What's the matter with Italy?
- 28 December 2011
- From the section Business
Italy has moved to centre stage in the eurozone debt crisis.
While Greece generated a lot of noise, it is now seen as a sideshow.
Greece's debt problems are already widely known and the immediate consequences of a Greek default largely anticipated.
Moreover, the size of the Greek economy is small enough that the direct damage, if Greece stopped paying its debts, should be quite manageable for the eurozone.
Instead, the big fear is "contagion" - that a Greek default could trigger a financial catastrophe for other, much bigger economies - in particular Italy and Spain.
And it seems it is Italy that is now seen as the lead candidate for that contagion. But why is this?
According to Germany's Chancellor, Angela Merkel, "Italy has great economic strength, but Italy does also have a very high level of debt and that has to be reduced in a credible way in the years ahead."
As with Greece, she and other eurozone leaders believe the solution is more government austerity - spending cuts and tax rises - by Rome.
However, some economists might disagree with her assessment.
The Italian government's debt, at 118% of GDP (annual economic output) is certainly high, even by European standards.
But dig a little deeper, and the picture changes.
Unlike their counterparts in Spain or the Irish Republic, ordinary Italians have not run up huge mortgages, and generally have very little debt.
That means that according to the Bank of International Settlements Italy as a country - not just a government - is not actually terribly indebted compared with other big economies such as France, Canada or the UK.
Moreover, the large debts of the Italian government are nothing new. It has got by just fine with a debt ratio over 100% of its GDP ever since 1991.
The main reason is because - unlike Greece - Italy has been actually quite financially prudent in recent times.
The government spends less on providing public services and benefits to its people than it earns in taxes, and has been doing so every year since 1992, except for the recession year of 2009.
Indeed, the only reason Italy continues to borrow at all is to meet the principal and interest payments on its existing debts.
So why is Italy in trouble now?
The reason is because its economy is so weak.
Italy is plagued by poor regulation, vested business interests, an ageing population and weak investment, all of which have conspired to limit the country's ability to increase production - problems that Italy's new government of unelected technocrats says it is trying to address.
The country has averaged an abysmal 0.75% annual economic growth rate over the past 15 years.
That is much lower than the rate of interest it pays on its debts.
And this creates a risk that the government's debtload could grow more quickly than the Italian economy's capacity to support it.
In the past, this risk has not materialised, thanks to Italy's relatively high inflation rate, which has steadily pushed up the government's tax revenues.
But now the outlook is much more grim.
Like other southern European economies, Italian wage levels rose too quickly during the good years, and left Italy uncompetitive versus Germany and other northern economies within the eurozone.
That lack of competitiveness is likely to mean many years of even weaker growth and low inflation, as Italian workers find their pay is frozen, or even cut, until they regain a price advantage over German workers.
But lower growth and inflation suddenly make the Italian government's debt load look much less sustainable.
Further government spending cuts are likely to hurt the economy even more, and - as Greece is discovering - may not even do much to improve the government's borrowing needs if they lead to a sharp rise in unemployment.
That scary outlook has freaked out markets, and lenders have been demanding a much higher interest rate from Italy in order to lend it the new money it needs to repay its old debts as they come due.
To borrow money for 10 years, current market prices suggest Italy would have to pay about 6.8% interest.
Germany, by contrast, must pay only 1.9%.
The situation is not looking quite as critical for Italy as it was a month ago, thanks largely to steps taken in recent weeks by the ECB to help prop up the eurozone's banks - which means the banks are in turn better able to prop up their governments.
But Italy's long-term borrowing cost has remained doggedly high. Because no matter how much cash the ECB throws at Italian banks, the country's underlying economic problems will not disappear overnight.
And of course this higher cost of borrowing makes Italy's debts look even less sustainable.
The risk is that the market's loss of confidence in Italy could well end up becoming a self-fulfilling prophecy.
If nobody will lend to Italy, then Italy cannot repay its debts. And if Italy cannot repay its debts, then nobody will lend to it.
And if markets do panic again, and switch their money out of Italian debt into "safe" German debt, Italy would need an enormous bailout that would dwarf the 440bn-euro bailout fund agreed in July.
The European Financial Stabilisation Facility is in any case looking dead on arrival.
Doubts over the ability of other eurozone countries - notably France - to foot their share of the collective bailout bill have made it harder for even the EFSF to borrow money.
Rating agency Standard & Poor's seemingly put the last nail in plans to use the bailout fund to rescue Italy and Spain, when it threatened to downgrade all eurozone governments.
Meanwhile other rescue plans - such as getting Europe's national central banks to lend to the International Monetary Fund, who would then onlend to Italy - have also fallen by the wayside.
So far, there has been no political will shown in the places that matter - the ECB headquarters in Frankfurt and the German capital Berlin - to launch a major rescue. Although if push comes to shove, that could well change.
The role of the ECB, and its potentially limitless firepower, is most relevant.
The central bank can literally create the money it needs to lend to Italy.
But so far, its new Italian head, Mario Draghi, has agreed with the German line that it would be a breach of the spirit of the ECB's mandate to countenance any form of "monetisation of government debt".
Behind the official line are three concerns that play on the minds of the ECB bankers, particularly its German ones:
- bailing out Italy will simply encourage its government to continue with their reckless spending
- printing money will stoke inflation
- if Italy failed to repay the rescue loans, it could leave the ECB itself in need of a bailout, and that could destroy its independence.
The rise of former European Commissioner Mario Monti to the Italian premiership following the ousting of Silvio Berlusconi has answered the first of those objections.
The likely recession in Europe also probably lays to rest the ghost of inflation even in German minds at least for the next year or two.
There is also growing talk of the ECB buying up government debt, from all governments, not just Italy's, by following the US central bank and the Bank of England in implementing "quantitative easing" to support the eurozone economy.