Be careful, Italy, or risk your credibility

10.07.11 Publication:

During the past two years of writing and talking a lot about Italy, whenever I have said something critical about weaknesses in the Italian economy, almost inevitably someone in the audience or among the readers has responded by saying “But we are not like Greece, and we survived the crisis very well”. The second part of that argument I have always disputed, as the facts do not support it, but the first I always agree with. That is why it is so strange, and potentially tragic, that Italy´s own government has seemed determined during the past few days to make Italy look more like Greece.

The panic in financial markets on Friday, with Italian shares being sold off and government borrowing costs rising, reflected exactly this sentiment. Just as for Portugal, Spain and Greece, economic growth in Italy is weak, with the country´s GDP and even manufacturing output recovering more slowly from the 2008-09 global crisis than has been the case in France, Germany or the Netherlands. But at least the country´s public finances were under control, with the budget deficit small and the ratio between public debt and GDP stabilised.

So, unlike in Greece, weak Italian economic growth did not imply that the country might become insolvent, unable to pay the interest on its huge public debts. Such a situation is never guaranteed to be permanent, however. For when it comes to public finances, the difference between comfortable stability and painful insolvency is quite a fine or small one.

A rise in the interest rates charged by bond investors, or a sudden rise in public spending or fall in tax revenues can turn a country quickly into crisis, especially when it has public debts that amount to 120% of GDP. (By the way, the public debts of America, a country often described as being fiscally reckless, total just 65% of GDP.)

Alternatively, a crisis can suddenly happen when doubts arise about the future conduct of government policy, as a result of political instability, because those doubts are therefore also about whether spending and taxes are going to be controlled properly. Italy´s weak economy and huge public debts make it vulnerable to exactly those doubts.

Previously during the economic crisis and slow recovery, fears about political instability and the financial markets seemed to help the government of Silvio Berlusconi. Whatever you may think of us, the government was able to say, you would be taking a big risk if you chose to change governments or force elections in this situation. Yet now, the battles inside the government have become far more destabilising than battles between the government and its critics. If this war continues, the more stable option would be to have early elections or a change of government.

The fiscal measures proposed by the minister of the economy, Giulio Tremonti, were accepted by the markets, but analysts both inside and outside the country noted one important feature of them: the main reductions in the budget deficit will take place far into the future. This is important now that the political battle between the President of the Council and the Economy Minister has come out into the open. For the inevitable conclusion that market analysts will draw is that the later cuts will never in fact happen. The credibility of the fiscal measures is crumbling.

Think about it from an outside observer´s point of view. On one day, the President of the Council declares that he has always been opposed to the war in Libya in which Italian forces are participating, as part of NATO. On another day, the President of the Council attacks his own Economy Minister, makes it clear he favours tax reductions, and allows one of his newspapers to publish damaging stories about Mr Tremonti. What is the outsider supposed to believe? The head of the government opposes his own government´s policies, and his own minister.

This is suicidal, from a national point of view. Credibility is being destroyed. The strongest aspect of the country´s economic policies, namely tight management of the budget deficit, is being put into serious doubt. If this goes on, Italy really will move into the same category in international investors´ minds as Portugal, Ireland, Spain and Greece: unstable, unsustainable and insolvent. Yet it is all so unnecessary.