Europe’s Risk Lies in Italy

The economic weakness in Europe redoubles the threat to the common currency. Italy’s setback in particular threatens the euro zone in two ways: (1) Because Italy is the zone’s third largest economy, failure there would place unsupportable burdens on Germany as it tries to sustain union. (2) The bad news could impede Prime Minister Matteo Renzi’s crucial reform agenda and so deprive Italy, and by extension the rest of Europe’s troubled periphery, of the only route to the economic efficiencies, growth, and the fundamental ability to meet financial obligations. A declaration of defeat for the common currency and dissolution would be premature, but the trends are worrisome.

Italy’s economic situation is far from encouraging. According to government sources, second quarter figures show the country slipping back into recession. The underlying situation is worse than this looks. During the past three years, the economy has enjoyed only one quarter of growth. It is now 9 percent smaller than it was before the crisis broke and has shown no gains on balance since 2000. The economic weakness has so limited the flow of tax receipts that Rome’s budget deficit this year will exceed the 3.0 percent of gross domestic product (GDP) allowed by EU guidelines. The government’s outstanding public debt equals €2.1 trillion, verging on an outsized 136 percent of GDP, up from 130.2 percent last year.

This continued weakness is all the more ominous because the rest of the zone, according to media sources, seems also to have faltered. German factory orders have declined sharply. The French economy is stagnant. During the first quarter of the year, seven of the 18 euro zone member economies shrank, and many governments are cutting their growth forecast for the rest of the year. Reports of deflation are also ominous. French consumer prices fell 0.4 percent in July, Portuguese prices fell 0.7 percent, and Spain saw the steepest price slide in five years. The picture lessens the prospects of any lasting financial solution, while the German weakness in particular, if it lasts, could take from the rest of the zone its greatest source of support.

The Italians blame their economy’s recent setback on renewed turmoil in the Middle East and on the tensions with Russia over Ukraine. Both places are important export markets for Italian products, especially the fashion and luxury goods at which the Italian economy excels. But still, this cannot explain the much longer period of economic malaise. It is this ongoing weakness that not only threatens the zone’s immediate stability but also makes fundamental reform simultaneously more urgent and more difficult to implement.

It was former Italian Prime Minister Mario Monti who first explained the essential need for fundamental structural reform. Italy, he explained, and the rest of Europe’s periphery has to grow if they want to meet their financial obligations and so resolve the crisis. The legacy of past budget profligacy, however, makes it impossible to use stimulative government spending to promote growth, as Italy and others have done in the past. Were investors to see Italy turn back to such practices, they would worry over a new avalanche of debt, flee existing Italian financial obligations, and make it unsupportively expensive if not impossible for Rome to borrow. Since the austerity required to avoid such reactions also dampens the pace of economic growth, the only answer to Italy’s dilemma, Monti argued, were reforms that could otherwise make the economy more dynamic, efficient, and competitive. Italy’s circumstances certainly offered ample room for improvement. The country had built up a stifling array of regulations in labor and product markets that had made it notably uncompetitive and inefficient, even by European standards.

Though Monti made some impressive initial gains in labor market reform, the drive lost momentum when he left office. Hope was renewed, however, when Renzi renewed the reform effort on entering the prime minister’s office last February. But for all his support, success is still open to doubt. The problem is that the good effects of reform will take time and will require shifting budget priorities, both of which demand patience and a willingness to make interim sacrifices, neither of which are plentiful, ever, anywhere, especially in an economically pressed environment.

Even the first stages of his reform agenda promise considerable initial strain. Renzi’s aim to free up labor markets by bringing Italy’s heavy labor taxes into line with the euro zone average will deny Rome revenues of an estimated €32 billion, a large figure that the government will need to make up with savings elsewhere in its budget. Renzi’s government would have to find an additional €18 billion to rationalize the unemployment benefits program as promised, €7 billion for promised tax cuts to low income people, and €5 billion for Italy’s long-neglected schools. It would also need to find €13 billion to refurbish much neglected infrastructure. Ports in Italy, for example, are in such disrepair that it takes 17 days to export goods, half again longer than the EU average.

All would be a tall order in good economic times, but especially difficult when a shrinking economy is otherwise thinning revenue flows and increasing demands for social services. No doubt there is ample in Italy’s notoriously bloated budget that the prime minister could tap to finance these reform objectives. But having the room and even finding those sources is very different from actually implementing a change in budgetary priorities, especially in a pressured economic environment. Undersecretary to the prime minister, Graziano Delrio, has quickly assured all and sundry that government plans to wring savings from elsewhere in the budget are on track, but, then, he would say that.

If, despite the exigencies of immediate economic setbacks, Renzi can stick to these and further plans for fundamental economic reform, there is reason to expect accelerated economic growth down the road, despite the overall budget austerity otherwise required, a prospect that could relive much of the present financial strain by allowing Italy to discharge its overhead of financial obligations. If others – Spain, Greece, France, Portugal, etc. – follow the reform example, the zone would offer a promise of still greater relief. But if immediate economic pressures derail the reform effort, in Italy and the rest of the periphery, the financial crisis would have no end in sight, and, whatever Germany’s commitment, the probability of the euro’s dissolution would rise meaningfully.

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