Greece’d Lightning and the Italian Stallion

As the new year begins to unfold, political instability coupled with ingrained economic malaise is likely to conjure up a perfect storm in the eurozone. If 2014 was the year when the world pretended to ignore Europe’s problems, 2015 will be when Europe hits the headlines again. And the euro will be at the center of it all.

Hostility towards the euro is on the rise in the countries that have been severely affected by the continent’s economic and financial crisis. In Italy, only 54 percent of people surveyed in the latest Eurobarometer poll support Europe’s single currency. In Cyprus, only 51 percent do. And in Portugal and Greece as many as 35 percent would like to scrap the euro altogether.

This sentiment translates into politics. In Italy, the Northern League and the Five-Star Movement, both openly anti-euro, together hold about 30 percent of the votes. In Greece, Syriza, the party that is due to win the snap general election at the end of this month, is prepared to live with the euro, but advocates a radical change in the economic policies that underpin Europe’s monetary union. Similarly in Spain, Podemos, the newly established anti-establishment party, is campaigning for the overhaul of the euro. (On the flip side, there are countries that are still happy to adopt the common currency, such as Lithuania, which became the 19th member to do so earlier this month.)

Protracted economic difficulties, lack of leadership, and an inflexible policy response to the crisis explain the widespread disaffection in those countries for Europe’s economic and monetary integration. More than six years after the global financial crisis, the eurozone has not recovered the economic losses. A double-dip recession and a modest recovery have resulted in real GDP about 3 percent smaller than in the final quarter of 2007.

This figure looks even worse when compared to the only economy of similar size that went through the crisis simultaneously, the United States. Its output is now some 6 percent bigger than in the final quarter of 2007. Having moved in synch with the euro area during the crisis years from 2008 to 2010, since 2011 the United States has been growing steadily. In 2014, the U.S. economy expanded at 2.2 percent — a good performance relative to that of other advanced economies — and is expected to hit 3.1 percent this year. The eurozone’s GDP, by contrast, will grow by 1.3 percent this year, from 0.8 percent in 2014. But even this modest growth is far from certain. In its latest World Economic Outlook, the International Monetary Fund suggests that the euro area faces a 40 percent chance of returning to recession in 2015 and a 30 percent chance of deflation.

For years now, lack of opportunities and an uncertain future have plagued the fortunes of millions of people in the eurozone. Low growth — and a prolonged slump in some countries — has resulted in fewer jobs being created. Across the eurozone, the unemployment rate stands at approximately 10 percent, with peaks of almost 13 and 26 percent in Italy and Greece, respectively. For the respondents to the Eurobarometer, unemployment is by far the most pressing concern (45 percent) followed by the economic situation (23 percent). Yet more worrying is the sense that there is no improvement down the road: 45 percent of people in the Eurobarometer survey do not expect any significant economic recovery. Economic malaise is now so deeply rooted in some areas of Europe that rekindle domestic demand has become almost a titanic task.

Should we be worried? Deep-seated pessimism and widespread hostility toward the euro could produce a potentially destabilizing mix in both Italy and Greece, where political restlessness could spill over into the economy and seriously undermine Europe’s monetary union. In both countries, the forthcoming elections of heads of state have opened a number of uncertain scenarios. The likely victory of Syriza will push Greece to renegotiate the terms of its bailout. In Italy, Matteo Renzi, the prime minister, needs all help he can possibly get to elect the new president, and he may be tempted to promise a dilution of fiscal discipline for support to ease this process. But, with Italy’s debt at more than 132 percent of GDP and the deficit close to the 3 percent threshold, any suggestion for more flexible fiscal adjustment will fall on deaf ears in Germany.

Angela Merkel has her own eurosceptics to appease and so she may be willing to gamble Europe’s future in order to send a clear message to Italy not to mess about. Here is the scenario. If the going gets tough, Germany and other northern euro member states will respond by threatening to cut Greece out. It would be a calculated gamble. We are no longer in 2012 when denying Athens the second bailout would have triggered a major crisis. The contagion from Greece would be limited. Italy, on the other hand, remains the country that can bring the euro down. So showing toughness to Greece would be a lesser evil compared with a confidence crisis triggered by Italy pushing for renegotiating its fiscal commitments.

All eyes are now on Greece, but Italy is the country that will determine the future of Europe’s single currency. Popular discontent is directly correlated with prolonged economic problems. The current recipe does not work and continuing to ignore the evidence is unwise and potentially very disruptive. But for Germany and other member states, tough fiscal rules are the only way to frame unpredictable domestic politics. Political stability and institutional regeneration are therefore essential to put Italy’s economy back on track. The election of the president will show whether the current prime minister has credibility and support to push through the reforms that the country desperately needs. Only then he will be in the position to suggest more manageable fiscal rules.

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