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Credibility is not everything

UPDATED: Changes in the Italian government are driven by the country’s dire debt situation. This column, which updates a 31 October column that illustrated the unsustainability of Italian debt, argues that Berlusconi’s departure is necessary but far from sufficient. Drastic, but evenly distributed measures of consolidation and reform are necessary.

Editor's note: This column further updates the column originally posted on 31 October 2011. 

Prime Minister Berlusconi received just 308 votes in the Italian House of Deputies; the measure (an important but technical matter, the Final Balance Report) was approved even though this did not reach a majority of 316 because of mass abstention by opposition members. The consequences are severe however, since this was basically a ‘shadow’ vote of confidence and the Prime Minister lost.

Berlusconi: What's Next?

These are, in my opinion, the four most likely scenarios.

  1. Berlusconi, after the meeting with President Napolitano, insists on resigning only after the approval of the Stability Plan agreed with the EU and the ECB. The parliament quickly approves the Plan with some some support from the oppositions;

  2. Berlusconi resigns but  is replaced by one of his party faithfuls (e.g. Mr Alfano, PDL party President, or Mr Letta, his Under Secretary);

  3. None of the above, as the Berlusconi straw men would not be able to elicit the support from the opposition;

  4. Mr Napolitano could then give an exploratory mandate to Mr Monti (or someone similarly well respected) who draws support from centrists and the centre-left party.

If the Monti option is pursued, there are two possible outcomes:

(a) political stalemate : Berlusconi's party, together with the Northern League, opposes anyone not drawn from its ranks, the Monti experiment fails and new elections are called with a Berlusconi caretaker government, unable to implement the Plan. Spreads soar, Italy files for intense ECB/IMF emergency resuscitation aid, bonds price collapse sending huge shocks to banks' balance sheets and possibly leading to widespread bank runs.
(b) coalition government: in order to gain time and avoid a sharp defeat in the elections, the PDL breaks up with the Northern League and accepts an independent new Prime Minister and a coalition government, in order to implement the measures contained in the EU/ECB letter. New elections are be postponed until sometime next year. Spreads fall, although only gradually.

Which scenario will materialize will depend on what sort of influence Mr Berlusconi will be able to retain in his own party. The larger his influence the more likely the stalemate scenario (Let Samson die with all the Philistines !)   

Update from 7 November 2011

Finally, Berlusconi’s time seems to be over. A slow, but seemingly unstoppable landslide of rightwing MPs to the centre-left opposition is making it very likely that, next Tuesday, the government will lose its majority in a crucial parliamentary vote on the Stability Law. He may even resign before the vote.

Resigning early would not just be to avoid a shameful dethroning (Mr. Berlusconi’s penchant for shameless behaviour is notorious), it would give him leverage when it comes to crowning his successor. Resignation might also facilitate an eventual resurrection in due time.

  • If one of the Prime Minister’s straw men, such as Under Secretary Mr. Letter (a journalist and former employee of Berlusconi), succeeds his mentor, nothing will change and Italy will be doomed.
  • The alternative, seemingly favoured by President Napolitano, would be a centre-right centre-left Greek-style coalition headed by Mr. Monti.

A wise economist of international reputation and no political ambitions, he may succeed into forcing a recalcitrant Parliament (après moi le deluge) into approving drastic, but evenly-distributed consolidation and reform measures, and lead the country to new elections next year.

As I wrote in my 31 October 2011 column, Italy’s debt fundamentals are a disaster. Today, Italian spreads over 10 years German Bunds exceed 4.5% - escalating to levels of 15 years ago. Back then, the debt/GDP ratio was as high as today’s, but the primary balance was in a much better shape. With spreads at these levels, the haircut requirements for banks borrowing against Italian collateral will further reduce the attractiveness of Italian Bonds and accelerate the roll-over crisis.

Until a few months ago, the markets gave too little consideration to Italian fundamentals, assuming that Italy’s default and EZ exit was impossible. Today’s spreads with today’s deficits make a dangerous combination. Mr Berlusconi’s resignation, while probably necessary at this point, will hardly be a sufficient substitute for a painful and prolonged fiscal adjustment.

Mr. Berlusconi has lost contact with reality – according to him, Italians are unaware of the crisis, as “restaurants and travel agencies are full”. The truth is that the country’s shambles are well epitomized by the recent floods in Genoa and in the beautiful Cinque Terre of Liguria. Decades of abuse in construction, lack of infrastructure investment and widespread corruption are finally taking a heavy toll – on the land as well as on the economy.

Original column

31 October 2011

Many observers of the European debt crisis have embraced the idea that ​the dangers, in particular the risk of default of Italy, lie in the possibility of ‘multiple equilibria’. According to this view, when economic fundamentals, such as the debt/GDP ratio and the primary balance, are not quite ‘as good’ as to guarantee solvency but not quite ‘as bad’ as to make the country plainly insolvent, then the equilibrium outcome depends on market expectations (see for example Alesina et al 1989). In other words, self-fulfilling prophecies may generate opposite and unpredictable outcomes, for the same level of fundamentals. If the market assigns a high probability to a default, it will require a very high risk premium in order to buy governments bonds, making it convenient (or unavoidable) for the government to default, rather than risk strangling the economy in order to generate the surplus required to repay the loan (bad equilibrium). Whereas, if markets are confident in the government’s ability and/or willingness to repay, the low yields will generate the right incentives for the government to fulfil the market expectations (good equilibrium). This gives rise to the idea that ‘credibility is everything’.

One corollary of this approach, at the European level, is that unless the EFSF has sufficient firepower to fight off a speculative attack, say €3 trillion, it may not prevent a rollover crisis stemming from a shift in market expectations. Another corollary, relating to the Italian case, is that a sufficient condition for saving Italy is for Mr Berlusconi, who has lost international credibility, to step back. I argue here that this latter condition, while possibly being necessary at this stage, is unlikely to prove sufficient. Market fundamentals are, unfortunately, still decisive.

The theory

The argument for multiple equilibria has a number of problems. From the standpoint of the theory, it is well known that this result stems from two simplifying assumptions: that each economic agent fully observes all the relevant fundamentals, and that everyone has no uncertainty about the behaviour of other agents. This allows agents to coordinate perfectly on one or the other equilibrium. Yet, if these assumptions do not hold, then economic fundamentals are back on centre stage, as they unambiguously determine expectations themselves. Hence the equilibrium is again uniquely determined by the strength of fundamentals (Morris and Shin 2000).

The evidence

Figure 1. 

Source: Author’s calculation on Eurostat data

For the Italian case, the story of multiple equilibria is even less convincing. Figure 1 plots the average interest rate on Italian debt (red line), the ratio of the interest bill to GDP (blue line), the primary balance/GDP ratio (line in purple), and the debt/GDP ratio (green line, right scale) from 1996 to 2011 (the euro was introduced in 1999). The Figure shows how, 15 years ago, the elimination of currency risk allowed Italy to bring down the average cost of debt from 10% to below 4% today, while the interest bill fell from 12% to 4% of GDP, allowing a significant improvement of the budget and a strong reduction of the debt ratio, at least until 2004. Note, however that the adjustment effort, represented by the primary balance relative to GDP, gradually weakened over the years. In 2005–06, coinciding with the third Berlusconi government, the debt/GDP ratio started to climb back (Manasse 2011). In 2008–11, thanks to the crisis and the fourth Berlusconi term, the debt reached its 1996 GDP ratio, the primary balance fell in negative territory (and marginally rebounded). Fifteen years of progress were squandered. What the Figure clearly shows is that the puzzle is not that the interest rates are now going up, with a limited impact so far on the interest bill. The puzzle is that interest rates have risen so little and so late, despite the worsening of fundamentals. It is really not necessary to resort to esoteric explanations such as contagion (see Manasse and Triglia 2011) and multiple equilibria in order to explain the recent rise in Italian yields, when the debt/GDP ratio is back to its 1996 level and the primary surplus is about four points of GDP lower than in 1996.


Until a few months ago, the markets apparently gave too little consideration to fundamentals such as the debt/ GDP ratio and the primary surplus, thinking that Italy’s default and exit from the euro was inconceivable. If markets now think back, we can expect bond yields a return to the levels of 15 years ago. Mr Berlusconi’s resignation, while probably necessary at this point, will hardly be sufficient and substitute for a painful and prolonged fiscal adjustment.


Alesina, A, A Prati, and G Tabellini (1989), "Public Confidence and Debt Management: A Model And A Case Study of Italy", CEPR Discussion Papers 351.

Manasse, Paolo (2011), “Berlusconi nel "Chart of the Day"”, Back-Of-The-Envelope Economics, October.

Manasse, Paolo and Giulio Trigilia (2011), “The fear of contagion in Europe”, VoxEU.org, 6 July.
Morris, Stephen, Hyun Song Shin (2000), "Rethinking Multiple Equilibria in Macroeconomic Modeling”, NBER Macroeconomics Annual, 15:139-161.

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