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.
The upshot: you have an economy dominated by red tape and small companies, which lack the funding to make technology investments that would improve their competitiveness.
And all of that's before you get to the labor market, which, according to the OECD, lags on almost every measure of efficiency. Italy's 8% unemployment rate is actually reasonable by today's standards. But that only tells a small part of the story. Much like Greece (and increasingly, the U.S.), Italy basically has a split job market--one for the young, and one for the old. Senior workers are protected by inflexible employment laws that make them hard to fire. Meanwhile, young Italians, who have an unemployment rate above 27%, are relegated to short-term contracts that leave them hopping job to job. That's not a recipe for a productive labor force.
3. BLAME THE GOVERNMENT (AND THE MAFIA)
The thing is, most of those problems aren't actually new. As Daniel Gros, director of the European Center for Policy Studies, wrote yesterday: "The fact that Italy has always been an economic policy disaster area does nothing to help us understand why its growth slowed around 1999/2000." On a lot of traditional measures, like education and capital formation, Italy has actually been improving for the last decade. But one important thing has been deteriorating: governance.
That's not shocking. After all, when your prime minister has to battle charges of tax evasion, something is probably amiss. Since 2000, most measures of good government have been on a downward slope. Gros breaks out the following chart:
Corruption and weak rule of law are poisonous for business. Beyond that, they also allow the country's robust underground economy to flourish. Stereotypes about Sicilian mob bosses aside, more than 15% of Italy's economy happens in the shadows--the government regularly releases an official estimate--costing the government about 100 billion euros a year. If 15 percent of the U.S. economy were black market, it would amount to $2 trillion, as much as we pay in federal taxes.
4. BLAME THE SOUTH
Italy's troubles are also a regional story. When Giuseppe Garibaldi united the country in the 19th century, he brought together three distinct regions: the republics of the North, the central papal states surrounding Rome, and the southern Kingdom of Sicily. Some believed that the regions were too distinct to function as a single country. And as the Economist has pointed out, the cultural divides have stayed shockingly impervious to change. GDP per capita in the North and center is more than 40% higher than the south, which holds about a third of the country's overall population. Unemployment, crime, and black market labor are also concentrated in the South. Imagine a country composed entirely of New York State, Mississippi and Alabama, and you begin to understand Italy's crisis.
What comes next for Italy is largely anybody's guess. Prime Minister Silvio Berlusconi's offer to resign after parliament passes a package of austerity measures and economic reforms did little to calm the markets, due to lingering political questions. But assuming the economy survives the run-up on the government's debt costs, and a technocratic caretaker government takes over to implement some painful reforms, one has to wonder what the end result will be. Italy didn't have a massive housing bust like Ireland. It's recent spending hasn't been wildly out of control like Greece. Its problem, in the end, is still just growth. And while some proposed changes to the labor market may help goose productivity, slashing budgets could land the country in an even larger hole. Might it eventually have to leave the euro? Having control of its own currency would give Italy the ability to inflate away part of its debt and strengthen its exports. But Italy is also the third largest economy in the EU. How you could untangle the two is difficult, if not impossible, to imagine.
But let's worry about that later. First, let's hope we avoid a disaster -- and maybe remember what brought us there.