Italy’s Going Under, But Don’t Blame Berlusconi
The eurozone debt crisis simply refuses to go away. Last month’s latest and greatest plan put forward by European leaders has already been judged by financial markets to be insufficient. And while it is political uncertainty in Greece that has thrown the whole process into question, the main victim has actually been Italy; in the days since the rescue package was announced, Italy has found its borrowing costs rising to record levels as investors continue to expect the worst.
But why are investors picking on Italy? To some, the answer is obvious: Italy is just another Greece, only on a far bigger scale. The similarities are conspicuous, after all. Aside from those hot summers and striking Mediterranean coastlines, Italy also shares Greece’s outsized debt burden, a notoriously inefficient public sector, and uncompetitive industries. But these similarities should not fool us into thinking that Italy has been dragged into crisis for the same reasons. Unlike Greece or Portugal, Italy wouldn’t be experiencing such turmoil if the ground hadn’t already been thoroughly prepared by others. Put another way, Italy’s crisis is the result of what economists refer to as “contagion”; if someone else hadn’t gotten sick first, then Italy would likely still be relatively healthy today.
This is a crucial distinction with important policy implications. If the crisis now hitting Italy is the result of changes in market psychology rather than economic fundamentals, then the spending cuts being considered by Italy’s parliament, as helpful as they might be for Italy’s long-run budget prospects, will do nothing to avert catastrophe for the country in the short run.
THE KEY QUESTION is whether or not it is fair to describe Italy as “insolvent.” With Greece, there’s no such ambiguity: The Greek government clearly has no realistic chance of ever repaying everything it owes to its creditors, and is therefore well and truly insolvent. That is why no one is willing to lend to Greece any more, and why an essential piece of the most recent eurozone rescue plan was a write-down in the amount of money that Greece owes to a level that is plausibly manageable.
With Italy, however, things are less clear. Some observers, such as Paolo Manasse, an economics professor at the University of Bologna, argue that Italy’s debt burden has simply reached a level that is no longer sustainable given its recent history of poor growth and lackluster competitiveness, rendering the country insolvent in the same way as Greece. Indeed, there’s no denying that Italy’s economic growth has been dismal recently, or that its outstanding government debt is extraordinarily large: At about 130 percent of GDP, Italy has the second-highest debt-to-GDP ratio in Europe (after Greece, of course). These superficial similarities make it very easy to see Italy as simply another overly-indebted country in the eurozone periphery that is finally seeing its chickens come home to roost.
But this interpretation overlooks some crucial differences. For one, Italy’s stock of debt may be high, but this debt is largely left over from chronic deficit spending in the 1970s and 80s. Italy’s debt-to-GDP ratio has been over 100 percent for more than 20 years, yet until the past few months no one seriously questioned its solvency. And for most of the past decade Italy has actually run a primary budget surplus, meaning that it has been able to meet all of its spending needs, excluding interest payments, without any additional borrowing. Nor was that expected to change any time soon; as recently as June, a forecast by the OECD predicted lower deficits in Italy than in France or the UK, and for Italy’s debt burden to fall, not rise.
These are not the characteristics of a country with a runaway debt problem, and there was no significant indication that the financial markets viewed Italy’s debt burden as unsustainable. Yet suddenly, in early July of 2011, investors lost their willingness to lend to Italy and Italian interest rates began to leap upwards, unchecked until the European Central Bank stepped in to prevent market panic in early August. What changed?