What Italy tells us about Europe’s debt crisis

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So we all know Italy is a mess. Its government debt to GDP ratio of 127% in 2010 is the third worst in the OECD (after Japan and Greece). Economic growth is practically nonexistent, with growth surpassing 2% only once since 2001. So is it any surprise that Italy has been tarred as one of the PIIGS and fallen into a debt crisis?

Actually, it is. Yes, Italy has its economic problems, but its government has not been fiscally irresponsible, with a much more conservative record than most other countries in the developed world. In other words, Italy has been gripped by Europe’s debt crisis even though it really doesn’t deserve to be. That scary fact tells us a lot about where Europe’s debt crisis may be headed.

Though it is easy to poke fun at Italy, with its sometimes silly politics, archaic economic structure, low productivity and poor competitiveness, the government nevertheless should be praised for its sound financial management. Italy’s government debt level has not spiked upwards like it has in so many other developed economies in recent years, and it is roughly the same today as in the late 1990s. Nor did the government blow out its budget during the financial crisis. Here’s how Stephen King, chief economist at HSBC, explained Italy’s performance in a recent report:

While it was possible to argue that the Greeks had brought the crisis upon themselves, that the Irish had mismanaged their banking system, that the Portuguese had a cripplingly weak economy and that the Spanish had all sorts of demons hidden away in their unlisted banks, it’s a lot more difficult to argue that Italy has really done anything wrong…From a poor starting position, Italy’s fiscal behaviour has been exemplary in recent years…Whereas Germany’s debt/GDP ratio has risen by more than 25 percentage points, America’s by 33 percentage points and Japan’s by 73 percentage points, Italy’s has been virtually unchanged since the formation of the euro. Italy may have been bad in the past, but others are far naughtier today…The result of all this good behaviour is that Italy’s 2011 budget balance, according to the OECD, will be in line with the euro average and a lot better than the UK, the US, and Japan. Its primary balance – excluding debt interest payments – will be the best in the entire industrialised world, better even than Germany, better than the likes of Greece, Spain, Ireland and Portugal and, for what it’s worth, miles better than the UK,  Japan, and the US.

But markets have punished Italy anyway. Earlier this month, the yield on Italy’s sovereign bonds – an indication of how risky investors believe they are to hold – spiked over 6%. They have fallen recently, to around 5%, but to a great degree due to heavy intervention by the European Central Bank through a bond-buying program. The pressure on Italy has even sparked talk the country might default. Douglas McWilliams, CEO of the Centre for Economics and Business Research, proclaimed in a report earlier this month that “realistically, Italy is bound to default” due to its combination of low growth and high debt:

Although Mr. Berlusconi has actually managed to run a tight budget, it is still not tight enough. And if the markets continue to force on them borrowing costs at around 6% and growth stays close to zero, our calculations show the debt GDP ratio rising gradually to over 150% by 2017. Even if the cost of borrowing goes back down to 4%, their growth rate is so anaemic that we see the debt GDP ratio remaining at 123% in 2018. This is purely mathematical. Because the bond market has assumed optimistic growth rates, it believes that the critical bond yield above which a debt position is unsustainable is about 7%. Actually, with the very sluggish growth in Southern Europe as a result of the competitive hits that the countries have taken from staying in the euro, the maximum sustainable bond yield is nearer to 4‐5%.

So are the markets treating Italy unfairly? Probably. Why should Italy, which has at least attempted to get its fiscal accounts in order, be forced to pay yields multiple times higher than the U.S. or Japan, which have shown no such initiative? The fact that Italy is in the predicament it faces today tells us just how far and deep the European debt crisis has progressed. Italy is in effect getting punished for the bad behavior of others, especially the wishy-washy, self-involved leaders of the euro zone. It is because German Chancellor Angela Merkel, French President Nicolas Sarkozy and the rest of the bunch have failed to resolutely tackle the debt crisis that Italy is under pressure today. In other words, Italy is suffering because of the lack of real leadership in Europe.

Italy may also have sunk into the debt crisis for another, even scarier reason: Investors may be starting to price European sovereign debt based on an assumption the euro won’t survive. Here’s more from HSBC’s King:

The bet on Italian bonds is being made not because the Italian fiscal position is particularly bad but instead because of the fear associated with a euro collapse. The underlying assumption is simple. A eurozone collapse which led to the reintroduction of separate currencies would re-establish the old distinction between a “strong Deutsche Mark core” and a “weak periphery”. To compensate for the danger of peripheral currency weakness, spreads on peripheral bonds would then have to widen.

So the case of Italy highlights a few painful realities for the euro zone. First, individual reforms and austerity programs in individual countries within the euro zone are not sufficient to solve the debt crisis. We need to see reform and coordinated action across the euro zone. Secondly, growth has to be a priority, since with higher growth, the debt outlook for Italy, and the rest of the Europe, would improve, and so would investor sentiment. Third, and most importantly, the persistent inaction and lack of urgency on the part of the euro zone’s political leadership is beginning to make fears of a complete collapse of the euro self-fulfilling.