Italy, Europe and the Euro Crisis: Partnership for Reform or Discord for Disaster

Little more than two years ago, European news outlets and politicians spoke about the prospect of economic downturn and financial unrest as if it were only caused by the contained crisis in Greece.  Comprising less than three percent of the total Gross Domestic Product of the euro zone, the economically peripheral country posed little threat in the minds of political actors.  Investors disagreed.  Today, many of those same shortsighted politicians continue to add to the economic woes—only this time as statistics in the increased unemployment rate.

Some ousted leaders may have been correct in downplaying the seriousness of the Greek threat, but they perniciously underestimated the deeper pan-European problems that Greece reflected. The Greek situation has highlighted the frailty of other major European economies and the unsustainable nature of disjoint fiscal policy in the monetary union.  As the window of opportunity to act shrinks, the extent of necessary measures swells—all the while the requisite political will wanes.

While Greece threatened instability, emergent situations threaten total collapse.  Italy—the third largest economy in the entire euro zone—is the most recent and most serious concern in the sovereign debt crisis.  This paper will thus focus on Italy, the most recent and significant actor in the dramatic European saga. Italy demonstrates the economic and institutional factors that must be addressed, nationally and  EU-wide, for this crisis to be resolved.  Above all, however, Italy is not just a paradigm or microcosm of the European crisis that gives leaders the luxury of experimenting with possible solutions to the larger, continental threat.  Italy is the continental threat.  The opportunity to test solutions—if it ever existed—was exhausted with Greece.  This paper will focus on Italy because—if Europe does not act swiftly and correctly—not only will the euro zone necessarily fail, but the entire project of European integration will be brought to the brink.

I will begin with an exploration of the economic factors and corresponding institutional flaws within Italy that have caused this most recent scare.  I will then outline the associated economic and institutional problems in the European Union that have also contributed to the gravity of the situation.  I will finally discuss various proposals and possible solutions—domestically and internationally—and evaluate the possibility of long-term viability.  I posit that deep structural reform domestically and internationally is needed to resolve the current crisis, and that national leaders have not yet done enough to salvage the continental currency.

As yields on Italian bonds crept up to seven percent last month—the borrowing rate at which other European nations have needed financial aid—the government continued to refuse support.[i]  While it is true that Italy remains solvent, many of the arguments in support of Italy’s economic stability either do not withstand scrutiny or miss the point entirely.  As economist Tyler Cowen recently affirmed, one frequently cited optimistic argument about Italian debt is that it is largely held domestically.[ii]  The International Monetary Fund estimates, however, that bonds held by foreigners still constitute forty-seven percent of total Italian debt.[iii]  Furthermore, although Italy’s debt constitutes less than 120% of its GDP—compared to Greece’s 160% of GDP—Italy’s total GDP is seven times larger than that of Greece, making the absolute amount of foreign-held debt significantly larger.[iv] [v] [vi] [vii]  In fact, Italy’s absolute debt is higher than that of Greece, Ireland, Portugal and Spain combined, meaning that its sheer size—irrespective of its percentage of national GDP—makes it more concerning than other Southern European debts for its potential effect on the Eurozone as a whole.[viii]

Despite the insistence by the government that Italy remains a competitive producer, the nation has run a trade deficit since 2005.[ix]  While exports have actually begun increasing recently, the trade imbalance remained negative from September to January of 2011, at just over 23 billion Euros.[x]  Despite the putative success of Italian manufacturing, labor productivity remained stagnant from 2001 to 2005, and it actually diminished in the four-year period immediately thereafter, often recording the lowest in the OECD area.[xi]  As a result, Italy has recorded the lowest economic growth of any nation in the world—besides Haiti and Zimbabwe—and been the only OECD nation to record negative GDP growth per person over the past decade.[xii]  This reflects underlying and sustained structural problems in the Italian economic model and the country’s institutions, which I will attempt to identify shortly.

One of the measures of a sound economy—the successful development of human capital—also indicates grave systematic weaknesses in the Italian system.  While politicians continually dismiss the loss of skilled Italian youth to other countries by claiming the loss is less in absolute terms than that of other nations, those countries offset this trend with an import of talent in other sectors.  Italy, however, is the only large European economy that maintains a net brain drain.[xiii]  Italian youths continue to leave in droves, while Italy has one of the oldest populations and lowest birth rates in the world.[xiv]  At its current rate, Italy will either have merely two workers for every pensioner within a decade, or be forced to raise the retirement age drastically to 77 to maintain its current worker to retiree ratio.[xv]  The desire to maintain the standard of living and social services for an ageing population has contributed to rising levels of borrowing and, subsequently, been one of the underlying causes of the recent crisis.

These economic conditions reveal serious structural flaws in Italian institutions.  In order to achieve any long-term solution to the current crisis in Italy and, consequently, to the sustainable preservation of the euro zone, these flaws must be elucidated and corrected.  In addition to the aforementioned lack of competitiveness that has forced the state to borrow, tax evasion remains a serious problem in the southern peninsula.  Tax evasion has been a contributing factor in other Southern European debt levels, notably in Greece.  In Italy, the primary causes reside in institutional culture, namely in the limited use of electronic currency.  According to an estimate by the Bank of Italy, Italians evade an aggregate 100 billion Euros in taxes annually because of cash transactions.[xvi]  Additionally, the country’s banking association—ABI—asserts that the government loses 10 billion Euros every year in revenue paying for the security and labor necessary to process excessive cash payments.[xvii]  Furthermore, there seems to be a connection between tax evasion and government corruption, and Italy is ranked the most corrupt nation in all of Western Europe.[xviii]  Regardless of its role in contributing to tax evasion, government corruption has no doubt undermined investor faith in the political system and the credibility of reform.[xix]

Another problem  is the lack of efficient corporate expansion, caused partly by professional barriers to entry and the legal difficulty of mergers and acquisitions.  Italian law has often favored small family-owned businesses, and the continued political defense of family pact law has proven economically inefficient, regardless of its charming cultural motivations.[xx]  One of the few economically efficient initiatives of former Prime Minister Silvio Berlusconi included his abolition of inheritance and gift taxes at the turn of the century.  In 2006, however, Romano Prodi reintroduced such legislation and made it once again legal for family owned businesses to discriminate against non-family members and secure inherited ownership.[xxi]  This institutional action persists, despite independent studies—including a particularly comprehensive one by the Bank of Italy—demonstrating that firms’ returns diminished when management was handed over to a relative and increased with non-family management.[xxii]  Currently, 93% of all Italian firms are still family-owned, revealing the extent of institutional and legal action favoring inefficiency over expansion.[xxiii]  At the same time that the Italian government staunchly supports these inefficient business models, legal protection for efficient models  has been lacking.  As an example, bankruptcy provisions in Common Law tradition that permit and compel companies to restructure are generally made difficult under Italian Law in favor of punitive actions that help neither the creditor nor the debtor economically.[xxiv] [xxv]

Institutional and legal discrimination against Italian youths has also caused the serious brain drain outlined earlier; another cause of Italian economic ails.  While Prime Minister Mario Monti has recognized the need to make the labor market more flexible, he is a technocrat who can seem at odds with the interests of an ageing electorate.  The same cannot be said of his predecessors, who have favored undue burdens on young employees, while permitting older workers to continue with jobs from which employers are legally unable to fire them.  For example, Legislative Decree 276 in 2003—known popularly as Biagi law—permitted employers to easily fire employees without guaranteeing them extensive unemployment benefits—but only for employees in the youngest age bracket.[xxvi]  This complemented a 1995 pension reform that left older workers unaffected but diminished the current and future benefits for younger workers.[xxvii]  Such institutional discrimination through Italian legislation—with the support of an increasingly ageing electorate—has hurt Italian innovation, efficiency and future labor prospects by discouraging young talent to remain in the country.  In addition to outright legal discrimination, the Italian government has underutilized the talent of the younger generation and simultaneously inhibited innovation by investing less in Research and Development than any other pre-2004 member of the European Union.[xxviii]

Institutional discrimination against the younger bracket of the labor market is not confined to explicit legislation, but also results from one of Italy’s other major inhibitors of expansion and growth.  The prevalence of legal self-regulating guilds—known as “ordini”— has enervated competition and undermined efficiency.[xxix]  These guilds restrict entry into their professions in order to artificially inflate wages and secure employment. Such associations now exist in nearly every sector of the economy, and the requirement of membership—legally protected and monitored by a notary public—ensures the stranglehold of the groups over entire vocations.[xxx]  As a result, members of these professional associations gain undue profits from lack of competition, but keep national growth stagnant by limiting innovation, keeping costs artificially high, and crowding out new labor.

While this discussion is necessarily incomplete, it has outlined some of the major economic concerns and their various institutional causes within Italy.  Later, I will argue in favor of certain proposed and recently enacted reforms, but for now I will turn to a similar discussion of the economic causes of the crisis that originated outside of Italy and the corresponding failure of certain European Union institutions.

While political dialogue has focused on the debt of select nations, the European sovereign debt crisis is particularly protracted and dangerous because of the threat of contagion.  Investors have continued to panic from the levels of unsustainable debt incurred by all European nations, fearful that the entire continent could be headed toward default.  Indeed, twenty-three of all twenty-seven members are currently under a European Council judgment indicating inordinate fiscal deficits.[xxxi]  The economic conditions in certain European Union member states have thus triggered self-fulfilling prophecies by market speculators.  In this sense, Italy has suffered a bond run because of panic in countries like Greece, Spain, Ireland, and Portugal, even though Italy has run primary budget surpluses for years and remains solvent.[xxxii]  Markets have continued to undermine the notion of an economic union by discriminating between the bonds of different Member States in the European Union, fleeing to less debt-ridden countries like Germany and away from countries like Greece.  Over the course of the past year, this has caused investors in German bonds to gain 8.2%, and those in Italian bonds to lose 7.6%. [xxxiii]  As I will discuss shortly, these domestic gains have discouraged bold action by Germany to rectify imbalances across the Eurozone.

This is indeed a myopic and dangerous move.  Rising yields on Italian bonds, even though Italy is readily able to pay its interests for the immediate future, reveals that the number of European countries on which investors are willing to bet has artificially shrunk from pan-European panic.  The fact that Germany—the putative fiscal safe-haven of the continent—had had difficulty selling its debt demonstrates the negative reflexivity occurring in Europe.[xxxiv]  In other words, investors are feeding off their own fears of contagion and, as time passes, may eventually abandon Europe altogether.  The interconnectedness of European financial markets may expedite the spread of contagion.  For example, fears in Greece have spurred rises on Italian bond yields, which could cause a banking crisis in France, which owns more than half of all Italian debt held by European banks.[xxxv]  This would force the French government to incur greater debt to recapitalize its banking system, inviting already threatened downgrades by credit agencies and bringing panic to the United Kingdom, whose banks hold large portions of French debt.[xxxvi]  It is evident now that Italy is not simply the largest of the fiscally irresponsible Southern European nations, but can also become an example of how panic throughout Europe can bring down solvent Member States and cause the collapse of the entire European Union.  Only European leaders and institutions can solve the crisis now, and yet they are precisely the cause of the inflated economic ills outlined above.

Indeed, while the creation of the euro seemed to be a radical move toward economic integration, politics trumped sound economic considerations from the beginning.  The Stability and Growth Pact—adopted in 1997 to guarantee the stability of the euro zone and ensure Member State compliance—was more poorly enforced than it was inherently flawed. [xxxvii] [xxxviii]  Unfortunately this reveals the deeper institutional difficulty of creating a true economic union within the political framework of the European Union.  For example, perhaps the two primary institutional causes of the current crisis stem from the precedence of politics over economics.  Firstly, profligate nations that did not truly meet the convergence criteria were allowed into the euro zone for political reasons.  As illustration, Greece was deferred admission for four years because they lacked political influence, while Italy was admitted because of French political support, despite not truly meeting the necessary debt limit.[xxxix]  As a result, European supranational failings are in some sense responsible for the effects of the Italian crisis, as the nation’s problems have not actually changed since Europe chose to ignore them over a decade ago, encouraging further moral hazard.

The second and arguably more calamitous failing of the Stability and Growth Pact was that it failed to enforce its regulations even after admission.  Germany and France—generally regarded as two of the most fiscally secure states in the Eurozone—were in fact the two nations that set the current precedent that undermined the credible authority of the Stability and Growth Pact.  In 2003, the European Commission was forced to recommend sanctions after both countries defied the public deficit limit for three consecutive years.[xl]  Once again, politics trumped economics, as the national ministers of the Economic and Financial Council decided to wave such sanctions under political pressure.[xli]  In so doing, they sent a message to all Members States that it was acceptable to defy the necessary terms of the economic union —a message some nations took to heart.  The crisis in Greece began as much as a result of poor enforcement after its adoption of the common currency as from the fact that it was unfit for its initial admission, which was evident despite its government’s falsified economic portrait .[xlii]  Germany and France have preferred to allow their banks to purchase Greek debt rather than sanction the nation for rising levels.[xliii]

The blind hope the Economic and Monetary Union placed in convergence also devalued the necessity of European regulation to ensure that nations like Greece did not suffer from unsustainable inflated public sector costs after currency appreciation.[xliv]  This was an institutional oversight with severe consequences.  Similarly, the Stability and Growth Pact seemed to assume that investors would treat European debt as equally worthy, without any institutional guarantee or coupling of European debt.  It has become clear from the sovereign debt run that investors have concluded otherwise.  This poor assumption has led to national insolvencies in Europe, which unfortunately indicates another institutional oversight: that the European Union system simply had no backup plan to resolve domestic insolvencies.[xlv]  This lack of institutional agreement from the outset has left political leaders scrambling to concoct solutions as the crisis unfolds—and the generosity of the learning curve may just run out with Italy.

As politics has continued to trump sound economic policy in Europe, even the primary politically independent organ of the economic area has failed the common currency.  The European Central Bank does not seem truly independent enough in its current form to give credibility to the governments of debt-ridden Member States.[xlvi]  In fact, it is rather clear that the French government only submitted to formal independence to convince the Germans the ECB would nominally model the Bundesbank, all the while intending to maintain political influence over its authorities.[xlvii]  The Germans have likewise put political pressure on the bank, demanding the ECB not act as a lender of last resort or implement measures similar to the Federal Reserve’s quantitative easing that helped the US economy in 2008.[xlviii]  Even as markets responded positively to the implication that the ECB would defy such pressure and take a more active role in solving the crisis, ECB President Mario Draghi re-emphasized institutional restrictions, asserting that the European Union “[has] a treaty and Article 123 prohibits financing of governments.”[xlix] This further reveals that institutional strictures—along with personal refusal to use the “legal tricks” Draghi denounced—are undermining action to bolster the currency.

Further legal qualifications of the economic union have in some ways caused the crisis by sapping the strength and speed of European action.  German support for financing Greece was halted by its Constitutional Court’s threat to challenge any assistance under Article 125 of the Lisbon Treaty, which states, “A Member State shall not be liable for or assume the commitments of central governments.”[l]  While Europe finally did offer assistance, it came later, and the speed of European action since then has followed the same trend: when support finally is approved, its size and scope are no longer sufficient.  , The eventual establishment of the European Financial Stability Facility may create a firewall against Greek debt, but its details have taken too long to outline and its scope is simply too small to protect from potential calamity in Italy.[li]  As a result, suggestions for necessary changes, such as the proposed creation of a $3.1 trillion jointly financed fund to pay down the seventeen euro zone member debts, may require significant treaty changes, including renegotiation of the Lisbon Treaty.  These treaty changes are the only ultimate solution and perhaps the only short-term source of calm.  Nevertheless, according to German Chancellor Angela Merkel, they would still take too long to enact even under the circumstances.[lii]  While Italy is indeed culpable, the ultimate message from equally myopic European leaders is thus that Italy is too big to fail, but also too big to bail out.

And so we find ourselves at the height of a protracted crisis that continues to threaten European integration and the global economy because the continent’s leaders find themselves in a state of paralysis.  While various attempts have been made to reassure markets and calm the storms, action within the Italian government and within the European Union have been insufficient or misguided.  Nonetheless, there remains hope that the threatening consequences of failure compel proper action—hope that has been reinforced by the recent action of well-minded technocrats.

Since the fall of the Berlusconi government and the imposition of the technocratic governance by President Giorgio Napolitano—led by Premier Mario Monti—swift propositions have been made to contain and mitigate the effects of the crisis in Italy.  The most recently proposed austerity measures focus primarily on spending cuts and tax hikes, both of which are necessary in Italy.  Some of the reforms Prime Minister Monti has advocated include necessary increases in the retirement ages for men and women, as well as increases in the number of employed years necessary to receive pension benefits.[liii]  Monti has further begun structural reforms to correct some of the previously noted structural issues.  To combat tax evasion, the Italian government will eliminate tax amnesty loopholes, as well as lower the maximum cash transaction level, which will also combat the monetary inefficiency described previously, which has stagnated Italian growth.[liv]  The government also plans to increase value-added taxes, which will increase revenue sharply, especially when coupled with the aforementioned efforts to reduce cash transactions, which allow Italians to avoid paying VATs.[lv]  Furthermore, new legislation that will make it easier for employers to dismiss employees will make the Italian labor force more efficient, productive, responsive and mobile.[lvi]  Apart from these changes, however, the remaining measures hinge on the specifics on increasing revenue and decreasing spending.

This is ultimately the problem with the new proposals.  While the reforms give due attention to improving Italy’s account sheet, they fail to address the deepest—and most politically sensitive—structural problems in the economy.  The proposals are ultimately permutations of tax hikes and spending cuts that presuppose that Italy’s problem is an abundance of debt, when in reality it is a lack of growth.  Less than one-third of the increased revenue will go to spurring growth, and in the most standard and non-innovative ways.  While making it easier to fire employees is necessary, for example, Monti has failed to also increase taxes on the wealthiest Italians.  He claims that such an action would cause a capital flight in Italy.[lvii]  This is like the Northern League claiming eased immigration laws would cost Italian youths their plentiful jobs—except that Italian youths are decreasing in numbers from brain drain and low fertility and the economy needs those immigrants to fill labor shortage.  Likewise, Monti must realize there already is very little capital flowing into Italy, and there is no growth; raising taxes will only increase the government revenue to which the wealthy have avoided contributing for too long.

In addition to tinkering with the financial system, Italian leadership must tackle related societal issues. The government must eradicate the stranglehold of organized crime and government corruption—both economical inefficiencies that disjoint the markets.  According to some studies by leading trade associations, the power of the mafia is so significant that recovering the money it saps from the economy would be enough to pay off the vast majority of Italian debt.[lviii]  The technocrats need to end the “ordini” system of private cartels that crowd out competition and starve innovation in many fields.[lix]  The new cabinet must generate more opportunities for youths, eliminate laws that discriminates against the young, and combat the national brain drain.  Much of this will require increased investment in Research and Development, which has fallen over the last decade, along with innovation and—not coincidentally—the Italian standard of living over the same time period.[lx] [lxi]  The government still has yet to address the quaint but inefficient culture of family-owned businesses that keep average costs high and prevent more efficient mergers.  Lastly, while the government must spur production in the long run, it can begin by more successfully exporting the attractive goods the nation already produces.[lxii]  The current government has only had a month to enact changes, and it has successfully approached some of the fundamental issues holding back the Italian economy and making it a problem for the entire continent.  The problems run deeper, however, and the Italian government must begin making more radical changes more rapidly.

Italy, however, cannot solve the crisis alone at this point.  Although the Italian government has made reasonable progress, the elected leaders of Europe have unfortunately been slower and more ineffectual in staving off the crisis.  The creation of the EFSF may have brought down yields on Greek debt temporarily, but lack of details on funding sources have tarnished its credibility; regardless, its scope is not wide enough to withstand runs on Spanish debt, let alone that of Italy.[lxiii]  The most recent solution—deemed the “Euro Pact”—does admittedly move in the requisite direction of fiscal unity and corrects the problem of the Stability and Growth Pact by ensuring automatic penalties for non-compliance.  Nevertheless, the move has been coupled with decreased ECB investment in European sovereign debt—a move that is philosophically cohesive but economically disjoint.[lxiv]  In other words, while the Euro Pact and the reticence of the ECB both demonstrate an ideological urge to keep the burden on political actors, long-term political integration cannot be viable without short-term support from the ECB.  Moody’s rating agency has already threatened the most fiscally responsible nations in Europe with downgrades beginning next month for failure to address the immediate issue of sovereign debt.[lxv]

Ultimately, Europe has committed to the necessary long-term goal of centralized fiscal policy, but it has yet to solve the short-term credit crunch.  Only a more active European Central Bank can solve the crisis at this point—just as the Fed was active during the crisis in the United States a few years ago.  Politics has taken precedence over economics for too long in the European Union. While European memory resists appeasing indignant trouble-makers, this time it is the right thing to do: give the tempestuous economy what it wants and institutionally value it above politics.  This begins by allowing the politically independent central bank to do what is necessary, which is to back sovereign debt on the condition that political actors plan to achieve full fiscal integration.  While some may prefer heightened oversight in favor of fiscal integration, European leaders have proven their inability to mitigate political temptation when given the option, making fiscal integration effectively the safest form of oversight. Such integration will also reverse the current trend of necessary economic sanctions and austerity, which are unsustainable and economically deleterious in the long-run.

The resistance to such action, however, stems from legitimate concerns in Berlin.  The Germans and other hardliners are correct in that only a strict ban on bailouts will pressure Southern European leaders enough to hedge the risk of continued moral hazard.  This is, in some sense, what forced Berlusconi out of Italy, which may not have happened otherwise—or at least not so soon.  But, at the same time, there is so much reflexivity in the market, that no matter what Italy does at this point, investors will not trust the government alone.  As a result, Germany and the ECB must take some action in conjunction with Mario Monti’s reforms.  The terrible irony seems to be that for Italy to be forced to act, Germany and the ECB must credibly refuse to act—and if Germany and the ECB do act, then Italy may no longer be forced to act as well.

Nonetheless, Germany was right about this insofar as it is able to force non-political actors and technocrats to take the realms.  Therein is the credibility.  Now it must retreat from the same hard-line stance and support Italy in order to save the euro.  The Germans can allay their fears by relying on the ECB and other lending institutions, such as the IMF or foreign governments, to make interest rates for Italy high enough to deter any relapse into moral hazard.  In turn, however, there needs to be almost unconditional security of bonds guaranteed by the ECB—at least in the short-term so that inflation can still be avoided in the long-term.  This has already been suggested in the form of Eurobonds, which were also rejected by the Germans.[lxvi]  Claims that this is impossible because it would require treaty changes are moot at this point; if some form of joint debt assumption does not occur, the treaties are ineffectual anyway and the union they support could crumble.  Europe must change the treaties if necessary.  If that takes too long, they should defy them—after all, Europe has done so in the past when it was politically expedient, and it seems more compelling now that it is economically imperative.