Italy Versus Germany: The Real Story

In both Germany and Italy, the debate about the causes of the widening gap between the Eurozone’s economies No. 1 and No. 3 often goes astray. It reflects prejudices rather than sober analysis.

North of the Alps, some observers fret about deeply ingrained differences between Northern and “Latin” European economies. Because these economies are incompatible, inevitable tensions could eventually tear the Eurozone asunder, it is said.

Meanwhile, in Italy, the populists that are set to form a government tend to denounce the Eurozone’s fiscal rules as instruments of an alleged German hegemony and blame them for their own country’s malaise.

Both of these views are wrong

Germany is not inherently more dynamic than Italy. From 1991 to 2006, the GDP in both countries moved almost exactly in parallel (see chart). While Germany had to cope with the costs of reunification, Italy had to fix its budget to qualify for the euro as well as deal with the rapid rise of China which hit Europe’s traditional producers of mass-market goods more than other countries.

Note in particular that the advent of the euro in 1999 did not mark a break in trend for either of these countries. If anything, Italy even outperformed Germany modestly in the first half of the 2000s as it reaped the windfall from lower financing costs.

Pro-growth reforms make all the difference

Germany started to outperform Italy – and most other economies in Europe – after the structural reforms of 2004 took effect. Thanks to a serious labour market reform and other changes, Germany’s employment ratio has surged since 2005 after stagnating for the 13 years before.

Rising employment cured Germany’s past fiscal woes. If Italy wants to get on its feet, it needs to advance such changes instead of possibly reversing some reforms. Neither a fiscal boost, a devaluation nor any other demand-side gimmick can cure supply-side malaise.

Ahead: A fundamental challenge

The plans of Italy’s radical would-be government raise serious concerns for Europe. 5Stars and Lega apparently intend to breach the fiscal rules and directly challenge the European Central Bank through a local de facto legal tender (“mini-BOTs”).

The Greek crisis was about contagion control and the conditions Greece had to meet for support. In the case of Italy, which is in a far more comfortable financial starting position than Greece was in 2010-2015, the radicals are going further and question the political will to stay in the euro.

The big question: Noise or serious crisis?

The Italian situation could evolve in two different ways. Hemmed in by Italy’s constitution and their own precarious majority in parliament, the radicals may water down their plans to such an extent that the inevitable noisy confrontation with Brussels does not get out of hand yet despite major long-term risks.

Or the radicals may set off a chain reaction with rising yields and credit rating downgrades that pushes Italy into a major crisis, forcing the country to relent (as Greece did in 2015) or descend into chaos.
That risk needs to be watched closely.