Italy's debt has officially entered the danger zone. Here's how things got so bad for the biggest domino to fall in Europe.
Forget Lehman Brothers. Forget Greece. Italy, the world's eighth-largest economy, is teetering. Should it fall, the ensuing economic disaster will be unlike anything we've seen this decade.
The country's debt crisis, fueled by doubts over the government's ability to enact broad economic reforms, took a drastic turn for the worse yesterday, when Italy's bond yields rocketed above 7%. That's a crucial threshold--the bright red line Ireland and Portugal passed before their borrowing became so expensive that the European Union had to bail them out. This time, though, the stakes are higher and the options are more limited. Italy's debt is larger than the whole economies of Ireland, Portugal, and Greece combined. The euro zone simply might not have the political will or financial resources necessary to backstop those enormous obligations. As one analyst pointedly told CNBC, the country is "too big to fail, too big to save."
Like Venice in the lagoon, Italy's economy has been slowly sinking for a long time.
What's responsible for pushing Italy over the edge? Here are four forces to blame: the debt, the productivity shortfall, widespread corruption, or the slow South of Italy.
1. BLAME THE DEBT
Italy's debt ratio is the second worst in the euro zone, behind only Greece. The country's national debt weighs in at roughly 120% the size of its gross domestic product, or about $2.6 trillion. But that dizzying figure alone isn't what's causing panic in the marketplace. In fact, there was a time in recent memory when the market wouldn't have thought much of it at all. Italy has shouldered debt-to-GDP ratios well above 100% for about 20 years now, thanks largely to a government spending binge way back in the 1980s. In 1999, when Italy officially adopted the euro, its debt-to-GDP ratio was 126%.
So what changed? In a word: growth. Back in the go-go 1990s, Italy's government actually learned to budget carefully and enjoyed slow but consistent GDP growth. Low deficits kept the size of the debt stable, and an expanding economy, aided by moderate inflation, made it possible to finance interest payments on what the government already owed. Thus, the country's economy stayed afloat.
Then, like Venice in the lagoon, it slowly began to sink. Starting in 2001, Italy's GDP growth turned absolutely paltry. It finally plunged below zero during the global recession and has barely recovered since. Now investors are concerned about the country's ability going forward to cover its interest payments without incurring ever-higher levels of debt. Those fears, paired with jitteriness over Euro-zone neighbors like Greece, have forced Italy to pay more and more for credit. The 7% mark Italy crossed yesterday is key because, as Megan McArdle has pointed out, it's the cutoff where traders have to post extra collateral to buy and sell bonds. That's making it more expensive, and less appealing, for investors to lend Italy money. In the end, the government may not be able to sell enough new debt to cover its old debt--the same problem that put the stake in Lehman Brothers and Bear Stearns.
In a way, the easiest and oldest metaphor works best here. It's simplest to think of the Italian debt as a giant, maxed-out credit card tab. The government spent years covering the interest, but barely touching the principal. Then Italy's credit card company jacked up its APR--and we're all seeing the deeply unpleasant consequences unfold.
2. BLAME THE PRODUCTIVITY
Of course, poor long-term growth usually stems from poor economic fundamentals. And Italy's fundamentals are notoriously bad. It's difficult to pin down a single salient shortcoming, but its low productivity is a good place to start.
For developed Western economies competing with the rising powers in Asia, the most important route to growth during the past couple decades has been productivity--the amount of value each worker creates over time. Italy's productivity gains, meanwhile, have been abysmal. Reaching back to the 1990s, Italian employees have been clocking longer hours while producing less.
In June, the International Monetary Fund found that compared to other euro zone countries, Italy suffered from excessive regulation and a dearth of R&D spending. Because the economy is dominated by small and medium sized businesses--think of all those charming artisanal cheese and pasta makers--its capital markets are poorly devloped. And those mom-and-pop operations also aren't able to achieve the crucial economies of scale that create efficiencies.