From the July 2010 issue of Research Magazine • Subscribe!

July 1, 2010

Worrisome Italy

Shadows cross a once-sunny economy.

Charles De Gaulle reputedly once said that when it came to Europe, Germany was meat, France was potatoes and everything else was just a side dish. In his day, the European Community consisted of only six members, which included three small Benelux countries and Italy. So, his side dish remark was most likely meant for Italy and constituted the usual French putdown of Italians.

Greece's recent problems have focused attention on the PIGS -- Portugal, Italy, Greece and Spain -- amid much fear that the debt crisis could spread to Portugal or Spain (or to Ireland, sometimes added as the second I in PIIGS). Less noticed has been the rising -- and frightening -- danger of Italy becoming embroiled.

Italy is an economy that is larger and qualitatively far more important than Spain, Portugal, Ireland and Greece combined. Italy is Europe's fourth largest economy or even fifth largest; depending on the exchange rate between the euro and the pound, its GDP may be even larger than that of the U.K.

Italy's fiscal situation is by far the worst in the European Union. Its fiscal discipline, debt burden, ability to refinance its financial obligations and, ultimately, ability to pay its bills is precarious. True, its budget deficit has been brought under control and is relatively small by today's standards. It measures "only" around 5-6 percent of GDP, compared to the double digits in the United States and the U.K.

However, Italy's government debt stood at 115 percent of its GDP in 2009 -- measuring nearly $2.5 billion. The Economist Intelligence Unit estimates that its debt burden will rocket to 120 percent of GDP next year -- but this is optimistically predicated on interest rates remaining at their current levels.

Interest payments measure around 10 percent of Italy's overall budget, whereas yields on European government bonds are rising in today's jittery bond markets. Ten-year Italian government bonds yielded more than a full percentage point more than the German long bond in mid-May, or nearly 4 percent.

The rescue package by the IMF and the European Central Bank, unveiled in May, was designed to calm the nerves of European investors about the plight of Greece, Spain and Portugal. It measured around $1 trillion and even at this level it was not deemed completely adequate. What if it is called upon to support Italy's debt, which is 2.5 times higher than the size of the entire package? And what will be the future of the euro zone and the EU if Italy, a founding member, is forced to leave the monetary union?

Question of Growth

The current financial crisis is not, strictly speaking, a debt crisis, but a problem of economic growth. True, governments everywhere have been piling up debt rapidly. But it wouldn't have been such a major problem if it were a temporary measure and if rapid rates of economic growth were coming back imminently. After all, the U.S. emerged from World War II with a debt-to-GDP ratio roughly the size of Italy's today. Yet, it was able to grow out of the problem quickly and painlessly.

Italy's ongoing budgetary problems have largely been resolved. But if economic growth lags, then past profligacy, passed onto the current generation in the form of heavy debt, will start to loom large. Moreover, if growth remains weak, domestic demand will be sluggish and inflation will not re-emerge. On the contrary, deflation may become a threat and deflationary pressures will make the existing debt burden seem extremely onerous.

In the past, Italy was able to maintain its position as a major industrial economy because of three factors. First, its domestic markets remained closed to foreign competition; second, it could devalue the lira against the German mark in order to maintain competitiveness; and, finally, it had highly flexible, entrepreneurial family-owned firms.

All three factors have now changed. The highly protected domestic market, for example, gave Fiat an automatic 60 percent share of Italian car sales, which allowed the company to compete with Volkswagen for the title of Europe's largest automaker as recently as in the late 1980s. But the Italian market was gradually opened to competition -- first, from other European carmakers, and then from Japanese and Korean ones, as well. As a result, Fiat nearly went bankrupt in the 1990s. It has sorted out some of its problems, but its market share in Italy is now only slightly more than half of what it once was.

The adoption of the euro in the late 1990s was another blow to the traditional way of doing business in Italy. When the euro came into being, the lira was devalued one last time, and the German mark was fixed in the monetary union at a severely overvalued level. German manufacturers complained bitterly at the time, but by now they have been able to cut costs and increase their competitiveness. They are once again beating their Italian competitors both in Italy and in various export markets. Yet, the euro is permanently fixed and no devaluation is now possible.

Revenge on Marco Polo

The great 13th-century Venetian merchant Marco Polo is credited with introducing China to Western Europeans. Some historians also believe he brought back from his travels Chinese noodles and meat-filled wontons, which Italians then perfected into spaghetti, macaroni, tortellini and other pasta, now far better known around the world. Huge profits were made over the centuries by food companies founded by Italians in Italy, the U.S., Argentina and other parts of the world.

Now, the Chinese are ready to pay Italians back. Small, family-owned Italian companies, based mainly in northern and central Italy, have long been renowned around the world for producing high-quality engineering products, machinery and equipment, clothing, leather accessories, paper and a variety of other goods. They have the flexibility and managerial acumen to follow changing fashions, provide great quality and excellent design and even do what Italians are not traditionally good at -- keep their costs down.

But all of a sudden they find that the Chinese are beating them at their own game. Chinese companies are able to knock off their designs, closely match their quality and handily beat their prices. In Veneto, the prosperous province around Venice, Chinese products are not only seen as a threat to local exports, but have now started to inundate local markets as well. Even in Venice, world-famous glassware makers have to warn shoppers against far cheaper Chinese-made knock-offs available at some Venetian shops.

These factors are cutting into Italy's ability to grow and, ultimately, to fund its massive public debt. Italy is a big economy, with GDP that exceeds $2 trillion. But this is one of those cases when size doesn't really matter -- or at least doesn't matter all that much. Italy is a member of the Group of Seven, an exclusive club of the world's richest and most influential industrial nations. If Italy wobbles, it will mean that the bell is tolling for the industrial world as a whole -- a frightening vision of things to come for other rich economies.

Alexei Bayer is an economist and author based in New York City.

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