Hamish McRae: Why Italy needs to vote for austerity

Economic View

Italy goes to the polls amid the bleakest economic outlook for a generation. German business confidence shot up to the highest level for more than a year. And there you have it. There are two economies in Europe: the south is facing something of a catastrophe, with economies shrinking year after year, while the north is staging a decent recovery.

The reasons are so widely appreciated that there is not a lot of point in going over what has gone wrong. What matters is what happens next. That is hard to call because outcomes are determined more by politics than economics. But I think the best way to understand what is happening in southern Europe is to see it as a laboratory test for austerity, austerity that is far more severe than anything contemplated here in the UK.

If you look at the eurozone as a whole, economic activity declined by 0.6 per cent last year and according to European Commission forecasts is expected to fall by another 0.3 per cent this. But that conceals huge differences within the region. For example Germany is expected to grow by 0.5 per cent this year while Spain is predicted to contract by 1.5 per cent and Italy by 1 per cent. The Greek economy will have declined for six years in a row.

You can catch a glimpse of the social costs of this divergence in the right-hand graph, which shows unemployment in the eurozone as a whole and in Germany – the former would look even worse were Germany excluded. But note something else. Back in 2005 Germany had dreadfully high unemployment. It coped with this in a number of ways, including fiscal conservatism, but principally by holding down its wage costs and introducing labour market reforms – measures designed to counter the fact that Germany had entered the euro with the mark at a rather high rate.

People who argue now that Germany is getting great benefit from euro membership because otherwise it would have a less competitive exchange rate should note that Germany's lower costs are the result of many years of hard grind.

It follows that the course the southern European countries should follow now is that taken by Germany then. Austerity works, at least when coupled with structural reforms. In a sense that is already happening. Imports into southern Europe have collapsed while exports have not done too badly. The result is that the eurozone as a whole has massively increased its trade balance with the rest of the world. You see that in the main graph. Every other region in the world has moved in the other direction. This cannot continue indefinitely, though the timing and course of any correction is hard to call.

Credit Suisse reckons that the continuing trade and current account surpluses will push the euro up and that the most likely response to that will be even looser monetary policy. That might sustain a recovery but a weak one. That will probably turn out to be right. It would mean, however, that the euro would become more of a southern European currency, with the ECB acting more in the interests of its weaker members rather than that of its stronger ones.

That will create huge tensions, for it would imply a devaluation of the euro both externally (through a lower exchange rate) and internally (through higher inflation in the core countries). That runs against the ECB's mandate to ensure price stability and more generally the promise to the German people that the euro would be as good as the deutschemark.

So what gives? My instinct is that the most likely path is things will muddle along for quite a while yet. The two countries that matter most are Italy and Spain. What happens in Greece is of profound concern to people there but the economy is not big enough to unseat the rest of the eurozone. Assuming that there will be some growth in Spain and Italy, starting in 2014, it will be possible to sustain the austerity programmes in both countries until growth gradually returns and takes the pressure off. The real crisis will be in five years' time when the world economy hits its next cyclical downturn.

That at least seems to me to be the most likely outcome. But it depends on a number of things coming right, starting with these Italian elections.They are essentially about sustaining political support for austerity. If that support is still there – and there is a separate debate about the political make-up to sustain support – then one hurdle is passed. Everyone breathes again. On balance, I expect that will happen.

But if that support is not there, and we may not know for some months, then the rest of the eurozone has to decide what to do. The experience of the past year is that the European Central Bank will do "whatever it takes" to save the euro. Put crudely, it will print the money. But that only buys time and there will be another round of anguished talks about the terms under which the rest of the eurozone will support the country.

So if Italy's present austerity programme is abandoned there will have to be some sort of bailout. It is hard to see the form this will take but help for the banking system on the lines of that extended to Spain would be the first place to look. But we are not there yet.

You see the point. The eurozone as a whole is running a current account surplus. The sovereign indebtedness of the bloc as a whole is pretty much the same as that of the US and the UK, and vastly better than that of Japan. So the problems are manageable. But it is not an integrated region in economic outcomes as you can see in that chart on unemployment.

To correct this different performance requires Spaniards and Italians to behave like the Germans and the Dutch. The Italian vote is one test of the extent to which this is likely.

Start your day with The Independent, sign up for daily news emails
ebooks
ebooksA special investigation by Andy McSmith
News
Jerry Seinfeld Comedians in Cars Getting Coffee
peopleSitcom star urges men to be more supportive of women than ever
Life and Style
Living for the moment: Julianne Moore playing Alzheimer’s sufferer Alice
health
News
Jay Z
businessJay-Z's bid for Spotify rival could be blocked
Sport
footballLouis van Gaal is watching a different Manchester United and Wenger can still spring a surprise
News
The spider makes its break for freedom
VIDEO
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Evening Administrator

£8 per hour: Recruitment Genius: This Pension Specialist was established early...

Guru Careers: Executive Assistant / PA

£30 - 35k + Bonus & Benefits: Guru Careers: We are seeking an Executive Assist...

Ashdown Group: Graduate Application Support Analyst

£25000 - £30000 per annum + benefits: Ashdown Group: A global leader operating...

Reach Volunteering: External Finance Trustee Needed!

Voluntary post, reasonable expenses reimbursed: Reach Volunteering: Would you ...

Day In a Page

War with Isis: Iraq's government fights to win back Tikrit from militants - but then what?

Baghdad fights to win back Tikrit from Isis – but then what?

Patrick Cockburn reports from Kirkuk on a conflict which sectarianism has made intractable
Living with Alzheimer's: What is it really like to be diagnosed with early-onset dementia?

What is it like to live with Alzheimer's?

Depicting early-onset Alzheimer's, the film 'Still Alice' had a profound effect on Joy Watson, who lives with the illness. She tells Kate Hilpern how she's coped with the diagnosis
The Internet of Things: Meet the British salesman who gave real-world items a virtual life

Setting in motion the Internet of Things

British salesman Kevin Ashton gave real-world items a virtual life
Election 2015: Latest polling reveals Tories and Labour on course to win the same number of seats - with the SNP holding the balance of power

Election 2015: A dead heat between Mr Bean and Dick Dastardly!

Lord Ashcroft reveals latest polling – and which character voters associate with each leader
Audiences queue up for 'true stories told live' as cult competition The Moth goes global

Cult competition The Moth goes global

The non-profit 'slam storytelling' competition was founded in 1997 by the novelist George Dawes Green and has seen Malcolm Gladwell, Salman Rushdie and Molly Ringwald all take their turn at the mic
Pakistani women come out fighting: A hard-hitting play focuses on female Muslim boxers

Pakistani women come out fighting

Hard-hitting new play 'No Guts, No Heart, No Glory' focuses on female Muslim boxers
Leonora Carrington transcended her stolid background to become an avant garde star

Surreal deal: Leonora Carrington

The artist transcended her stolid background to become an avant garde star
LGBT History Month: Pupils discuss topics from Sappho to same-sex marriage

Education: LGBT History Month

Pupils have been discussing topics from Sappho to same-sex marriage
11 best gel eyeliners

Go bold this season: 11 best gel eyeliners

Use an ink pot eyeliner to go bold on the eyes with this season's feline flicked winged liner
Cricket World Cup 2015: Tournament runs riot to make the event more hit than miss...

Cricket World Cup runs riot to make the event more hit than miss...

The tournament has reached its halfway mark and scores of 300 and amazing catches abound. One thing never changes, though – everyone loves beating England
Katarina Johnson-Thompson: Heptathlete ready to jump at first major title

Katarina Johnson-Thompson: Ready to jump at first major title

After her 2014 was ruined by injury, 21-year-old Briton is leading pentathlete going into this week’s European Indoors. Now she intends to turn form into gold
Syrian conflict is the world's first 'climate change war', say scientists, but it won't be the last one

Climate change key in Syrian conflict

And it will trigger more war in future
How I outwitted the Gestapo

How I outwitted the Gestapo

My life as a Jew in wartime Berlin
The nation's favourite animal revealed

The nation's favourite animal revealed

Women like cuddly creatures whilst men like creepy-crawlies
Is this the way to get young people to vote?

Getting young people to vote

From #VOTESELFISH to Bite the Ballot