Monday, December 26, 2011

Italy dangerously close to insolvency and too big for Europe to Bail Out

THE WORLD ECONOMY’S future may hinge on Europe’s ability to resolve its debt crisis. And Europe probably won’t be able to resolve its crisis unless Italy gets its financial house in order. With a gross domestic product of $1.7 trillion and a national debt of $2.6 trillion, Italy is both dangerously close to insolvency and too big for the rest of Europe to bail out. The bond markets are charging Italy unsustainably high interest rates, and that won’t change unless and until the country can start shrinking its debt-to-GDP ratio.

Therefore, everyone should be rooting for new Prime Minister Mario Monti, the “technocrat” who replaced Silvio Berlusconi in November and who has recently pushed a $43 billion deficit-reduction package through the Italian Parliament.

Will it work? Assuming that everything goes according to plan, the package would give Italy a balanced budget by 2013. Mr. Monti’s program is heavily weighted toward short-term property, sales and fuel tax increases, though it would also cut funding for the country’s notoriously inefficient provincial and municipal governments.

Perhaps most important, the prime minister reformed old-age pensions, which account for about 30 percent of all public spending, by raising the retirement age and ending cost-of-living adjustments for better-off retirees. Mr. Monti also made a valiant stab at ending Italy’s culture of tax evasion by banning cash transactions larger than 1,000 euros.

The problem is that Italy cannot escape its financial predicament unless it starts growing again; in fact, until the Great Recession, Italy ran relatively small budget deficits, but its debt-to-GDP ratio rose because the economy expanded at an average rate of only 0.75 percent per year over the past 15 years.

Mr. Monti’s measures will almost surely hurt growth in the short run by reducing consumers’ disposable income. At more than 45 percent of GDP, the country’s tax burden is one of the highest in Europe. But the prime minister has announced no structural reforms that would enhance Italy’s ability to grow in the long run.

Italy’s fundamental problem is slow productivity growth; much of that relates to legislation that shelters favored industries and professions from competition and makes it nearly impossible to fire workers in firms with more than 15 employees.

As a result of the latter provision, known as Article 18, workers have little incentive to work hard once they’ve passed a probation period; firms have incentives not to hire, for fear of getting stuck with poor performers. Mr. Monti says he wants to tackle these restrictions, but his predecessor, Mr. Berlusconi, tried, and failed, to change Article 18 a decade ago, defeated by protests from Italy’s powerful trade unions.

Of course, even if Mr. Monti does manage to push through overdue legal and financial changes, Italy’s chronic nepotism would remain. Italy’s dwindling cohort of young people complain that family and personal connections, not skills, determine who gets ahead.

Italy’s best — and perhaps only — hope is that the country’s crisis is so desperate, and its realistic alternatives so few, that a nonpartisan leader may be able to overcome the interest-group resistance that has thwarted reform in the past. Certainly, Mr. Monti has no illusions about his challenge. “What we need is a revolution in Italians’ thinking and that takes time,” he has said. Alas, Italy’s time, like its cash, is running out.

- Washington Post

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