Going for Broke, Is Italy Next?
Going for Broke, Is Italy Next?

A huge government debt, a sluggish economy, and a divided political system are three of the biggest problems facing countries around the world. With a debt of 1.2 trillion Euros, a debt-to-GDP ratio of 120 percent, a government bond rate nearing seven percent and less than one percent annual growth, Italy’s new Prime Minister Mario Monte has his work cut out for him. Are these challenges insurmountable for Europe’s third largest economy?

Compounding the debt is the high interest rate of government bonds. Some estimate that Italy is the third largest issuer of debt in the world.1 Italy’s government, like many governments worldwide, issue bonds to pay for anything the government needs to do, such as infrastructure investments, military purchases, etc. High interests for government bonds means that the government has to pay back even more money to the entities (a bank, another country, etc.) that buy the bonds. When Greece and Spain faced bond rates that were higher than seven percent, the people rioted. So far this has not happened in Italy.

For every additional percent of interest, Italy has to pay an additional three billion euros in debt service. In seven years, when the bonds mature, the impact of the high interest rates will be devastating. Some countries have chosen to repay debt through austerity measures. Drastic austerity measures in Italy though could push the country into a recession, further increasing the debt-to-GDP ratio.2 Cuts made across the board tend to be inequitable and prevent much-needed investment as well.3 Some austerity is needed, but it needs to be accompanied by policies to increase exports.4

This analysis will examine the roots of Italy’s sovereign debt crisis, steps Italy will need to take to grow itself out of this debt, and the role of Europe in containing this crisis.

Where it all began, the roots of Italian Debt

Since the mid- 14th century, Italian city governments started using citizen funds for state purposes. Wealthy Florentines were required to buy city debt securities, which they were allowed to sell to others. Other city-states, such Siena, Pisa, and Venice, followed suit.5 The practice has been used ever since.

Modern Italian debt ballooned during the 1980s. Political parties funded government agencies and state-owned companies in the poor southern part of the country. To allow the parties to stay in power and keep the peace, clientelism, nepotism, corruption and tax fraud became commonplace. Huge city government expenditures still exist throughout the country, especially in provincial capitals run by coalition governments.6

Before joining the EU, Italy often devalued the lira as a means of retaining its economic competitiveness.7 Once Italy became part of the Eurozone, the problem did not resolve itself. Instead, the country became further indebted. The government spends 14 percent of its aggregate output on pension benefits for retired government workers. Only France pays a higher percent to pensions.

While the government has amassed large amounts of debt, Italian banks are in fine condition. The large banks had conservative lending policies and are well capitalized due to the high savings rate of the average Italians. In fact, Italians own about €4.832 trillion in real estate, of which only seven percent is burdened with mortgages. If this wealth was tapped through mortgages, Italy could eliminate its interest payment problem.8

One of Italy’s strengths is that more than half of the government debt is held domestically. Many small family businesses invest their pension funds in government bonds. Some believe that the real problem is not the size of Italy’s debt ratio or the deficit, but rather the cost of financing it from low growth.9

It’s all about Growth, how can Italy Grow Its Economy?

For the past decade, the Italian economy has been growing at an average rate of .2 percent per annum. There has been no productivity increase per hour worked. An IMF report notes that reform is needed across the economy to address low productivity and an inefficient public sector. Local expenditures account for one-third of public expenditure, which needs greater oversight.10

More than 13,000 businesses are government-owned, such as the postal service, the national railway provider, parts of the national airline, Alitalia, and electric and water utilities. Many of Italy’s small and medium-sized enterprises have not been able to grow. Privatization would help increase competition and profitability in the long-run, but the government would suffer in the short-run, as some of these businesses are highly-profitable.11

Competition is further hindered by high levels of business and service regulations. The tax burden is also high.12 Sales and income tax are high, even higher than Germany. Italy’s tax system needs urgent reformation.13 Political deadlock has prevented the passage of the reform agenda thus far, but many believe the new Italian Prime Minister will be able to do so.

Another sector that needs to be reformed to increase economic growth is the labor market. Italy’s labor market is split into two parts: 1) protected full-time workers with benefits and good wages and 2) temporary workers (mainly younger workers) who move from one contract to the next. Unemployment amongst youth is about 28 percent, while female employment is only about 40 percent. Harmonizing labor contracts and developing a more decentralized bargaining system could help increase productivity and competitiveness.14

Italy cannot do it alone, the Role of Europe

Italy accounts for 16.8 percent of the EU GDP. It is Europe’s third largest economy, behind Germany and France.
15 One of Italy’s challenges though is that it needs more export markets and European markets are contracting under austerity measures.16 This does not bode well for Martin Wolf’s recommendations, which rely on decisions made by Germany and the European Central Bank (ECB).

Martin Wolf recommends three steps to help Italy out of its debt crisis: 1) backstopping the financing for the rollover of sovereign debt (1 billion Euros/$1.4 billion), 2) seeking profitable and dynamic external markets, and 3) strengthening political underpinnings of the European Union (which makes break-up inconceivable).17

The European Central Bank has to decide whether it become like the U.S. Federal Reserve Bank and print money to ensure the markets run smoothly and bail out members of the Eurozone. The ECB has bought some small amounts of Spanish and Italian bonds, but not very large quantities.18

Traditionally, the ECB focuses on price stability and has not printed money, as some believe this is not allowed. The ECB is actually forbidden to finance the Eurozone governments. French and German leaders believe that the crisis is pressuring European governments to rein in spending and enact needed reforms. They believe an ECB rescue would not solve the problem, just push it further down the line. German banks are the biggest contributor of capital to the ECB and hold two of the twenty-three votes in the bank’s governing council.19

The ECB could buy unlimited bond and print money, but it needs political cover to do so. Germans are understandably cautious because if Italian (or Spanish) bonds are downgraded in the same way Greece’s were, then German banks would have to recapitalize the ECB. In other words, German taxpayers would be covering the debt of other Eurozone countries without parliamentary approval.20

What’s Next for Italy

Prime Minister Monte recently unveiled his growth-boosting program to the Italian Senate. He seeks to change the labor market and pension system, fight tax evasion, and address the problematic regulations that hinder growth. All Italians were asked to sacrifice and he pledged that the sacrifices will be evenly spread. The current two-tiered employment system will be changed and more young Italians will be given access to jobs. Professional guilds will be deregulated and opened up to competition. Property taxes on first homes will be introduced. Tax evasion and the underground economy (said to be worth 20 percent of the annual GDP) will be addressed. His three targets are: fiscal rigor, economic growth and social fairness.21

His speech has been well-received by commentators across Italy. 22 If passed, it will make a serious dent in Italy’s debt and, more importantly, address many of the structural problems that have contributed to the debt in the first place. Hopefully Italians will find the political will to pass the legislation and make the sacrifices necessary for their government to recover and to serve as a model for countries around the world facing many of these same problems.


1 Gorenstein, Peter. “Italian Debt Crisis Has Global Markets on Edge. Here’s Why It Matters to You.” Yahoo Finance. November 7, 2011.
2 Irvin, George. “Italy’s crisis could be a blessing in disguise.” The Guardian. November 7, 2011.
3 “Italy’s Main Challenge Is To Boost Growth.” IMF Survey Online. July 12, 2011.
4 Wolf, Martin. “Europe must not allow Rome to burn.” The Financial Times. November 15, 2011.
5 Smoltczyk, Alexander. “Italians Leave Fears of Debt Crisis to Others.” Spiegel Online. October 19, 2011.
6 Ibid.
7 Johnson, Eric. “Fixing Italy will be no monty.” The Sydney Morning Herald. November 17, 2011.
8 Smoltczyk, Alexander. “Italians Leave Fears of Debt Crisis to Others.” Spiegel Online. October 19, 2011.
9 Irvin, George. “Italy’s crisis could be a blessing in disguise.” The Guardian. November 7, 2011. 10 “Italy’s Main Challenge Is To Boost Growth.” IMF Survey Online. July 12, 2011.
11 Smoltczyk, Alexander. “Italians Leave Fears of Debt Crisis to Others.” Spiegel Online. October 19, 2011.
12 “Italy’s Main Challenge Is To Boost Growth.” IMF Survey Online. July 12, 2011.
13 Smoltczyk, Alexander. “Italians Leave Fears of Debt Crisis to Others.” Spiegel Online. October 19, 2011.
14 “Italy’s Main Challenge Is To Boost Growth.” IMF Survey Online. July 12, 2011.
15 Cadman, Emily and Birkett, Russell. “In numbers: Italy’s importance to the Eurozone.” The Financial Times. November 16, 2011.
16 Johnson, Eric. “Fixing Italy will be no monty.” The Sydney Morning Herald. November 17, 2011.
17 Wolf, Martin. “Europe must not allow Rome to burn.” The Financial Times. November 15, 2011. 18 Ewing, Jack and Kulish, Nicholas. “European Rift on Bank’s Role in Debt Relief.” The New York Times. November 17, 2011.
19 Ibid.
20 Ibid.
21 Povoledo, Elisabetta and Donadio, Rachel. “Italy’s New Premier Offers Broad Plan to Reform Finances and Spur Growth.” The New York Times. November 17, 2011.
22 Ibid.

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