Blog Post

The Italian Lira: the exchange rate and employment in the ERM

In the decades before Italy joined the Euro, the Lira was devalued many times relative to the Deutschmark. Were these re-alignments accompanied by long term improvements on the labour market? The data suggests this was not the case.

By: , and Date: January 13, 2017 Topic: European Macroeconomics & Governance

In a recent paper, Ferdinando Giugliano and Christian Odendahl argued that the two causes of Italy’s poor economic performance in the past 20 years have been Euro membership and, more importantly, a failure to apply deep reforms.

In its annual evaluations, the European Commission has talked repeatedly about structural weaknesses (see most recent report here) and there is little disagreement on the need for structural reforms.

But the role of euro membership is less clear. Does a flexible exchange rate offer an additional instrument that can bring lasting benefits beyond the immediate impact on the trade balance?

In this blog we ask whether the exchange rate actually helped Italy to achieve sustainable employment gains in the past.  We look at the period between the start of the Exchange Rate Mechanism (ERM) in 1979 and the full abandonment of the Lira in 1999.

We observe that exchange rate volatility and depreciations during that period do not appear to have benefited employment in Italy. By contrast, it is in periods of stable exchange rates that the Italian economy moved towards reaching its potential, which also brought benefits in employment.

The history of the Lira in the era of ERM was one of multiple devaluations and volatility. Table 1 summarises the size and timing of the Lira’s re-alignments vis-à-vis the Deutschmark (DM) within the ERM. (As the currencies were allowed to fluctuate within bands, these re-alignments were not necessarily the way that actual exchange rates changed.)

In cumulative terms, the Lira lost around  half (53%) of its value vis-à-vis the DM by the end of this 20-year period. However, there were not equivalent gains in real terms, since employment levels at the end of this period were very similar to what they were at the start.

In order to summarise the Lira’s exchange rate movements and their impact on the real economy we observe four distinct periods.

Figure 1:  The Italian Lira vs the DM.

Source: IMF International Financial Statistics (Monthly frequency)

Notes: An increase denotes depreciation of the Lira. ITL/DM; colours correspond to the 4 periods described in the text.

MD 13 01 17_1

The first period is 1980 – 1987. This period saw seven exchange rate realignments, which reduced the value of Lira in small steps. At the end of this period, the value of the Lira had fallen by 33%.

The first four years of this period were ones of stagflation with very high, but rapidly declining, inflation and zero growth. A concerted effort in Italy, not unlike that made in the rest of the world, did reduce inflation. However, there were also with major losses in growth and employment, again not unlike what we saw in the US, for example. Importantly, Italy maintained competitiveness with respect to its trade partners and managed to achieve positive growth and improvements in employment in the second half of this period.

Figure 2: Output and employment growth, Inflation (in GDP terms), Y-o-Y % changes

Source: IMF International Financial Statistics (National Accounts section – Quarterly) and Istat.

MD 13 01 17_2

In the second period, 1988 – 1992, the exchange rate was stable. There was a small realignment within the ERM in 1990 but not one that had any impact on the actual exchange rate. The end of the period was Italy’s departure from the ERM in September 1992 (although this was not triggered by Italy itself). During this period, inflation had successfully been reduced, growth was positive and there were signs that the economy was operating at its potential. This had led to visible gains in employment.

But two pressures were building up, which eventually ended this period of stability. First, Italy was starting to lose competitiveness as its real effective exchange rate (ULC based shown in figure 3) lost more than 10 per cent. At the same time, and following re-unification, inflationary pressures in Germany were leading to increases in the interest rate. Indeed, from the start of 1990 we saw a real divergence in the path of policy interest rates. But as the German policy rate increased there was also pressure for the DM to appreciate. These pressures became unsustainable (in terms of reserves) and the ERM was forced to break in 1992.

Figure 3: Real Effective Exchange Rate

Source: IMF International Financial Statistics (Monthly frequency) – inverted scale.

Notes: *An increase denotes real depreciation.

MD 13 01 17_3

The split of the ERM in 1992 also marked the start of the third period, a period of volatility and large losses for the Lira. At the starting point, there was agreement on a 3.5 per cent Lira devaluation and 3.5 per cent revaluation for everyone else with respect to the central parity. For the Lira, this amounted to a total of 7 per cent immediate devaluation and an almost 15 per cent effective devaluation within the first month. In a comment to La Stampa Mario Monti commented that this event was “a grave defeat for Italian economic policy.”

Figure 1 shows that the depreciation of the Lira continued for some time. Even though it did recover somewhat, the Lira would not return to the 1992 value before the pre-fixing of exchange rates in 1997, in order to qualify for EMU.  Till the end of 1996, the Lira lost 22 per cent with respect to the Deutschmark. This brought big improvements in competitiveness, especially in ULC terms, which translated to an increase in net exports. However, the start of this period saw Italy enter a recession and there was a real reduction in employment. Unemployment rose to levels higher than those prior to the ERM.

The Lira rejoined the ERM at the end of November 1996. Thus our fourth period, beginning in 1997, is the start of transitioning to the European single currency. Stable exchange rates were associated with stable levels of employment. On the first of January 1999, the currencies were locked into their central parities and monetary policy was centralised with the creation of the Euro.

Giugliano and Odendahl do not suggest that exiting the euro is the right way for Italy. But others do. And this discussion is not new.  But even if one could ignore the possible political or indeed legal difficulties with pursuing such an option, the gains in the real economy associated with exchange rate movements have been very limited in Italy in the past. By looking at these four distinct periods between the start of ERM and abandoning the currency, we observe that exchange rate volatility and distinct depreciation episodes do not appear to have benefited employment in Italy. This is not to say that depreciations did not help the trade balance. But what they do not appear to have done is to provide sustainable gains in competitiveness that would translate to real and long lasting economic growth.

Technical appendix

Notes on Table 1

Source:  Eichengreen, B., & Wyplosz, C. (1993). The Unstable EMS. Brookings Papers on Economic Activity, 51-143. Gros, D., & Thygesen, N. (1998). European Monetary Integration. New York: Addison Wesley Longman. Maes, I., & Quaglia, L. (2003). France’s and Italy’s Policies on European Monetary Integration: a comparison of ‘strong’ and ‘weak’ states. EUI Working Papers, and IMF International Financial Statistics (IFS). Shows % realignment of the bilateral ITL/DM central rate resulting from the different realignments. The last row shows the month-to-month depreciation in the market rate (end August-end September) when Italy left the ERM.

Notes on figure 2

Notes: GDP volume and GDP deflator year-on-year % changes; the employment rate (measured on the right-hand scale) is defined as employment (seasonally adjusted) to labour force (seasonally adjusted). For both series, the age group is >15 years old. Essentially, what is shown is 100% minus the unemployment rate for this age class. For seasonal adjustment, X-12 ARIMA was used.

Notes on figure 3

REL.CP: Relative consumer prices; RULC: Relative unit labour costs. Series are rebased so that 1997M1=100.

REER BASED ON RULC refers to the relative normalized unit labor cost in manufacturing index from the IMF IFS (line reu in the IFS) that was discontinued in March 2010.   Output per man-hour is normalized to remove distortions arising from cyclical movements (e.g. labor hoarding) using the Hodrick-Prescott filter. The series was calculated based on a basket of 17 economies.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

The exchange rate and inflation in the euro-area: words following facts

The reduced references in the speeches of the President and Vice-president of the ECB to exchange rate changes in assessing inflation developments correspond to a decreased pass-through from the exchange rate to inflation. So, as it should be, words have followed facts

By: Francesco Papadia Topic: European Macroeconomics & Governance Date: February 16, 2018
Read article More on this topic More by this author

Blog Post

Economies of States, Economies of Cities

Both in Europe and the US, economists are starting to notice how the economies of cities have been sometimes diverging from the economies of states. While some areas thrive, others may be permanently left behind. Maybe it is time to adopt a more clearly sub-national perspective. We review recent contributions on this issue.

By: Silvia Merler Topic: Global Economics & Governance Date: February 5, 2018
Read about event More on this topic

Past Event

Past Event

Europe’s immigration and integration challenges: Financial and labour market dimensions

The event, organised by Bruegel in cooperation with the Institute for International Affairs will discuss these and related questions and will also feature the launch in Rome of the study authored by Zsolt Darvas on the impact and integration of migrants in the European Union.

Speakers: Roberto Ciciani, Zsolt Darvas, Marcela Escobari, Tatiana Esposito, Manjula M. Luthria, Carlo Monticelli, James Politi and Nathalie Tocci Topic: European Macroeconomics & Governance Location: Banca Monte dei Paschi di Siena, Via Mighetti 30/A, Rome, Italy Date: February 2, 2018
Read article More on this topic

Blog Post

The ever-rising labour shortages in Europe

Historically high labour shortages in most central-eastern and north-western EU countries suggest that the immigration of central Europeans to north-west EU countries did not take away jobs from local workers on a significant scale. But as labour shortages now exceed their pre-crisis peak, several urgent measures must be considered to help to combat the problem.

By: Zsolt Darvas and Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: January 25, 2018
Read article Download PDF More on this topic

Blueprint

People on the move: migration and mobility in the European Union

Migration is one of the most divisive policy topics in today’s Europe. In this publication, the authors assess the immigration challenge that the EU faces, analyse public perceptions, map migration patterns in the EU and review the literature on the economic impact of immigration to reflect on immigration policies and the role of private institutions in fostering integration.

By: Uuriintuya Batsaikhan, Zsolt Darvas and Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: January 22, 2018
Read article More on this topic More by this author

Blog Post

The financial side of the productivity slowdown

Scholars have devoted much research to the “productivity puzzle” that has emerged after the crisis, and some are investigating the role of financial frictions and capital allocation in relation to this phenomenon.

By: Silvia Merler Topic: Global Economics & Governance Date: January 22, 2018
Read article More on this topic More by this author

Podcast

Podcast

Remaking Europe

This instalment of the Sound of Economics features Bruegel fellows Reinhilde Veugelers, Simone Tagliapietra and J. Scott Marcus explain how European industries are adapting to new manufacturing, and what more can be done to help EU countries and companies keep pace with the burgeoning 'Industry 4.0'

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: January 19, 2018
Read article More on this topic More by this author

Blog Post

The growing presence of robots in EU industries

While it is always tempting to try to predict future patterns in the automation of European industries, it is also insightful to assess key dimensions of their robotisation so far, starting from the pre-AI era. This article presents evidence on the use of industrial robots by European industries from 1993 and onwards.

By: Georgios Petropoulos Topic: Innovation & Competition Policy Date: December 20, 2017
Read article More by this author

Podcast

Podcast

Inclusive Europe: a journey towards integration

How has immigration become an essential part of the EU? What incentives should be made to encourage EU intra-mobility? Why and how should we proceed to foster refugees' inclusion in the EU? Zsolt Darvas and Manu Bhardwaj of Mastercard Center for Inclusive Growth discuss the future of migration within the EU.

By: The Sound of Economics Topic: European Macroeconomics & Governance, Global Economics & Governance Date: December 14, 2017
Read about event More on this topic

Past Event

Past Event

Better policies for people on the move

This event discussed the impact and integration of migrants as well as national and European immigration policy challenges.

Speakers: Manu Bhardwaj, Elizabeth Collett, Zsolt Darvas, Eva Degler, Maria Demertzis, Arjen Leerkes, Rainer Münz, Matthias Oel, Alessandra Venturini and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: December 13, 2017
Read article More on this topic More by this author

Blog Post

Moroccan job market issues, and labour trends in the Middle East and North Africa

Morocco is an interesting case of structural labour market disequilibrium despite respectable growth, and illustrates the issues facing the region’s oil-importer countries

By: Uri Dadush Topic: Global Economics & Governance Date: December 7, 2017
Read about event More on this topic

Past Event

Past Event

Flexicurity and labour market reforms in Europe

This event will discuss the potential of the flexicurity model as employment strategy and the way it could be implemented in European countries to be successful.

Speakers: Grégory Claeys, Philip Collins, Werner Eichhorst, Antoine Foucher, Maria Jepsen and Marco Leonardi Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: December 4, 2017
Load more posts