The eurozone debt crisis simply refuses to go away. Last month’s latest and greatest plan put forward by European leaders has already been judged by financial markets to be insufficient. And while it is political uncertainty in Greece that has thrown the whole process into question, the main victim has actually been Italy; in the days since the rescue package was announced, Italy has found its borrowing costs rising to record levels as investors continue to expect the worst.
But why are investors picking on Italy? To some, the answer is obvious: Italy is just another Greece, only on a far bigger scale. The similarities are conspicuous, after all. Aside from those hot summers and striking Mediterranean coastlines, Italy also shares Greece’s outsized debt burden, a notoriously inefficient public sector, and uncompetitive industries. But these similarities should not fool us into thinking that Italy has been dragged into crisis for the same reasons. Unlike Greece or Portugal, Italy wouldn’t be experiencing such turmoil if the ground hadn’t already been thoroughly prepared by others. Put another way, Italy’s crisis is the result of what economists refer to as “contagion”; if someone else hadn’t gotten sick first, then Italy would likely still be relatively healthy today.
This is a crucial distinction with important policy implications. If the crisis now hitting Italy is the result of changes in market psychology rather than economic fundamentals, then the spending cuts being considered by Italy’s parliament, as helpful as they might be for Italy’s long-run budget prospects, will do nothing to avert catastrophe for the country in the short run.
THE KEY QUESTION is whether or not it is fair to describe Italy as “insolvent.” With Greece, there’s no such ambiguity: The Greek government clearly has no realistic chance of ever repaying everything it owes to its creditors, and is therefore well and truly insolvent. That is why no one is willing to lend to Greece any more, and why an essential piece of the most recent eurozone rescue plan was a write-down in the amount of money that Greece owes to a level that is plausibly manageable.With Italy, however, things are less clear. Some observers, such as Paolo Manasse, an economics professor at the University of Bologna, argue that Italy’s debt burden has simply reached a level that is no longer sustainable given its recent history of poor growth and lackluster competitiveness, rendering the country insolvent in the same way as Greece. Indeed, there’s no denying that Italy’s economic growth has been dismal recently, or that its outstanding government debt is extraordinarily large: At about 130 percent of GDP, Italy has the second-highest debt-to-GDP ratio in Europe (after Greece, of course). These superficial similarities make it very easy to see Italy as simply another overly-indebted country in the eurozone periphery that is finally seeing its chickens come home to roost.
But this interpretation overlooks some crucial differences. For one, Italy’s stock of debt may be high, but this debt is largely left over from chronic deficit spending in the 1970s and 80s. Italy’s debt-to-GDP ratio has been over 100 percent for more than 20 years, yet until the past few months no one seriously questioned its solvency. And for most of the past decade Italy has actually run a primary budget surplus, meaning that it has been able to meet all of its spending needs, excluding interest payments, without any additional borrowing. Nor was that expected to change any time soon; as recently as June, a forecast by the OECD predicted lower deficits in Italy than in France or the UK, and for Italy’s debt burden to fall, not rise.
These are not the characteristics of a country with a runaway debt problem, and there was no significant indication that the financial markets viewed Italy’s debt burden as unsustainable. Yet suddenly, in early July of 2011, investors lost their willingness to lend to Italy and Italian interest rates began to leap upwards, unchecked until the European Central Bank stepped in to prevent market panic in early August. What changed?
The argument made by the Italy-is-insolvent camp is that this summer Italy’s economic outlook began to look worse than expected, and the Italian political system demonstrated that it was unable to effectively address the country’s economic problems by failing to make progress on long-term structural reforms. To make things worse, a public spat between Italy’s prime minister and finance minister cast doubt on the government’s ability to enact major new austerity measures. But while the lack of positive policy developments in Italy certainly didn’t help matters, it doesn’t seem sufficient to explain the sudden and dramatic reevaluation of Italy’s prospects that took place in July. Political dysfunction in Italy is nothing new, and it’s not at all obvious what specific new information about Italy’s governance was gained by market participants this summer.
A more plausible explanation has to do with other important developments that were happening outside of Italy at exactly that time. It was in July that it became evident that the problem in Greece had not yet been solved, that European leaders had no credible plan to do so, and that political disagreements within the eurozone would very likely mean that the crisis would drag on with no clean end in sight.
The sharp realization that the Greek debt crisis was gaining strength rather than abating naturally caused investors to consider how that might affect other countries. If European leaders were not able to deal with a relatively small country like Greece, how would they be able to contain the crisis if it started to spread elsewhere? It suddenly became clear that if the market started dumping the bonds of additional eurozone countries, policymakers would not have a plan to stop it.
And here’s where the logic of self-fulfilling vicious cycles takes over. Imagine that you’re an investor who believes that Italy is fundamentally solvent, but also recognizes that there is some risk that Europe’s debt crisis could spread. You know that any increase in interest rates paid by Italy will have an unusually large impact on its budget deficit, simply due to the large debt overhang that Italy has carried for the past two decades. And as a result, you recognize that among all eurozone countries, Italy is uniquely vulnerable to any upward tick in its borrowing costs. So, just to be safe, you decide that discretion is the better part of valor and that it might not be a bad idea to stay out of the market for Italian government bonds until the eurozone demonstrates that it has its act together.
The result of this reasoning was that investors started abandoning Italian bonds, and interest rates began to skyrocket. Of course, these sharply higher interest rates suddenly made Italy’s fiscal outlook deteriorate … which made more people shun Italian government bonds, driving interest rates still higher. Wash, rinse, repeat. All of a sudden, a country that had been on a perfectly sustainable track was now at risk of becoming insolvent—purely because of a change in investor psychology. There was no change in Italy’s economic fundamentals in July. This was contagion, pure and simple.
ECONOMISTS HAVE SPENT a lot of time studying this ugly phenomenon. In the late 1990s several Asian countries fell victim to the same sort of contagion during what became known as the “Asian Flu.” Though before the crisis no one had thought that countries like South Korea were insolvent, a self-fulfilling downward spiral in investor psychology caused several Asian countries to suddenly lose access to international capital markets. In the case of Asia the IMF stepped in with short-term financing to bridge the liquidity gap until the vicious cycle was broken. Unfortunately, the IMF also required the victims of contagion to implement austerity measures now widely recognized as destructive and unnecessary as the price of its support. Since the cause of the crisis had nothing to do with excessive government borrowing in countries like Korea, it was a dubious logical leap to think that sharp cutbacks in government spending would solve it. In retrospect even the IMF recognized that its indiscriminate demands for austerity were wrong.
Yet that mistake is now being repeated in Europe. Political leaders in Germany and France are pressuring Italy to cut government spending in order to further increase its primary budget surplus. But if market psychology continues to drive Italian interest rates higher, the dollars Italy saves through spending cuts will be overwhelmed by its higher borrowing costs, which are far greater in euro terms than any cuts in government spending that could realistically be achieved. And so Italy’s budget outlook will still look worse rather than better, the market will remain unwilling to lend, and Italian borrowing costs will continue to rise. To make matters worse, austerity will lead Italy’s economy to shrink, just as it has done in the UK, Greece, and elsewhere, making the trajectory of Italy’s debt burden look even less sustainable.
Austerity as a response to the recent rise in Italy’s borrowing costs is therefore exactly the wrong policy prescription. It misdirects attention from the real problem, which is the self-fulfilling negative-expectations spiral in the debt market that Italy has gotten trapped in, and it is counter-productive by sabotaging desperately needed economic growth. Yes, structural reforms would be welcome to help improve Italy’s long-run growth prospects, but by themselves such measures will not alter market psychology by enough to end the crisis. Instead, the only way to break out of the remorseless spiral of contagion is to take radical steps to fundamentally change market expectations about Italy’s debt market.
The European Central Bank is the only institution that has such power right now. By declaring that it will provide unlimited liquidity—which it is uniquely able to do through its power to create euros, and which is something that central banks throughout history have traditionally done in times of need—the ECB could suddenly and permanently break the vicious confidence cycle. Once markets believe that Italy’s interest rates will stay low, Italy’s debt picture suddenly looks sustainable again, and the crisis is contained.
Yet due to a combination of excessive caution, a desire by many to view the eurozone crisis as a morality story rather than an example of vulnerability to financial markets, and an unwillingness to put the eurozone’s future over parochial interests, it seems likely that the ECB will continue to sit on the sidelines. Policymakers in Europe are right to fear contagion. Unfortunately, their proposed solutions are doing nothing at all to stop it.
Kash Mansori is an economist and consultant who provides analysis of financial and economic issues on his blog The Street Light.