The EU's Day of Reckoning: Italy Is Too Big to Bail Out

An Italian sovereign debt crisis is the ultimate European nightmare.

Italy is one of the world’s leading tourist destinations. The ruins of the Roman Empire, in particular, the Coliseum, Palatine Hill, the Pantheon and the Forum, are major attractions. New ruins are now being created to mark the political decay at work at the heart of Italy’s democracy and economic policymaking. These new ruins could well include the country’s central bank and parliament as well as the Eurozone as the stage is set for Europe’s next big economic debt crisis.

At the center of the brewing storm is the issue of confidence. When investors trust sovereign debtors, governments have access to credit markets. When investors lose confidence in a country’s ability to pay, they head for the door. The cost of borrowing goes up and at some point it hits a level where it becomes unaffordable to raise money.

Such a loss of confidence afflicted Cyprus, Ireland, Greece and Portugal between 2010 and 2012, shutting them out of public borrowing, creating the European debt crisis and forcing them to seek financial assistance from the European Union, European Central Bank and International Monetary Fund. Italy barely avoided that embarrassment.

Italy’s escape from an embarrassing bailout came via the intervention of the European Central Bank led by Mario Draghi. The dapper Italian head of the ECB in 2012 vowed to do “whatever it would take” to save the euro and hold the Eurozone together. That promise helped calm debt and equity markets, reopen access to capital markets and firm up European sovereign debt prices.

The ECB’s words were combined with country specific reform programs, which sought and are still seeking to liberalize sclerotic labor markets, streamline bloated public sectors, improve tax collection and launch privatizations. In the end, these structural reforms are intended to improve government finances and cut public sector debt while stimulating economic growth and badly needed private sector jobs. All of this would reaffirm investor confidence in Italian, or for that matter, Greek, Irish and Portuguese debt.

At least that was the way things were supposed to happen. The problem is that reforms in a number of countries were not vigorously pursued, because the ECB’s policies allowed political elites, like Italy’s, to avoid unpalatable measures. But the power of Draghi’s public declarations, which calmed European debt markets during 2012-2014, is diminishing. Unsurprisingly, 2015 increasingly has the look of a year of reckoning for Italy.

Conditions are aligning that could push Italy into a severe new economic crisis. To its credit, the government has managed to keep its fiscal deficit to around 3 percent of GDP over the past several years and Prime Minister Matteo Renzi is attempting to push a labor reform bill through parliament. The problem is that this is probably too little to late to help matters.

The economy is in its third recession in six years, unemployment is 13.2 percent and youth unemployment is at 43 percent (according to national statistics office Istat). Growth prospects are not robust – a meager return of 0.2 percent real GDP expansion is set for 2015. Furthermore, Italy’s demographics are dismal. Designated by Moody’s Investor Service as one of the “super-gray” countries, the number of aging Italians dependent on a shrinking workforce is growing. This provides a considerable structural headwind to the economy.

Related to bad demographics is Italy’s 2,700 page labor code, which makes it almost impossible for companies to fire workers.  Italian companies find themselves in an uncompetitive position as they cannot move rapidly to downsize businesses or adopt new strategies. It has also divided the work force into the older entrenched and often unionized working class and a younger work force that is forced to look to temporary jobs as one of the few outlets for employment. Many young and talented opt to leave. In its in its 2014-2015’s assessment of global competitiveness, the World Economic Forum ranked Italy 45th out of 144th, but its labor market rigidness was 136th, government efficiency at 143rd, and inability to make efficient use of its talent at 130th.

All of this is reflected by the recent discussion over Ferrari’s consideration of moving its fiscal residence outside of Italy to save on corporate taxes. Carla Ruocco, a lawmaker for the opposition Five Star Movement observed: “Corporate taxes remain too high, investment plans to modernize the country are nowhere to be seen, while resources are getting destroyed by corruption. Given this business environment, it’s not surprising that more and more companies and investors are fleeing the country.”