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.