Competitiveness Revisited: Labour Costs, Financial Flows and the Case of Italy

Explanations of Italy's and Germany's position within the Eurozone commonly focus on trade ‘competitiveness,’ a concept measured in terms of unit labour costs. This trade-centric view offers a poor explanation for the evolution of the two countries external debt levels following the adoption of the Euro. It also fails to explain the external financial fragility that Italy has repeatedly experienced in the period since 2010. Both outcomes are better explained by dynamics in cross-border financial markets. Monetary union created large incentives for banks in the Eurozone's core states, including Germany, to direct funds to banks in the Eurozone's periphery (those countries whose banks had earlier faced higher currency-related risk premia in obtaining external financing). Domestic policy decisions in Germany further contributed to this outcome. In the period since 2010, the Eurozone's rules-based governance model and the failure of governments to create a common safe asset for banks became a major factor contributing to Italy's financial fragility. It remains to be seen whether Europe's response to the COVID-crisis will mark a watershed, and break these financial markets dynamics.