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.

Read about event More on this topic

Past Event

Past Event

Rationale and limitations of SURE

This event will discuss SURE, a new European Union instrument for temporary ‘Support to mitigate Unemployment Risks in an Emergency'

Speakers: Roel Beetsma, Elena Carletti, Grégory Claeys and Gilles Mourre Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 15, 2020
Read article Download PDF More on this topic

Working Paper

Forecasting exchange rates of major currencies with long maturity forward rates

This paper presents unprecedented exchange rate forecasting results based upon a new model which approximates the gap between the fundamental equilibrium exchange rate and the actual exchange rate with the long-maturity forward exchange rate.

By: Zsolt Darvas and Zoltán Schepp Topic: Global Economics & Governance Date: April 2, 2020
Read article More on this topic More by this author

Blog Post

How COVID-19 is laying bare inequality

COVID-19 is laying bare socio-economic inequalities and could exacerbate them in the near future. The virus is a risk factor particularly for those at the lower end of the income distribution, who are vulnerable to the interaction of the shock with income, socio-economic and urban inequalities.

By: Enrico Bergamini Topic: Global Economics & Governance Date: March 31, 2020
Read article More on this topic More by this author


Why OMT is not the solution for Italy right now

The Outright Monetary Transactions tool is not well suited for Italy right now. Italy needs fiscal support both by itself and by the EU. Italy and the rest of the EU need a fiscal bazooka. We should find a way of backstopping our economies immediately.

By: Maria Demertzis Topic: European Macroeconomics & Governance Date: March 16, 2020
Read article More on this topic More by this author

Blog Post

To save the Italian economy from the Coronavirus, Rome prescribes a stimulus

Faced with a difficult prognosis, the Italian government has prescribed a three-step strategy to treat the worse economic symptoms of the Coronavirus. The medicine is money and the dosage is €4.5 billion

By: Simone Tagliapietra Topic: Global Economics & Governance Date: March 3, 2020
Read about event More on this topic

Past Event

Past Event

The quality and quantity of work in the age of AI

At this event, the panelists will discuss the implications of Artificial Intelligence on the labour market and the future of work in general.

Speakers: Robert Atkinson, Anna Byhovskaya, Maria Demertzis, Carl Frey and Daniel Samaan Topic: Innovation & Competition Policy Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: February 5, 2020
Read article Download PDF More on this topic

External Publication

Manufacturing employment, international trade, and China

The decline in manufacturing employment is often seen as a major reason for rising inequality, social tensions, and the slump of entire communities. With the rise of national populists and protectionists in recent years, the issue has become even more prominent.

By: Uri Dadush and Abdelaziz Ait Ali Topic: Global Economics & Governance Date: November 28, 2019
Read article More on this topic More by this author


Under swollen tides, Venice says more about our future than our past

While tides high enough to submerge Venice used to be rare, occurring every two to three decades, they have now become increasingly regular. Five of the ten highest tides in recorded history occurred over the last 20 years, with the most recent one having occurred just last year. Is this the new normal?

By: Simone Tagliapietra Topic: Energy & Climate Date: November 18, 2019
Read about event More on this topic

Past Event

Past Event

Improving regulatory policy formulation and institutional resilience in Europe

Are large differences in the resilience of individual economies related to differences in the quality of country-level institutions that shape the absorption and response to these shocks? At this event we'll discuss the evolution of labour markets, and the role of institutional design and good process.

Speakers: Arup Banerji, Maria Demertzis, J. Scott Marcus, Céline Kauffmann and Rogier van den Brink Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: November 13, 2019
Read article More on this topic

Blog Post

Talking about Europe: La Stampa 1940s-2010s

An on-going research project at Bruegel seeks to quantify and analyse printed media discourses about Europe over the decades since the end of the Second World War. In this third blogpost, we carry out the exercise on 9.9 million articles from an Italian daily newspaper, La Stampa. The trend increase in the frequency of European related articles, previously found looking at the French and German press, is confirmed in the case of Italy.

By: Enrico Bergamini, Emmanuel Mourlon-Druol, Francesco Papadia and Giuseppe Porcaro Topic: European Macroeconomics & Governance Date: October 22, 2019
Read article More on this topic More by this author


Why Europe needs a change of mind-set to fend off the risks of recession

Recession! This is the new worry in Europe and the US. A simple look at google trends shows that in Germany, France and the US, search interest for recession peaked in the last weeks. In Italy, the peak already occurred end of January. Whether a recession is actually occurring is difficult to gauge in real time. But there can be no doubt that significant risks such as the trade war and no-deal Brexit exist.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: September 2, 2019
Read article More on this topic

Blog Post

‘Lo spread’: The collateral damage of Italy’s confrontation with the EU

The authors assess whether the European Commission's actions towards Italy since September 2018 have had a visible impact on the spread between Italian sovereign-bond yields and those of Germany, and particularly whether the Commission’s warnings have acted as a ‘signalling device’ for bond-market participants that it might be difficult for Italy to obtain the support of the ESM or the ECB’s OMT programme if needed.

By: Grégory Claeys and Jan Mazza Topic: European Macroeconomics & Governance Date: July 8, 2019
Load more posts