The Economics of European Integration - The Perspective of Italy

Seminar Paper, 2013

34 Pages, Grade: 2.0


Table of contents

1. Abstract

2. Introduction
2.1 The Research Question
2.2 The Theory of Optimum Currency Areas
2.3 Country Overview

3. Asymmetric tendencies/shocks in Italy
3.1 GDP development
3.2 Competitiveness
3.3 Current Account Balance
3.4 Unemployment
3.5 State budget and indebtedness
3.6 Long-term Interest Rates

4. Sustainability of the current budget deficit shock

5. Ways to overcome the crisis

6. Measures taken to overcome the crisis

7. Conclusion

8. Bibliography

1. Abstract

After a successful launch of the Euro and some beneficial years for the countries in the European Monetary Union enjoying low interest rates, the bankruptcy of Lehman brothers in 2008 triggered a global financial and economic crisis which especially in the European Monetary Union turned into a sovereign debt crisis. Based on the ninth edition of Paul De Grauwe’s book “Economics of Monetary Union”, this paper analyzes Italy’s economic development in the last years and shows the benefits and costs for Italy of being in the European Monetary Union. After one decade of having a common currency, this paper aims to answer the question if it was a good or a bad decision for Italy to have joined the European Monetary Union.

2. Introduction

Economic integration has a lot of benefits for the participating countries. Falling trade barriers like customs increase the trade between the countries. Companies can benefit from having access to new or larger sales and procurement markets, consumers can benefit from lower prices and more choices. Higher competition within the common market can lead to higher innovativeness of companies and thus to better competitiveness outside of the common market and more exports to the rest of the world. In the end also the governments of the participating countries can benefit from growing economies and higher tax revenues, just to mention some of the benefits.

After having gone through the first steps of economic integration, the countries of the European Union reached a point when they had to decide whether to introduce the Euro as a common currency or not. A common currency can bring even more benefits than just a common market. It improves price comparison among countries, reduces transaction costs and eliminates currency risks. It creates policy credibility and trust of the financial markets and thus reduces the costs of borrowing for the member states because of lower risk premiums (= interest rates) asked for by investors. It attracts foreign investors and can boost the economies in the whole Monetary Union. Therefore, in 1999 Italy became one of 12 founding countries of the European Monetary Union by adopting the Euro and relinquishing the national currency Lira. The common currency Euro was launched on January 1, 1999 however, only for accounting purposes. It was introduced into circulation on January 1, 2002 after a transitional period of three years in all the countries within the European Monetary Union. In Italy the Euro was introduced at a fixed conversion rate of 1 Euro = 1936.27 ITL (Italian Lira).[1] After the Euro has been circulation for over ten years now it becomes visible that for some countries having one common currency not only has benefits. There is also a price to pay for those benefits, especially in the case of negative asymmetric shocks, as the case of Italy will show.

2.1 The Research Question

From today’s point of view the purpose of this paper is to analyze the costs and benefits of joining the European Monetary Union for Italy with special regard to Robert Mundell’s theory of optimum currency areas (OCA-theory) (1961)[2], the occurrence of asymmetric tendencies/shocks, their relevance for the country, and the question of overcoming of those shocks.

In the end a clear answer is given if it was a good or a bad decision for Italy and its economy to join the European Monetary Union, that is if the benefits of this step outweigh the costs or vice versa.

2.2 The Theory of Optimum Currency Areas

The highest price for each member state for joining the European Monetary Union, is the loss of an own national currency, which means the loss of the national monetary policy instrument. This is the loss over the possibility to determine interest rates, the loss of having control over the money supply in the country, and loss of control over the exchange rate. That limits a country’s possibilities to react to asymmetric shocks and prevents a national central bank from lowering the interest rate, devaluing the own currency and/or providing enough liquidity to overcome a potential liquidity crisis during such a negative shock (and the other way around during a positive shock). In the end this can lead to mistrust by investors in the country’s ability to pay back its debts, thus to higher costs of borrowing and in the end to a solvency crisis and finally the default of a country. So joining a monetary union becomes costly in the case of asymmetric shocks, especially in the case of negative asymmetric shocks. But when do we speak of an asymmetric shock and what are the sources of asymmetric shocks? First of all an asymmetric shock is a shock affecting the countries unequally. If a shock affects all countries equally it is called a symmetric shock. For an example of an asymmetric shock imagine the following two country scenario in a monetary union with a common currency and a common central bank, developed by Robert Mundell in 1961.[3] Assume there is a shift in demand in the case of Italy and its most important trading partner Germany which could be based on changed consumer preferences. The aggregate demand in Italy declines and in Germany it increases at the same time. One has to distinguish between a permanent and temporary shock, so in this case the shift in demand is assumed to be permanent. In Italy the output level goes down and unemployment goes up, in Germany it is vice versa. As the two countries are in a monetary union, Italy cannot use monetary policy to lower interest rates and devalue the own currency in order to stimulate demand. Germany on the other hand cannot use restrictive monetary policy. So is there any alternative to adjust this asymmetric shock in demand? Yes, if wages are flexible and/or labor mobility is given, the asymmetric shock can be overcome. If wages go down in Italy due to lower demand for labor and go up in Germany due to higher demand for labor, aggregate supply in Italy will be boosted until the former output level and a new equilibrium is reached at a lower price level than before. At the same time the aggregate supply in Germany will decrease until the former output level and a new equilibrium is reached at a higher price level than before. The new situation will leave Italy with higher and Germany with lower competitiveness. This could lead to a rise in aggregate demand in Italy and a decline in aggregate demand in Germany and the whole process could be turned around.[4]

The following figure is illustrating the above described scenario.

Figure 1: The automatic adjustment process in a demand shock (Italy left, Germany right)

illustration not visible in this excerpt

Source: De Grauwe (2012), p. 5

The second alternative to reach equilibrium again is labor mobility. Instead of adjusting the wages, workers from Italy who have lost their jobs could move to Germany to compensate the increased demand for labor in Germany. If none of both occurs, neither wage adjustments in Italy, nor labor movement from Italy to Germany, the only way to overcome the disequilibrium is through higher prices and inflation in Germany by higher wages and the upward shift of the supply curve there.[5]

So what does the mean for Italy? Has Italy experienced any asymmetric shocks since joining the European Monetary Union? If yes, what kind of shocks and was Italy able to overcome these shocks? Are wages flexible and is labor mobile in Italy? Have any measures been taken? These questions will be analyzed in the following chapters of this paper, beginning with a short country overview.

2.3 Country Overview

The peninsula of Italy (Italian Republic) with its capital Rome is located in southern Europe. The total population in July 2012 was estimated at about 61.3 million out of which about 80% are Christian and almost 20% Atheists and Agnostics. It is the 23rd biggest country of the world in terms of population and its official language is Italian. The population growth rate in 2012 is estimated at 0.38%. The area of the country comprises 301,340 square kilometers including the islands of Sardinia and Sicily which as well belong to the country. It has borders with Austria, France, Holy See (Vatican City), San Marino, Slovenia, and Switzerland. The coastline is 7,600 kilometers long. Its natural resources are coal, mercury, zinc, potash, marble, barite, asbestos, pumice, fluorspar, feldspar, pyrite, natural gas, crude oil reserves, fish, and arable land. Economically, in terms of GDP per capita in purchasing power parity Italy globally ranks 44th with a GDP per capita (PPP) of $30,500 (2011) and 11th in terms of total GDP in purchasing power parity with a total GDP (PPP) of $1.847 trillion (2011). The service sector has the highest contribution to the GDP (73.4%) followed by the industrial sector (24.7%) and the agricultural sector (2%). The most important export trading partners are Germany, where 13.3% of all exports go to, followed by France (11.8%), the US (5.9%), Spain (5.4%), Switzerland (5.4%), and the UK (4.7%) (2011). The most important import trading partners are Germany (16.5%), France (8.8%), China (7.7%), the Netherlands (5.5%), and Spain (4.7%) (2011).[6]

3. Asymmetric tendencies/shocks in Italy

In this chapter the Italian economic situation is analyzed in order to find out if any asymmetric shocks or tendencies can be detected in the country’s recent history.

3.1 GDP development

In the first step the GDP development will be analyzed. The following figure shows the GDP growth rates of various Euro area countries including Italy and an Euro area average for the years between 1992 and projected 2011. The data for 2012 and 2013 are estimations.

Figure 2: Real GDP growth rate - percentage change on previous year 1992-2013

illustration not visible in this excerpt

Source: Eurostat

In the first period between 1992 and 1999 when the Euro was launched, the Italian GDP was growing at between about 1% and 3% annually, with the exception of 1993 when it had a negative growth rate of about 1%. During the same time the Euro area average GDP growth rate was slightly higher, never exceeding 3% (data beginning in 1996). The country with the most volatile GDP growth rates was Finland with growth rates between -3.5% in 1992 and 6.2% in 1997, which was the highest growth rate of the presented countries in the figure during the stated 20 years. Italy’s highest GDP growth rate was in the year 2000 amounting to 3.7%, which was exactly the Euro average of that year. In the following three years the Italian economy, like most of the other European economies, was growing slower reaching a 0% growth rate in 2003. This year was also the turning point and in the following years until 2007 the Italian economy was growing at growth rates between 1% and 2.2%, closely to the Euro average which still was slightly higher (about 1% each year). Finland and Greece were the fastest growing countries until 2007 reaching growth rates of above 5% in several years. In the year 2008, known as the year of the Lehman Brothers bankruptcy, Italy’s GDP decreased by 1.2% showing the worst performance of the shown countries in that year, while the Euro area economies grew by 0.4% on average. In the following year however, all European economies (except Poland, which is not shown in the figure)[7] experienced a recession. Finland, whose GDP decreased by 8.5% was hit hardest, followed by Italy (-5.5%), which was not far away from the Euro area average (-4.4%). Portugal was hit least with a GDP decrease of only 2.9%. With the exception of Greece all the shown countries were able to recover in 2010 already and grow (Italy 1.8%, Euro area average 2) or at least remain at the 2009 level (Spain -0.3%). In 2011 a slight growth of 0.4% of the Italian GDP could be measured, which was the third worst performance after Greece and Portugal. In 2012 and 2013 it is even expected to fall by 2.3% and 0.5% respectively while the Euro area average GDP growth (including Greece) is expected to be around 0% in both years. Germany and Finland were able to recover fastest from the recession and are projected to grow further in 2012 and 2013, however, slower than in 2010 and 2011.

Leaving the estimated data of 2012 and 2013 aside, during the whole period between 1992 and 20011 the Italian GDP growth rate never deviated more than 1.4 percent points from the Euro area average, which was in 1999. Italy was also never able to grow faster or shrink slower than the Euro area average in the analyzed 20 year time period, even before the Euro was introduced. The relatively poor performance especially in the last years needs to be investigated further. So in the next step the country’s competitiveness is analyzed in terms of unit labor costs and the current account balance.


[1] Cf. European Central Bank (URL), accessed on 04.01.2013

[2] See Mundell (1961)

[3] See Mundell (1961)

[4] Cf. De Grauwe (2012), pp. 3-5

[5] Cf. De Grauwe (2012), p. 5

[6] Cf. Central Intelligence Agency (URL), accessed on 03.01.2013

[7] Cf. International Business Times (URL), accessed on 08.01.2013

Excerpt out of 34 pages


The Economics of European Integration - The Perspective of Italy
University of Applied Sciences Berlin
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Analysis of the Italian economic development after joining the European Monetary Union with special regard to Robert Mundell's Theory of Optimum Currency Areas
economics, european, integration, perspective, italy
Quote paper
Raphael Krenke (Author), 2013, The Economics of European Integration - The Perspective of Italy, Munich, GRIN Verlag,


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