Italian Tragedy

Italian Tragedy

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Anyone with an interest in government finances and public spending must, by now, have developed a morbid fascination with Italy.

The country slid into recession again this month, wiping out not only its post-recession growth but much of its growth since it joined the Euro.

Screen Shot 2014-08-17 at 134854 Chart via Matt O’Brien at the Washington Post.

The pattern of Italy’s GDP growth has become detached from that of the rest of the G7. Since the crash, all the other major economies have grown, albeit at different rates. Italy, though, is on a severe downward slide.


Chart via Ben Chu.

Some people blame the Euro for this but Italy was in trouble before it joined the single currency. Both Italy and the UK crashed out of the ERM in 1992. For the UK, this was the start of a decade of high growth but Italy’s economy stalled in the years after and grew much more slowly for the rest of the decade. Briefly, in 1991, Italy overtook Britain and France to become the world’s 4th largest economy. Since then, though, it has been a tale of slow decline.

The Italian government had borrowed heavily during the boom years and the slowdown saw its debt-to-GDP levels steadily rise.

g7-debt-historyChart via Paul Krugman

This excellent piece by Economics Help explains the story in detail. The upshot, though, was that by the start of the recession, Italy’s debt was way ahead of most of the other major economies.

Major Economies Debt

Source: IMF World Economic Outlook 2014

But here’s the twist. Italy reduced its deficits drastically in the 1990s. For many years now, it has run a primary surplus. This means that, before debt interest, its government revenue is higher than its public spending. Unlike many other countries, including Britain and the USA, it is not borrowing to fund public services and social security.

Screen Shot 2014-08-17 at 160245

Chart via Igor Di Giovanni

It is, however, having to borrow to fund the debt repayments on its historic borrowing which is why, despite its primary surplus, it is still running a deficit and its debt is still going up.

This OECD chart illustrates the problem.

3.2 General government primary balance and interest spending as a percentage of GDP (2011)

OECD deficit 2011

Source: OECD Government at a Glance

Even though it is running a primary surplus, Italy’s debt repayments are higher than those of most other countries. It is running a deficit simply to pay the interest on its debt.

It gets worse, though, because Italy’s borrowing costs are relatively high. This is not just because of its high level of debt. As I’ve said before, credit ratings and borrowing costs are based on a number of factors. As this Business Insider chart shows, there is little relationship between a country’s debt level and the amount of interest it has to pay.

Screen Shot 2014-08-18 at 122800

Japan, with a humongous debt-to-GDP ratio, can borrow more cheaply than most other countries because it borrows in its own currency, its economy is growing, most of its debt is held by locals and it has a very stable political and social system. Despite its high debt, it is seen as very unlikely to default.

None of these is true of Italy. Its economy has been slowing down over decades and it is notorious for political instability. It can’t use its own central bank to buy government bonds because it no longer has one. Consequently, its 10-year borrowing costs soared after the recession, hitting 7 percent at one point in 2011 and rising close to 5 percent after its election stalemate last year. By comparison, the US and UK 10-year costs are around 2.4 percent and Germany’s just over 1 percent. It took intervention by the European Central Bank to bring Italian borrowing costs back down.

The result of all this is that Italy is increasing its debt just to service its ever increasing debt. It doesn’t take much imagination to see where this will lead. As we know, despite what politicians say, governments very rarely reduce their debts, they just rely on inflation and economic growth to reduce the relative size of their debts. Take away the growth, then, and you’re in real trouble.

As Edward Hugh says:

The problem is that Italy has an appallingly low trend GDP growth rate – possibly negative at this point – and nothing which has happened since the financial crisis ended suggests it is going to to improve radically anytime soon, in fact there are good reasons to think that growth could even deteriorate further.

And don’t expect much help from the private sector. That’s collapsing too, says Roberto Orsi:

The situation of the Italian economy is simply dramatic. Recently, a study has appeared which reveals how the current crisis (2007-2013) is in many ways much worse than the 1929-1934 contraction. In the present crisis, investments have collapsed by 27.6% in the five year period, against 12.8% in the interwar depression. GDP has declined by 6.9% against 5.1%. Italy, with the second largest manufacturing sector in Europe after Germany, has lost about 24% of its industrial production, going back to the 1980s level. No data is currently showing any sign of recovery. From the beginning of this year, the country has lost over 31,000 companies. Every day 167 retail units are lost, signalling an authentic disintegration of the retail sector. The automotive sector, a crucially important one for the Italian economy, has been constantly contracting: from about 2.5 million cars sold in 2007, sales in 2012 reached only the 1.4 million mark (the 1979 level) and they are still contracting this year. Construction, the other pillar of the national economy, is in rout: the 14% slump in 2012 is only the last in a series of difficult years. Home sales have dropped by 29% in 2012 against the already miserable 2011, to the 1985 level of 444,000 units, about half the number of 2006. Of course, the consequences of this economic disaster in terms of loss of employment are dire: unemployment is now at almost 12% and growing fast.

Who’s going to provide the investment to grow Italy’s economy again? Its private sector is dominated by small firms who are traditionally reluctant to invest, its state running a primary surplus just to keep up with its debt and its educated people are leaving the country.

It’s difficult to see how Italy will get out of this mess. Some say it should leave the Euro but to do so would be a de facto default with horrendous consequences for the rest of Europe. In any case, the country’s other structural problems would still be there if it left the Eurozone. It could even speed up the brain-drain as rich Italians pick up their Euros and run.

More austerity is unlikely to help either. Italy’s public sector finances have been running a surplus for over a decade. As Edward Hugh says, it would need to run a 6.6 percent surplus for another decade just to get its debt down to 60 percent of GDP. With a shrinking economy, falling tax revenues and a fleeing intelligentsia, this looks improbable.

The speed of Italy’s decline is astonishing. Italians once celebrated displacing Britain and France as the world’s 4th largest economy. Now, a mere twenty or so years later, a knackered state, with hardening arteries and on ECB medication, is trying to outrun a rising tide of debt, and losing. It is a depressing and rather frightening story.


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