Italy’s Debt Crisis: Sentiment or Reality?

Far be it from me to trivialise the significance of Italy’s sovereign debt problems, especially when so much heavyweight opinion is weighing in with analyses that demonstrate just how dire the whole situation is.  But, at the risk of appearing foolish I will venture to suggest here that Italy’s problems are perhaps not quite as immediately and inevitably catastrophic as they are being portrayed in some quarters.

The problem appears to be one of iliquidity as opposed to insolvency.  Notwithstanding a budget deficit estimated to be 4 percent of GDP by the EU Commission, Italy is running a primary budget surplus, in other words, once interest payments on debt are accounted for it is actually spending less than its receipts from the usual sources including taxation. Now that the spread on Italian sovereign bonds over German bunds has reached 570 basis points, when during the good times the spread was as low as 9 basis points, the tempting conclusion would be that Italian bonds were not offering value then; they are now, so buyers should be purchasing more Italian bonds at more attractive yields.  Moreover, one might also speculate that the ECB’s operations to buy Italian debt to keep yields down might actually yield that august institution a profit in the long-run. 

The unwelcome complication is that the balance sheets of the natural buyers of Italian debt have been dented owing to losses incurred on existing holdings of Italian bonds, and such buyers are therefore scarcely in a position to assume greater holdings of Italian bonds.  And, Italian sovereign debt is certainly at a burdensome level, at a net level of some 100 percent of GDP.  It is estimated by Alen Mattich writing in the Wall Street Journal that next year Italy will need to raise €325[1] billion from capital markets in new funding to cover the budget deficit and to replace maturing debt. It is estimated that to completely stabilise the Italian debt situation and return confidence to the markets, around €1 trillion would be required, which far exceeds the capacity of the EFSF. However, the paradox is that was such a sum to become known to be available, nowhere near as much would be required as renewed confidence would bring private investors flooding back to the markets.

Why Italy’s need for funding does not constitute an immediate problem is that the maturity structure of Italian debt is relatively long at 7 years so does not have to be rolled over immediately.  This means that yields at 7.5 percent do not make an immediate difference to the interest costs of funding the deficit.

Italy: Fundamental Fiscal Position

	2004	2005	2006	2007	2008	2009	2010	2011	2012	2013
Net Lending/Borrowing (% of GDP)	-3.6	-4.4	-3.3	-1.5	-2.7	-5.3	-4.5	-4.0	-2.4	-1.1
Output Gap (% of GDP)	0.0	–0.4	0.8	1.5	–0.5	–3.9	–3.2	–2.8	–2.5	0.0
Structural Balance (% of GDP)	–4.3	–4.5	–3.3	–2.5	–2.6	–3.9	–3.1	–2.6	–1.1	–1.2
Net Debt (€ bn)	97.1	89.3	89.8	87.3	89.2	97.1	99.4	100.4	100.7	94.8

Source: IMF World Economic Outlook, September 2011

Concomitantly though, Italy is saddled with a lacklustre economy. Data pertaining to Italy’s car giant Fiat has recently been reported by various news sources. For example Bloomberg Business Week (Oct 31-Nov 6,2011, pg 30) reported that Fiat’s Italian workers produce 30 cars per year per worker, and operate at 33 % of capacity. In contrast, Polish workers at Fiat’s plant in Poland produce 100 cars per year per worker, operate at over 73 % capacity and earn 1/3 the wages earned by Italian labour.  Consequently 22,000 Italian factory workers produce 650,000 cars, while Fiat’s 6,100 Polish workers produce 600,000 cars. Nor do these figures capture standards of workmanship. Standards of workmanship in Italy have been at the heart of the issue of why it’s always been a difficult decision to buy an Alfa Romeo (manufactured of course by Fiat), notwithstanding the attractive styling and design flair that has always been a hallmark of the best Italian products.

Scant wonder then that the IMF forecasts that Italian GDP will grow at a rate of some 1 percent per annum for the next three years, coupled to an inflation rate of about a percent a year as well. This is scarcely the ideal recipe for escaping a burdensome debt level.  But these forecasts are surely predicated upon Italy remaining a member of the Eurozone. Should Italy exit the Eurozone a seismic shift to the numbers can be expected; in other words all bets are off. Following on from an exit from the Eurozone, its currency would be substantially weaker, with materially higher inflation and also stronger growth following an initial slump.

However, a careful analysis shows that in terms of the economic drivers that are thought to drive growth, Italy has been performing moderately well. Of course, it is changes in the important indicators that drive growth, not the absolute levels of the indicators. For instance, non-construction investment spending has held up well, lifting the net capital stock by 19 percent between 1999 and 2009. The percentage of the workforce with a degree increased over the same decade, from 13 percent to 18 percent, indicating that investment in human capital has also been robust. R&D spending, although low at only 62 percent of the Eurozone average, has also been rising.  Moreover, the kind of outcome favoured by those who favour a policy approach centred on structural adjustment has indeed been happening; there is evidence that both product and labour markets have become more flexible and open.  For more on this see Barry Eichengreen

The essential difference between illiquidity and insolvency is that when illiquidity is the issue, the problem is in essence about cash flows; once the problem is resolved creditors can still expect to get paid. So the problem distils to one of necessary forbearance.  When the problem is insolvency the inescapable fact is that somebody will have to incur losses; not everybody will get paid.  Then the issue is one of apportioning losses between different creditors. 

Where illiquidity is the issue, as it is now, sentiment plays a big role.  As soon as sentiment improves, cash constraints can vanish overnight as normal flows resume again in financial markets. Then the €1 trillion required to stabilise Italian debt reverts to a potential number only that does not have to be deployed in reality. Extremely gloomy sentiment is clearly contributing in a major way to the strains of the Eurozone, but this is subject to change. 

Political analysis indicates that an important factor retarding economic performance in Italy is deficient standards of governance.   Thus, were an improved government in respect of criteria such as maintenance of the rule of law and government effectiveness coupled to low levels of corruption to follow on from the current state of political flux, this could be the trigger for a substantial improvement in sentiment.  Unlike Greece, it is not yet inevitable that Italy’s debt difficulties will end in tears. 

Obliquely, it is being suggested that the best political arrangement for countries such as Greece and Italy under the circumstances is government by technocrats. The thinking is that technocrats are required to implement necessary economic remedies, in the mould of the “libertarian paternalism” approach. However, I don’t believe this is right. The approach is flawed in that it implies that there is an obviously correct path for these countries to follow, and it’s merely a matter of implementation.  The range of economic alternatives available to Europeans and individual citizens of Europe is complex and the choice of the optimal policy mix is far from straightforward. The citizenry of Europe is confronting some difficult choices. Thus, government by technocrats becomes a kind of politburo. Such an entity is fatally flawed in that it is deficient in information flows – feedback - about the outcomes arising from the choices it makes and the policy solutions it implements.                

Under normal circumstances, Italy, albeit an economy rather limping along, should have no difficulty meeting its funding requirements from capital markets. But these are extraordinary times, when the very future of the Eurozone project is being called into question.  It is important though that the problem is fundamentally one of liquidity rather than of insolvency.  The question is whether any institution, either the ECB or the IMF, has the resources and the political capital to provide the liquidity Italy needs. It was said of some banks that they were “too big to fail”.  The problem with sovereign debtors encountering funding problems is that they may be “too big to be rescued” in that no institution may have the resources to continue providing liquidity until sentiment improves and the balance sheets of creditors improve. 

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[1] The amount of new funding required at €25 billion is lower than the 4 percent budget deficit (in 2010 the budget deficit at 4.6 percent of GDP was €72bn) owing to the primary surplus.