No, one of them is not Silvio Berlusconi’s “bunga bunga” parties. Silvio himself isn’t among those reasons, either. The prime minister said on Tuesday that he’d resign once he ushered some economic reforms through the legislature. It is true that many inside and outside of Italy had come to see the scandal-ridden gaff-machine as the country’s problem. His inability to implement the tough austerity measures and reforms investors and his euro zone compatriots have been demanding damaged his credibility and the country’s reputation in international markets. But Berlusconi’s departure is not necessarily the solution, either. Will investors be convinced an Italy without Berlusconi is a less risky Italy? It doesn’t look like it. Yields on benchmark Italian government bonds spiked again on Wednesday, topping the 7% mark (the highest since the euro was founded in 1999), even after investors got the news of Berlusconi’s impending farewell. If those yields keep rising, the country’s $2.6 trillion mountain of debt could become unsustainable. Clearly, the concerns about Italy run much deeper than who sits in the PM’s office.
That’s why, in my opinion, the growing financial strain on Italy and the political turmoil in Rome are the scariest events yet to emerge from the spiraling euro zone debt crisis. In fact, what’s going down in Italy is more important to the world economy than anything else right now. Here’s why:
First, Italy is not too big to fail. What I mean by that is Italy is too big to be bailed out. When Greece got itself into trouble, the European Union and International Monetary Fund could easily muster up the resources to prevent default. But with Italy’s debt load bigger than that of Greece, Ireland, Portugal and Spain combined, there isn’t likely to be enough money to bail out the country. There definitely aren’t sufficient funds available in the euro zone’s overstretched $1 trillion rescue fund. And even if the Europeans could come up with the cash, it would likely be politically impossible for them to use it in an Italian rescue. Look at the bickering and hesitation that has delayed and troubled the second Greek bailout. Could Europe get together for a gargantuan Italian rescue? Highly unlikely. That means Italy is on its own, responsible for fixing its own mess, with little hope of receiving the kind of aid that has saved the Greeks, Portuguese and Irish.
Secondly, to fix that mess, Italy has to uproot some deep economic problems. As I’ve mentioned before, the reasons behind Italy’s descent into the euro zone debt crisis are much different than those that have undermined other countries in Europe. While Greece and Portugal are being punished for long-running profligacy and Ireland for a sudden burst of debt created by its massive housing and banking bust, Italy has in fact been something of a good fiscal citizen. Yes, its government debt to GDP ratio stands at a lofty 127% — the highest in the euro zone outside of Greece — but that level is more or less where it was in the late 1990s. And taking out interest payments on existing debt, the Italian government runs a budget surplus. For all of the excess Berlusconi flaunted in his personal life, he was a choir boy when it came to fiscal policy compared to most of his euro zone colleagues.
So why the rising bond yields? Italy is being roasted for being Italy. The economy barely grows and doesn’t create jobs for the nation’s youth. It ranks low in competitiveness surveys and has terrible labor productivity. In other words, for Italy to escape the debt crisis, it has to tear apart the structure of its economy – liberalizing labor markets and increasing competition to spur greater productivity and create jobs. That’s not easy under the best of circumstances, and we’re not in the best of circumstances. Investors will be pressing Rome to go on a reform crash course, undertaking measures immediately that should have been introduced over many years.
Third, we should doubt whether Italy’s political system can produce that rapid-fire reform. The types of reform Italy needs will be highly unpopular with voters. They mean higher taxes, fewer government services, more competition and, if we really start gutting the economic system, likely longer working hours. Italy will need some gutsy politicians to approve such measures. And will Rome get them? Who knows. The political scene post-Silvio is murky. Berlusconi himself is in favor a new election; if that happens, the uncertainty in Rome could drag on for weeks if not months. The Italian political system has not shown the sense of urgency the crisis demands. Will that change after Silvio’s departure? We’ll have to see who takes his place, and what sort of authority that new cabinet has. But I wouldn’t get my hopes up. Italy has a long history of suffering with chaotic, short-lived administrations. We have no reason to be certain that Rome will break with tradition this time.
Fourth, Italy could spark even wider contagion. About a year ago, analysts were questioning if Italy even deserved to be counted among the PIIGS. Financial calculations told us Italy was at much less risk of insolvency than Greece, Ireland, Portugal or Spain. The fact that Italy has sunk to where it is today shows just how deeply the euro zone debt crisis has infected the core of the monetary union. And the nature of Italy’s problems indicates its version of the debt crisis could drag on for some time. We’ll need to build an entirely new political consensus on economic reform; then those reforms won’t necessarily show positive results right away. Investors could stay nervous for some time to come. That runs the risk of Italy being a launch pad for more contagion, perhaps spreading the crisis to France, Belgium, and so on.
Fifth, Italy is probably the biggest threat to the global economy right now. Just look at the sort of chaos tiny Greece has caused for global markets. A destabilizing Italy, the world’s 8th-largest economy, could send shockwaves around the world that would rival, even possibly exceed, the ones we saw extend from Wall Street in 2008. The entire European banking sector would reel. I am not predicting such a crisis will take place. But a lot is riding on what happens in Rome over the next few weeks.
And that’s truly scary.