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vox
The fate of the euro and the fate of Italy are now intertwined. The euro will not survive if Italy is forced to default because its government can no longer refinance the part of its 1.5 trillion debt coming due every year. The firepower of the European Financial Stability Facility (EFSF) would not be sufficient to safeguard Italy, even if the IMF were to provide a couple of hundreds of billions of additional funding. In short, Italy is too big to fail, but also too big to save. Can Italy save itself? Some analysts are pessimistic (Manasse 2011) but I believe there still is a path to success.
Italian reforms
The Italian government is pushing a strong and credible fiscal adjustment through Parliament. But this might not be enough to prevent another sell-off in the Italian bond market. Experience has shown that spikes in the risk premia lead to a self-reinforcing negative spiral under which higher interest rates put into doubt the solvency of the government, and threaten the survival of the Italian banking system which gets cut off from the normal interbank (and other) cross-border financing channels. However this vicious circle can be broken to allow the Italian government to survive a substantial period of high interest rates as it did in the 1990s when interest rates were in the double digits for several years. (See my analysis of this period and what is different today.) The distribution of tasks should be simple: Italian households should finance their own government by buying
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Can Italy survive the financial storm? | vox - Research-based policy analysis and com...
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its debt, and The ECB should prevent a collapse of the Italian banking system. A first, key element of survival is thus that the new high-cost debt should be sold mostly to Italians. In this way the higher cost of debt service will not be a burden on the country, but just a redistribution of income between savers and taxpayers. To the extent that the new, high cost debt instruments are sold to foreign investors they constitute a burden on the entire economy because they lead to a deterioration in the current account. This should be avoided by using regulatory and other levers to entice Italian savers to shift to Italian government debt (typically BOTs and BTPs). (On the difference between domestic and foreign debt see my Policy Brief). At present about one half of all Italian public debt is held in Italy. If the proportion of new debt bought by domestic savers could be increased to at least three fourths the negative feedback loop mentioned above could already be much reduced. There would then be much less need for the ECB to buy more Italian public debt.
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Can Italy survive the financial storm? | vox - Research-based policy analysis and com...
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Concluding remarks
Of course, this survival strategy makes sense only if the long-term adjustment is also taken care off. On the fiscal front this seems to be the case. What has to start yet is to make the Italian economy competitive again by reducing labour costs. It took even Germany the better part of a decade before it could make up for the overvaluation with which it had entered the Eurozone. But the process of reducing wage costs must now start to convince financial markets that Italy will be able to grow again on the back of growing exports, as it did in the 1990s. Provided the real sector of the economy can be shielded from the worst effects of the financial storm the country should have enough time for the real adjustment to bear its first fruits.
References
Manasse, Paolo (2011) Credibility is not everything, VoxEU.org, 9 November.
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19/12/2011