Surging interest rates on Italy’s government debt represent an existential threat to the eurozone: with over $2.5 trillion in government debt, Italy may be too big to save. Higher interest rates impose a large, additional budget hit, but even more ominously, they affect the rates at which Italian firms and households borrow and make Italian banks—which hold Italian government bonds well in excess of their tier 1 capital—even more risk-averse, stifling the country’s already anemic growth.
It is difficult to find the silver lining in this abysmal development but, if there is one, it is that rising Italian interest rates will refocus attention on the only long-term solutions to the Euro crisis: the recovery of competitiveness in the European periphery and a tighter fiscal union. If markets continue to demand still higher interest rates of Italy—as they did of Greece, Ireland, and Portugal, and are doing of Spain—no tweaking of the European Financial Stability Mechanism or its bailout terms can save Italy. Given the dire global repercussions of a financial collapse in Italy—with or without Spain—a concerted G20 intervention should be considered. Such an intervention would, in effect, be a bailout not just of Italy but of the euro itself and of the eurozone as a whole, and should carry conditions that apply to all eurozone countries.
The Debt Problem
Italy is one of the most indebted countries in world, but that is hardly new: its government debt has exceeded 100 percent of Gross Domestic Product (GDP) since 1992. Moreover, compared to most other advanced countries, its fiscal management has been respectable in recent years. In the ten years preceding the financial crisis, Italy averaged a primary surplus (revenue minus spending, excluding interest payments) of 3 percent of GDP, over twice the eurozone average. As a result, its public debt fell from a peak of 122 percent of GDP in 1994 to 104 percent in 2007.
Italy’s relatively robust banks and its decision to adopt a de minimis stimulus package meant that the deterioration in its fiscal accounts during the financial crisis was contained compared to other countries. Since 2007, Italian public debt is estimated to have increased by 17 percent of GDP, a performance comparable to Germany’s (15 percent of GDP increase in debt), while Ireland (89 percent), Greece (47 percent), the United States (37 percent), and Portugal and Spain (both 27 percent) did much worse. The International Monetary Fund (IMF) expects Italy to be the only eurozone country to post a positive primary balance this year, and its debt/GDP ratio to gradually decline through 2016. Despite this relatively strong performance, the sharp rise in interest rates is making Italy’s debt burden unsustainable. However, though this sovereign debt crisis is its most acute symptom, Italy’s malady runs deeper, and its roots are found in the nexus between growth and competitiveness.
The Growth Problem
Italy’s long-term growth dynamics are among the worst in the advanced world, undermining its ability to service its debt. Since the 1990s, Italy’s labor force growth slowed markedly—and is projected to be negative this decade—while the rate of investment has declined modestly. Both of these factors represent a drag on growth compared to the 1970s and 1980s. However, faltering productivity is by far the most important reason for Italy’s remarkable growth slowdown. Its total factor productivity growth—the central driver of growth in advanced countries—has been lagging that of most other G7 countries and turned strongly negative in the 2000s, coinciding (causally or not) with euro adoption (see chart below).
The implications of Italy’s anemic growth, combined with high interest rates and high debts, are that larger primary surpluses (in the region of 5 percent of GDP) are needed just to stabilize the debt ratio. Achieving such large surpluses on a sustained basis presents a major political challenge—in only a few exceptional cases have advanced countries maintained such a surplus for a sustained period since World War II. But it also raises a more fundamental question: how can Italy break out of its rut of stagnating living standards and a government in perpetual austerity? Until this question is addressed convincingly, financial markets will continue to sense that the current Italian policy stance is not a credible one.
The Competitiveness Problem
These doubts are compounded by Italy’s massive loss of competitiveness since adopting the euro. In what should now be a familiar story, the interest rate decline and confidence surge in Greece, Ireland, Italy, Portugal, and Spain (GIIPS) that accompanied the introduction of the euro created a wave of spending and borrowing that raised the price of non-tradable goods and services relative to those that are tradable, and wages (labor is internationally immobile) relative to productivity. These wage increases—paired with a simultaneous suppression of unit labor costs in Germany, a relatively high euro, and a shift of resources toward Italy’s non-tradable sectors—have significantly reduced Italy’s and the other GIIPS countries’ presence on export markets. Tellingly, despite a 5.3 percent decline in domestic demand in Italy from 2007 to 2010, Italy’s current account deficit worsened from 2.4 percent of GDP to 3.5 percent during the same period.
Despite the deflationary effect of declining domestic demand, there is little sign that Italy is recovering competitiveness, as measured by unit labor cost—although its competitiveness gap with Germany has finally stopped widening (see chart below). So far, only very modest structural reforms have been introduced (for example, it is now easier to start a business and public-sector pay is more closely tied to performance than in the past).
What Italy Can Do
Unwinding Italy’s debt problem requires a two-part strategy: fiscal and structural. Sixteen months ago, when Italy faced interest rates of around 4 percent, we warned that Italy’s situation was more precarious than it looked and recommended an aggressive policy response. Specifically, we suggested that Italy increase its primary balance to 4 percent of GDP, cut public-sector wages by 6 percent, and pass critical structural reforms that remove labor and service market rigidities.
Now, with interest rates at 6.2 percent, these solutions are no longer sufficient. Italy must aim to raise its primary balance to approximately 5 percent and cut public-sector wages by 10 percent. In addition, it must more aggressively pursue structural reforms that restore competitiveness and stimulate growth, beginning with labor market reforms. Italian leaders must take these bold steps immediately to reassure markets: bond yields are quickly approaching the 6–7 percent threshold that touched off the interest rate spikes in Greece, Ireland, and Portugal that prompted EU and IMF rescues (see charts below).
What the World Can Do
A bailout of Italy—on the order of that organized for Greece, Ireland, and Portugal—would require a loan of $1.4 trillion. Bailing out Spain would cost an additional $700 billion. Such sums, representing some 16 percent of eurozone GDP, are unlikely from eurozone members alone, even if the IMF provides one-third of these amounts. Such bailouts would not only strain the frail political support for these exercises to the breaking point, they would also call into question the debt-carrying capacity of the core European countries.
At the same time, given the systemic global implications of a financial collapse in Italy, and possibly Spain, the rest of the G20 could hardly stand idly by as another Lehman-class global credit crunch unfolded.
A globally coordinated bailout—led by the IMF and including bilateral assistance from the United States, Japan, China, the UK, and other countries—would amount to 5 percent of the rest of the G20’s GDP. It would inevitably have to carry far-reaching conditions not only on Italy, along the lines set out above, but also on the rest of the eurozone.
What form would those conditions take? They would essentially push for changes that many European observers have been advocating but that politicians have been reluctant to pursue. They would probably include: a formula for principal reduction for countries in the periphery or for assistance as they leave the eurozone; mechanisms for increased fiscal transfers and shared fundraising (such as through the euro bond); closer coordination of fiscal policy; and structural reforms to encourage labor-market flexibility and labor mobility within Europe.
For the proud countries of Europe, these would be bitter pills to swallow. But they are the consequence of their continuing inability to shape their own future.