The euro faces two possible futures: Spain or Italy.
The first is one where the Spanish economy ekes out just enough growth that parties from across the political spectrum are willing to take turns pushing through the policies that Europe's new holy trinity of Brussels, Frankfurt and Berlin — the European Union, European Central Bank and Germany — have prescribed. The second is a much less benign scenario in which Italy's traditional parties implode under the weight of long-term stagnation, and populist ones determined to rip up the country's existing concordat with Europe rise in their place. The danger there is that the nature of the euro means a political crisis in one country could easily turn into a financial crisis in the rest, potentially calling into question the very existence of the common currency.
The issue, then, isn't so much whether Europe ends up more like Spain or Italy, but rather which of those countries can make the other more like it.
Six or seven years ago, that would have seemed like an absurd thing to ask. Back then, Spain and Italy were, in a lot of ways, mirror images of each other. They were both struggling with the fact that they could no longer devalue their way out of trouble; both had separatist movements being fueled by persistent gaps between their prosperous norths and underdeveloped souths; and, more to the point, both looked as if they were about to be forced out of the euro by their ruinously high borrowing costs. Since then, though, they have diverged about as much as possible. Spain has grown so fast that its GDP per working-age adult, which adjusts for the graying of its population, is 3.3 percent above its pre-crisis peak, while Italy's is still 5.5 percent below its peak.
This is just the continuation of what had been happening before the crash. Spain, as you can see below, did much better during the boom and, despite initially falling, has now done so much better during the bust that its economy has grown more than twice as much as Italy's going back to 1990.
So it's no wonder, as the Wall Street Journal's Greg Ip points out, that markets barely noticed when Spain's government briefly collapsed last week — but started panicking when Italy's did. The first, after all, was just a story about short-term political fortunes, while the second was about the long-term survival of the common currency. Which is to say that there was no doubt that no matter who Spain's new leader ended up being, they would want to stay in the euro, while there was plenty of doubt that Italy's would do the same.
But the most relevant questions are why Spain has been doing so much better and what Italy could do to become more like it. Part of the answer is simply that Spain has been permitted to run bigger deficits in the last few years, but only part. A much bigger piece is that Italy has forgotten how to do the one thing that's more important than anything else if you're going to be a part of the euro: become more productive. The ECB doesn't just decide how much monetary stimulus to give its countries. Because it's responsible for keeping its nations' borrowing costs down, the central bank also must decide how much fiscal stimulus it will allow them — which isn't much. The result is that governments can't do anything themselves to fight recessions. All they can do is try to help their businesses regain competitiveness so that they can export their way out of trouble. And that's something Italy does particularly badly.
Well, at least in playing by the rules that Germany has set up. Those restrictions prevent countries from becoming more competitive in the easiest way they could — by not doing a thing and waiting for their rivals to raise wages even more than they have — because Germany is doing its best not to play along. It wants to keep its own costs down, which means that everyone else has to reduce their costs instead. The problem is that, as we've seen in Spain and Italy, workers are loath to take pay cuts even in the face of mass unemployment. The best those countries can do, then, is to freeze wages while their workers figure out how to be more productive — paying people the same to do more is just a gentler kind of cut — assuming, that is, that workers can increase their efficiency. Spain has been able to boost its productivity and, as a result, has cut its unit labor costs quite a bit; Italy has not and has seen its labor costs continue to rise.
It's the difference between a country that can succeed in the euro and one that can only hope to fail a little bit less.
But while it's clear that Italy has a productivity problem — its central bank estimates that between 1995 and 2016 it grew 0.3 percent a year, compared with 2 percent for Germany — what's less clear is why. The country's sclerotic labor markets and abundance of red tape don't seem to be to blame. Instead, economists Bruno Pellegrino and Luigi Zingales have found that the major problem appears to be that Italy's small-business sector has been slow to adopt labor-saving technologies, such as computers, the result in no small part to leadership whose incompetence is surpassed only by its nepotism (or, it's hard to tell, maybe the other way around).
This is not easy to fix. Italy, in the antiseptic language of MBAs, needs to rationalize the 95 percent of its firms that have 10 or fewer employees by letting (or pushing) the worst of them to go out of business and the best of them to be absorbed by larger companies with deeper pockets. In other words, it needs to increase unemployment at a time when it's already in double-digits and 20 percent of the country's 15- to 24-year-olds, which is the worst in the euro zone, are neither working nor in training nor even in school. In the long run, this policy would enable people and money to move to where they'd be the most useful instead of where they have the most family connections. But, as the saying goes, in the long run your political career will be dead if you try it. Smart economics doesn't always make for smart politics.
Italy needs its establishment parties to work together on this to share the political pain. But that, of course, is the one thing they can't really do anymore. That's because those parties have used up most of their popularity on various austerity programs, which might be the biggest obstacle to turning Italy's disaster of an economy into a bad, but acceptable, one like Spain's. (As an aside, it shows how low the bar is that Spain, which for all its growth still has 16 percent unemployment, is considered something of a euro zone success story nowadays.) The problem is that the euro neuters the center-left by forcing everyone to follow the same budget-cutting policies usually associated with the center-right. Why vote for the socialists if they're offering just slightly different budget cuts than the conservatives? Voters will opt for the far-left and far-right instead, as they have in Italy, neither of which is amenable to these kind of reforms — or, we'll see, perhaps to the euro itself.
The irony is that the euro started as a political project that didn't always work economically but might now be an economic project that doesn't work politically — which is the only way things could get worse.