppose Mario Monti’s technocratic • Renegotiate all EU treaties including the fiscal compact
government. and eurozone.
• The founding members belonged to the National Alliance, the • Increase support for Italy’s law enforcement and
successor to Italy’s neofascist parties.19 armed forces.
• It favors nationalism, national conservatism, and • Reduce taxes and bureaucracy.
euroskepticism. • Enforce immigration laws and tougher penalties for
• It is in a center-right coalition with Forza Italia and Northern violent crime.20
League. Its policies are similar to the Northern League, but
with support based in Central and Southern Italy.

Source: Authors.

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ITALIAN RISKS TO THE EUROZONE DESMOND LACHMAN AND RYAN NABIL

Notes
1. John Follain and Chiara Albanese, “Italy’s President Dissolves Parliament, Triggering Elections,” Bloomberg, December 28, 2017,
https://www.bloomberg.com/news/articles/2017-12-28/italy-s-president-dissolves-parliament-triggering-elections.
2. Organisation for Economic Co-operation and Development, “Selected Indicators for Italy,” https://data.oecd.org/italy.htm.
3. Organisation for Economic Co-operation and Development, “Quarterly Growth Rates of Real GDP, Change over Previous Quar-
ter,” https://stats.oecd.org/index.aspx?queryid=350#.
4. Organisation for Economic Co-operation and Development, “Unit Labour Costs,” https://data.oecd.org/lprdty/unit-labour-
costs.htm.
5. Reuters Staff, “EU Shoots Down Berlusconi Parallel Currency Proposal,” August 23, 2017, https://www.reuters.com/article/us-
italy-currency-berlusconi-commission/eu-shoots-down-berlusconi-parallel-currency-proposal-idUSKCN1B32BP.
6. Eurostat, “Government Debt Up to 89.5% of GDP in Euro Area,” July 20, 2017, http://ec.europa.eu/eurostat/documents/2995521/
8118661/2-20072017-AP-EN.pdf/83147478-c193-40e9-8a0a-b76e56a5cebc.
7. Eurostat, “General Government Gross Debt—Quarterly Data,” http://ec.europa.eu/eurostat/tgm/table.do?tab=table&init=1&
language=en&pcode=teina230&plugin=1.
8. European Central Bank, “The Size and Composition of Government Borrowing in the Euro Area,” May 2010, https://www.ecb.
europa.eu/pub/pdf/other/mb201005_focus04.en.pdf?a09af0170bd1d12f1eb8ba4c8a9baa6e.
9. World Bank, “Bank Nonperforming Loans to Total Gross Loans,” https://data.worldbank.org/indicator/FB.AST.NPER.ZS?end=2016
&start=2005&view=chart.
10. European Central Bank, “Balance Sheet Items,” http://sdw.ecb.europa.eu/browseExplanation.do?node=qview&SERIES_KEY=117.
BSI.M.IT.N.A.A30.A.1.U2.2100.Z01.E.
11. Francesco Anania and Emanuele Vena, “Electoral Political Polls,” Termometro Politico, https://www.termometropolitico.it/
sondaggi-politici-elettorali.
12.
European Commission, “Public Opinion,” http://ec.europa.eu/COMMFrontOffice/publicopinion/index.cfm/Survey/
getSurveyDetail/instruments/FLASH/surveyKy/1092.
13. World Bank, “GDP (Current US$),” https://data.worldbank.org/indicator/NY.GDP.MKTP.CD.
14. Reuters Staff, “Factbox: Italy’s Election—Parties, Leader and Programs,” Reuters, December 28, 2017, https://www.reuters.com/
article/us-italy-election-parties-programmes-fac/factbox-italys-election-parties-leaders-and-programs-idUSKBN1EM1HE.
15. Reuters Staff, “Factbox.”
16. Reuters Staff, “Factbox.”
17. Binnie, “Italy’s Norther League Pledges to Put Right ‘Error’ of Euro.”
18. Reuters Staff, “Factbox.”
19. Edwards, “An Introduction to Italy’s Small Political Parties.”
20. Fratelli d’Italia, “The FDI-AN Program for the European Elections 2014,” http://www.fratelli-italia.it/programma-europa/.

11