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.

Voices
On the last day of campaigning before the polling booths open, the SNP leader has written to voters in a final attempt to convince them to vote for independence
voicesIs a huge gamble on oil keeping the First Minister up at night?
Arts and Entertainment
Rosalind Buckland, the inspiration for Cider with Rosie died this week
booksBut what is it like to be the person who inspires a classic work of art?
Life and Style
techApple has just launched its latest mobile operating software – so what should you do first?
News
A male driver reverses his Vauxhall Astra from a tow truck
newsThe 'extremely dangerous' attempt to avoid being impounded has been heavily criticised
PROMOTED VIDEO
Arts and Entertainment
Lionel Messi in action for Barcelona
filmWhat makes the little man tick?
Arts and Entertainment
tvReview: An undercooked end (spoiler alert)
News
i100
News
ebooksAn unforgettable anthology of contemporary reportage
Arts and Entertainment
Pharrell dismissed the controversy surrounding
musicThe singer said 'the last thing I want to do is degrade'
Sport
Cesc Fabregas celebrates his first Chelsea goal
footballChelsea vs Schalke match report
Arts and Entertainment
Toby Jones (left) and Mackenzie Crook in BBC4’s new comedy The Detectorists
tvMackenzie Crook's 'Detectorists' makes hobby look 'dysfunctional'
Life and Style
fashion

Olympic diver has made his modelling debut for Adidas

News
i100
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

Trainee Recruitment Consultant Birmingham

£18000 - £23000 per annum + Comission: SThree: The SThree group is a world lea...

Trainee Recruitment Consultant - Birmingham - Real Staffing

£18000 - £23000 per annum + Commission: SThree: Real Staffing are currently lo...

Recruitment Consultant - Soho - IT, Pharma, Public Sector

£20000 - £25000 per annum + OTE £35,000 first year: SThree: The SThree group i...

Sales Executive

£20 - 24k (Uncapped Commission - £35k Year 1 OTE): Guru Careers: We are seekin...

Day In a Page

Mystery of the Ground Zero wedding photo

A shot in the dark

Mystery of the wedding photo from Ground Zero
His life, the universe and everything

His life, the universe and everything

New biography sheds light on comic genius of Douglas Adams
Save us from small screen superheroes

Save us from small screen superheroes

Shows like Agents of S.H.I.E.L.D are little more than marketing tools
Reach for the skies

Reach for the skies

From pools to football pitches, rooftop living is looking up
These are the 12 best hotel spas in the UK

12 best hotel spas in the UK

Some hotels go all out on facilities; others stand out for the sheer quality of treatments
These Iranian-controlled Shia militias used to specialise in killing American soldiers. Now they are fighting Isis, backed up by US airstrikes

Widespread fear of Isis is producing strange bedfellows

Iranian-controlled Shia militias that used to kill American soldiers are now fighting Isis, helped by US airstrikes
Topshop goes part Athena poster, part last spring Prada

Topshop goes part Athena poster, part last spring Prada

Shoppers don't come to Topshop for the unique
How to make a Lego masterpiece

How to make a Lego masterpiece

Toy breaks out of the nursery and heads for the gallery
Meet the ‘Endies’ – city dwellers who are too poor to have fun

Meet the ‘Endies’ – city dwellers who are too poor to have fun

Urbanites are cursed with an acronym pointing to Employed but No Disposable Income or Savings
Paisley’s decision to make peace with IRA enemies might remind the Arabs of Sadat

Ian Paisley’s decision to make peace with his IRA enemies

His Save Ulster from Sodomy campaign would surely have been supported by many a Sunni imam
'She was a singer, a superstar, an addict, but to me, her mother, she is simply Amy'

'She was a singer, a superstar, an addict, but to me, her mother, she is simply Amy'

Exclusive extract from Janis Winehouse's poignant new memoir
Is this the role to win Cumberbatch an Oscar?

Is this the role to win Cumberbatch an Oscar?

The Imitation Game, film review
England and Roy Hodgson take a joint step towards redemption in Basel

England and Hodgson take a joint step towards redemption

Welbeck double puts England on the road to Euro 2016
Relatives fight over Vivian Maier’s rare photos

Relatives fight over Vivian Maier’s rare photos

Pictures removed from public view as courts decide ownership
‘Fashion has to be fun. It’s a big business, not a cure for cancer’

‘Fashion has to be fun. It’s a big business, not a cure for cancer’

Donatella Versace at New York Fashion Week