article

07.11.11

Is Italy Next?

Jittery investors are concerned that Italy may not be able to pay off its debt. Stefan Theil reports on the different scenarios facing the large yet sluggish euro-zone economy.

If tiny Greece, with its population of 11 million, can shake the entire continent and its mighty euro currency, and send ripples across the global economy for more than a year now, then Italy (the euro zone’s third-largest economy after Germany and France) could send them into the abyss.

Yet that scenario is beginning to unfold. Since Friday, nervous investors have been dumping Italian government bonds, which sent bank stocks plummeting. They’re worried that the perpetually flat-lining Italian economy will make it impossible for the country to pay back its 1.8 trillion euro ($2.5 trillion) public debt, worth a staggering 120 percent of the national GDP, the second worst ratio in Europe after Greece’s 152 percent. (For comparison: as bad as it is, America’s public debt will hit "only" 100 percent of GDP in 2011.)

Because Europe has not been able to contain the much smaller crisis in Greece, any hint that the problems are spreading to big countries like Italy and Spain—the latter was also hit by a sell-off this week—is deadly. These countries are much too large for the EU to bail out, as euro-zone governments and the European Central Bank have been trying to do in Greece, to little avail. Together, Italy and Spain have $8.8 trillion in outstanding public and private debt, of which they owe $874 billion to French and German banks alone. “If Italy, a country that is much too big to fail, falls, then the euro falls, too,” Italian Finance Minister Giulio Tremonti warned this week.

Europe’s Plan A—a series of bailout packages that amount to putting ever larger bandages on what is by now a rupturing aorta—has so obviously failed after more than a year of trying. The scary part is that there appears to be no Plan B.

Making it worse, in this case, is the country involved. With Italian President Silvio Berlusconi on trial for alleged sex with an underage prostitute and Tremonti associated with an adviser's corruption scandal, and the two fighting each other like cats and dogs, the last thing anyone needs is an existential crisis centered on Italy, whose government has been the laughingstock of Europe.

Here are three scenarios of what could happen:

Scenario 1: The worst case

Italy, along with Greece, Ireland, Portugal, and possibly Spain, goes to the dogs. If markets become convinced these countries will not be able to repay a portion of their debts, then many of Europe’s banks—which own much of this shaky debt—will be hit by another 2008-style financial crisis. The effect would be another global slowdown, hitting fragile economies like America's hard (among other effects, the euro would crash versus the dollar, making American exports more expensive). Governments would collapse, economies stall, and the euro likely break up, perhaps into a northern and southern zone, as some German economists and politicians have suggested.

The last thing anyone needs is an existential crisis centered on Italy, whose government has been the laughingstock of Europe.

Scenario 2: Muddling through

There was talk this week about doubling the euro rescue fund to 1.5 trillion euros. The theory is that some of the money could tide over the Italian government until it can get a better deal on the regular bond markets again. If necessary, the European Central Bank can keep Italian banks afloat with cheap money, just as it continues to do in bankrupt Greece and struggling Ireland. None of this will help, however, unless the Italian government passes tough reforms to make the country’s languishing economy more competitive again, a highly unlikely event given Berlusconi's preference for organizing bunga-bunga parties and chasing underage belly dancers. Muddling through would likely take years before any economic turnaround, with any sudden crisis taking Europe back to Scenario 1.

Scenario 3: Germans to the rescue

The largest, richest, and most stable country in Europe sits like the spider in the web, essentially controlling Europe’s purse strings. Any plan has no chance without Chancellor Angela Merkel’s backing. One possible way out involves “federalizing” a portion of the debt, with all European countries jointly liable. In essence solid countries like Germany and France guarantee part of the debt of their profligate neighbors. For all debt beyond a set limit, each country would have to go to private investors. This would only work with tough rules, including possible defaults on the private part of the debt, in order to keep banks from recklessly buying up junk debt and starting the cycle all over again, and it does not solve the problem of uncompetitive southern economies racking up huge deficits. For now, Germany strictly opposes any joint “Eurobonds,” with fierce opposition from media and voters who don’t understand why thrifty Germans should be liable for the debt of work-shy southerners.

In other words, it's a fairly safe bet to expect the crisis to get worse before it gets better.