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 anaemic 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 the world, but that is hardly new. Its government debt has exceeded 100% of GDP since 1992. Moreover, compared to most other advanced countries, its fiscal management has been respectable in recent years. In the 10 years preceding the financial crisis, Italy averaged a primary surplus (revenue minus spending, excluding interest payments) of 3% of GDP, more than twice the Eurozone average. As a result, its public debt fell from a peak of 122% of GDP in 1994 to 104% in 2007.
Italy’s relatively robust banks and its decision to adopt a minimalist 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% of GDP, a performance comparable to Germany’s (15% of GDP increase in debt), while Ireland (89%), Greece (47%), the US (37%), and Portugal and Spain (both 27%) did much worse.
The 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 (Baldwin et al.,2010). Since the 1990s, Italy’s labour force growth has 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 Figure 1 below).
Figure 1. Average total factor productivity growth by decade
Sources: Author's calculations based on World Bank, IMF and OECD data.
The implications of Italy’s anaemic growth, combined with high interest rates and high debts, are that larger primary surpluses (in the region of 4.5% of GDP) are needed just to stabilise 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 (labour is internationally immobile) relative to productivity. These wage increases – paired with a simultaneous suppression of unit labour 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% decline in domestic demand in Italy from 2007 to 2010, Italy’s current-account deficit worsened from 2.4% of GDP to 3.5% 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 labour 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).
Figure 2. Change in real effective exchange rates since 2000
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%, we warned that Italy’s situation was more precarious than it looked and recommended an aggressive policy response (Dadush et al. 2010). Specifically, we suggested that Italy increase its primary balance to 4% of GDP, cut public-sector wages by 6%, and pass critical structural reforms that remove labour and service market rigidities.
Now, with interest rates at 6.2%, these solutions are no longer sufficient. Italy must aim to raise its primary balance to approximately 5% and cut public-sector wages by 10%. In addition, it must more aggressively pursue structural reforms that restore competitiveness and stimulate growth, beginning with labour market reforms. Italian leaders must take these bold steps immediately to reassure markets: bond yields are quickly approaching the 6–7% threshold that kicked off the interest rate spikes in Greece, Ireland, and Portugal that prompted EU and IMF rescues (see Figure 3).
Figure 3. Ten-year bond yields
What the world can do
A bailout of Italy – on the order of that organised for Greece, Ireland, and Portugal – would require a loan of $1.4 trillion. Bailing out Spain would require an additional $700 billion. Such sums, representing some 16% of Eurozone GDP, are unlikely from Eurozone members alone, even if the IMF were able to provide some significant part of these huge amounts. (In the case of Greece, Ireland and Portugal, the IMF provided one-third of the total.) Such bailouts would not only strain the frail political support for these exercises to 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 US, Japan, China, the UK, and other countries – would amount to 5% 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 conditions on the Eurozone 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; pursuit of a monetary policy more reflective of conditions in the periphery; demand expansion in the core; and structural reforms to encourage labour mobility within Europe.
For the proud countries of Europe, these conditions will be bitter pills to swallow – the consequence of their demonstrated inability to master their own future. But we are now at the stage where we need to save the euro from the Europeans.
Baldwin, Richard, Daniel Gros, and Luc (eds.) (2010), Completing the Eurozone rescue: What more needs to be done?, A VoxEU.org Publication, 17 June.
Dadush, Uri et al. (2010), “Paradigm Lost: The euroin Crisis”, Carnegie Endowment for International Peace.