An irony of Italy’s unfolding political and economic drama is that many of the current holders of Italy’s bloated and ever-increasing government debt were once proud holders of Argentina’s now defaulted sovereign bonds. As Mario Draghi, the country’s new central bank governor, warns that the Italian economy has “run aground” and as in the run up to next month’s elections Prime Minister Berlusconi periodically vents about “the euro having been a disaster for Italy”, one has to wonder at what stage Italy’s bondholders will get the feeling that they have been to this sad movie before.

For quite aside from Italy’s disturbing political and institutional weaknesses--as exemplified by the current fractious and polemical election campaign and by yet another big banking scandal that further besmirches the Italian financial system’s reputation--the country’s present economic and financial predicament is conceptually remarkably similar to that of Argentina in the late 1990s. Mr. Draghi himself implicitly recognizes this similarity when he correctly asserts that Italy must improve its productivity performance if it is to have any hope of reversing the country’s relative decline.

The most striking of the similarities between today’s Italy and yesterday’s Argentina is the extremely rigid currency arrangements in which the two countries managed to lock themselves. As a reaction to its harrowing mid-1980s experience with hyperinflation, in 1991 Argentina nailed its currency “immutably” to the Convertibility Plan cross. It did so in the hope of forcing upon the country the low inflation and fiscal policy discipline that it had never before enjoyed.

In a similar effort to impose macro-economic discipline, Italy too has supposedly given up forever any room for exchange rate flexibility. It did so in 1999 by abandoning the lira in favor of the euro. Gone were supposed to be the days of high inflation and periodic lira devaluations. In were supposed to be the days of fiscal discipline and structural reform.

By abandoning the lira, Italy, like Argentina before it, has given up all macro-economic policy flexibility to stabilize its economy. No longer having its own currency, Italy cannot engage in periodic exchange rate devaluations, as it did in the past, to rectify losses in international competitiveness.

And no longer having its own monetary policy, Italy has to accept the interest rates set by the European Central Bank even though these rates might not necessarily conform to Italy’s particular circumstances. When Mr. Trichet recently tightened European monetary policy because of high international oil prices, did he really give much weight to Italy’s present cyclical weakness?

As if no longer having an independent monetary and exchange rate policy were not bad enough, under Europe’s Fiscal Stability Pact, Italy is committed to strengthening its public finances at a time of cyclical weakness. For like Argentina of the 1990s, Italy’s public finances are in a real mess. With a public debt to GDP ratio in excess of 105 percent, Italy is the most indebted of the major European countries. And with a government budget deficit of around 4 percent of GDP, despite the relatively low interest rates at which that deficit is still financed, Italy is in clear violation of Europe’s Maastricht criteria.

More disturbing still is Italy’s present lack of international competitiveness. Over the past five years, Italy has lost around 20 percentage points of competitiveness to Germany as wage increases in Italy were not matched by productivity gains. At the same time, Italy’s failure to modernize its industries and to move up the technological ladder has left Italy exposed to the full winds of Chinese competition in today’s increasingly globalized economy.

Italy’s loss of macro-economic policy instruments would not be of such great moment if its economy were booming. All too sadly, however, this is far from the case. Already over the past three quarters, the Italian economy has for all intents and purposes been in recession. And under the weight of high international oil prices, this recession is only likely to deepen.

As was the case of Argentina before it, the only real way out for Italy is for it to restore competitiveness through far-reaching structural reforms, especially in the labor market. However, if the present election campaign is anything by which to go, one needs to ask how much more likely are such painful reforms in Italy today than they were in Argentina under Carlos Menem. One also needs to remember how difficult it will be for Italy to regain competitiveness in a very low inflation environment.

In the absence of real reform, the most likely scenario for Italy will be a prolonged period of economic stagnation, if not recession, and an ever increasing public debt. This will likely lead the rating agencies to again lower their Italian outlook and it will force the ECB to periodically bail Italy out notwithstanding the ECB’s “no bail out” clause. However, in the same way that Argentina made the mistake of forever counting on IMF goodwill to paper over its economy’s weaknesses, Italy will be making a grave error if it postpones painful market reforms and relies instead on the indefinite indulgence of the ECB.

Desmond Lachman is a resident fellow at AEI.