Unlike Greece, Italy may well be ‘too big to save’. Its collapse could have implications not only for Europe and the EU, but globally.
Like Greece, Italy is ‘too big to fail’ but, unlike Greece, it may well be ‘too big to save’. The cost of the bailout package for the Hellenic Republic totalled €310 billion. Such an amount could be covered by lenders such as the International Monetary Fund and the European Stability Mechanism (the EU’s rainy-day kitty) whose combined reserves are €900 billion. However, the debt Italy has amassed is six and half times that of Greece; if it ever suffered a similar downfall, the flow of funds would surely be insufficient to weather the crisis. It is therefore quite disconcerting that the Italian economic outlook is gloomy.
Italy’s per capita Gross Domestic Product (GDP) – the value of goods and services produced per person – is 8% below its 2007 level, meaning it still has not recovered from the Great Recession. This is reflected in the fact that one in four 15-34 year olds are not in employment, education or training; the highest rate in the EU. In fact, bar Greece, the Italian economy expanded at the slowest rate in the Eurozone over the last two years and the last four years. For both periods more than half of those nations grew twice as much. And yet the disparities may get worse.
Total factor productivity measures how much output a country produces for a given level of labour and capital input. Changes in this metric usually presage mirror developments in long-term economic growth. And from 2014 to 2016 Italy improved it by just over a half a percent, merely a third the (mean) rate of increase for the other large economies in the Euro area (namely Germany, France, Spain, and the Netherlands). Thereafter, it rose by less than a third of a percent, hinting that Italy is simply struggling to use its assets efficiently; perhaps a harbinger of future limp growth.
For many analysts, this is unsurprising; there are well-known deficiencies in the Italian economy. Consider breakthroughs in science and technology, which drive growth. These are not fortuitous one-off events but rather the products of many inputs, namely quality and lengthy education; a focus on research; and attracting and retaining talent. None of which are particularly characteristic of Italy, unfortunately. Take the length of education; here it comes up short. Among 35 of the richest nations in the world (except Turkey and Mexico), it has the lowest percentage of citizens with university degrees in every age range (25-34, 35-44, 45-54, and 55-64 year olds).
Nearly one in every two working-age adults have not completed upper secondary education (high school), and only one in every four 25-34 year olds are tertiary educated (university). Consequently, the proportion of workers who are under-skilled for their current job is double the OECD (rich nations’) average. In a recent report the OECD noted that “under-skilling is especially high in Italy, reflecting the low levels of skills [among the populace]”.
But even those who are high-skilled are under-utilised. The total public and private spending on research & development in Italy (as a percentage of GDP) is relatively meagre; it is 60% more in the other large economies of the Euro area. No surprise then that Italy also has the least number of researchers (per 1,000 employees) in the Eurozone. Scholarly individuals are simply more likely to pursue opportunities elsewhere. That is why a third of emigrants are university graduates and why these voids are not filled by new entrants. Indeed, as the OECD wrote, “the inflow of new [university] graduates to the labour market is relatively small”. Thus, structural defects put growth in jeopardy. Worse, the weaker the economy gets, the harder it is to correct them. And there is reason to suspect times will get tougher.
Consider the fuel of economic growth: capital investment. One way a country can lose it is by investors selling its government-issued bonds. When this happens, the nation’s central bank must buy them. After enough of these purchases its reserves diminish and so it has to borrow from the European Central Bank (ECB). Thus, its bank balance at the ECB (usually called the Target2 balance) is a direct reflection of the quantities of capital flowing in or out of the country. And Italy’s figure for this has worsened by more than any other country since 2015, with the net amount owed to the ECB nearly doubling (to 28% of GDP). Thus, just at a time when Italy needs investment, capital is fleeing fast.
Other macro developments disappoint, one being that borrowing costs are rising. To see why, note that governments (through their central bank) issue bonds to raise money. In doing so they borrow a certain amount from an investor in return for payments commensurate with an interest rate (called a coupon rate). The higher the interest rate, the more the government must pay, and therefore the greater the returns to the investor. When the demand for the bond drops, the government must compensate by increasing interest rates. In other words, it offers larger payments to entice at least one of the now smaller pool of investors to lend it money.
With that in mind, consider the recent announcement by the ECB that it will wind down its massive Quantitative Easing program, which it undertook to stimulate the European economy in 2015. The program consisted of purchasing about €720 billion worth of bonds a year. Removing this sizeable demand will, like in the example above, push interest rates (borrowing costs) higher. This may improve the profitability of the banking sector (as they profit on the difference between the short-term government bond interest rate and the smaller consumer deposit rate). But overall this development will not be promising; it will entail weaker economic growth. This is because elevated interest rates discourage borrowing and encourage saving. Both effects reduce consumer spending. That, along with bigger loan payments, will make it difficult for companies to grow and pay their employees.
Similar effects can arise from greater oil prices, which are now at their highest level since 2014. In this case, Italian companies will find it harder turn a profit with costlier production and transportation. They may have to sell their products at inflated prices, which will shrink consumer purchasing power (or relative wealth) and as such, essentially contract spending.
Hence, Italy faces challenges in growing its way out of trouble. As a result, debt payments might be harder to make. And this is especially the case if the mountain of debt extends taller, which it may very well do. In the last 50 years, Italy has never run a budget surplus. This means that it continually adds to its debts by spending more than it raises. It certainly does not help that the state struggles to collect all the taxes owed to it. The OECD observed that “the amount of outstanding tax arrears [or unpaid taxes] is exceptionally large,” reaching a level “far higher than all other OECD and G20 economies”. For example, three-quarters of the way through 2015, “total tax arrears [had] exceeded €750 billion,” which is broadly equivalent to a full year’s tax revenue.
Moreover, budget surpluses could be even more difficult to attain in the future. With life expectancies up, the population is aging fast: only Japan has a greater share of its populace over the age of 65. Thus, pension and healthcare payments will swell, increasing government spending. And simultaneously the tax base will shrink due to low birth rates, of which only South Korea has lower (among OECD nations). Therefore the size of the working population will decline and concomitantly will the tax revenues.
The proposals from Italy’s current stable of politicians may too exacerbate these already precarious finances. Disconcertingly, they have no qualms about expanding government spending, and are preparing to do so in two notable ways. First, both parties in government advocate scrapping the pension reforms of 2011, which elevated the retirement age. Such a move is expected to necessitate extra pension payments to the tune of €15 billion a year. Second, the Five Star Movement party has prescribed a basic monthly income of €780 for all those in need or seeking work. The invoice total for this one is around €30 billion. They are also bent on reducing the tax base through enacting flat income-tax rates of 15% and 20%.
Bold reforms like these are arguably frivolous and inauspicious but, at the very least, perilous. Markets agree: at the very sign that the two parties would form a coalition, Italy’s short-term bond yields suffered the biggest one-day jump since 1992. In other words, the returns demanded by investors on Italy’s bonds soared. This is because they worried the new government might not be able to repay them.
When the capacity to repay debts is in question, investors may take their funds elsewhere. The self-reinforcing loop of capital flight that ensues will almost certainly dash any hopes of a quick recovery. Worse, if any of these problems ensure Italy maintains its feeble economic performance, then it could be ensnared by the so-called “Euro Trap”. That is, when other Eurozone countries grow at a faster clip, prices in their economies would climb swiftly. Consumers would therefore be encouraged to spend more because it is expected that soon prices will rise again. Before long the cycle spirals out of control.
To avoid such a fate, the European Central Bank must heighten interest rates in order to balance incentives and thereby halt the inflationary spiral. However, this inadvertently imposes higher interest rates on Italy despite its weak inflation and ossified economy. The resulting consequences can be disastrous for reasons mentioned before. But more, elevated interest rates will entice investors to hold bonds denominated in euros since the returns are now enlarged. This means the demand for euros will surge, and therefore they will become more valuable; the knock-on effect being that goods or services priced in euros will now be more expensive for those holding other currencies. Thus, the main driver of Italy’s economy – its exports – could bear a tremendous toll as markets favour other, cheaper produce. The mechanism is deemed a “trap” precisely because relative stagnation could bring about inordinate interest rates which, in turn, may perpetuate the stagnation.
All-in-all, Italy faces a flurry of seemingly insuperable challenges, even without mention of the commonly cited ones, like red-tape and pervasive corruption. Lacking a bailout, its collapse could have implications not only for Europe and the EU, but globally. Even just domestically, millions of people, especially those in the south, would languish in further economic turmoil. That is why it is essential a turn-around occurs soon. Whether or not it does though, only time will tell.