The solution to Italy's woes is quite simple - leave the euro

Mind you, not all of this is due to the euro. There is a desperate need for reform yet the political system seems incapable of delivering what is needed. And Italy has been one of the prime sufferers from the rise of the emerging markets.

Whereas Germany produces high-spec, large consumer durables and machinery, Italy has been specialised in precisely the low-to mid-spec consumer goods which China and others have come to produce more cheaply.

The euro has certainly not helped because, from the start, Italian costs continued to rise faster than they did in Germany and other core countries. This time, though, there was no let out from the exchange rate. So Italian costs and prices were left high and dry.

True, the inflation rate has come down sharply. Indeed, it is now slightly negative. This is hardly surprising given that the unemployment rate is running at 12.6pc. Unlike some of the other peripheral members of the euro, however, Italy has not done much to reduce the competitiveness gap. With so much spare capacity, it is possible that pay and other costs will start to fall markedly, as they have in Spain, Greece and Ireland. But if this happens, although it will eventually make Italian products more competitive, it will also worsen Italy’s other big problem – debt.

Although at 3pc, the government’s deficit is not particularly high, the real financial problem lies with the stock of debt, built up through a long run of deficits. Strikingly, during the recent period of “austerity”, the debt ratio has been rising. It now stands at about 130pc of GDP. If the economy stagnates and prices drop, then nominal GDP will fall. That would cause the ratio of debt to GDP to rise even if the budget were in balance so that the amount of debt had stopped rising.

Italy is very close to the situation that economists call a “debt trap”, that is to say when the debt ratio rises exponentially. From this the only escape is through inflation or default. Italy cannot itself inflate while it has no separate currency. So, unless something big starts to change pretty soon, Italy is on course for the mother and father of a sovereign default.

You frequently hear the view that a government debt crisis in Italy is impossible because the Italians have such a high personal savings rate and, accordingly, there are always the funds to buy the debt. Equally, it is often argued that, unlike Portugal or Greece, the Italian external position is not too bad, with liabilities to foreigners only larger than external assets to the tune of about 30pc of GDP. This means that Italian debt is mostly owed to Italians.

This is largely true – so far as it goes. Admittedly, because Italy is not a big external debtor there is limited risk of a crisis of international indebtedness of the sort that periodically afflicts various emerging markets. But there can still be a fiscal crisis. Just because Italians have large savings does not mean that they will willingly pour money into government bonds, particularly when the unsustainability of the public finances implies that at some stage there will be a default.

As we have seen, Greek debt can be “restructured” without shaking the financial system. This is because Greece is small. But Italy is decidedly not. The Italian government bond market is the third largest in the world, after the US and Japan. Someone somewhere is sitting on some huge stocks of Italian debt – mostly Italian banks. So a debt crisis would morph into a banking crisis.

Not that you’d think there was a problem if you looked at market interest rates. The markets are happy to lend to the Italian government for 10 years at 2.4pc, only 1.3pc above the German equivalent. Mind you, before a crisis hits this is exactly what markets are typically like. Their speciality is to shift from insouciance to panic in a jiffy.

How could Italy escape from all this? The deep-seated problems will not improve overnight. The country needs fundamental reform of its political system, its courts, its tax system and its labour laws. Even if all this were achieved, though, Italy would still be mired in public debt.

Like the rest of the eurozone, what Italy needs most immediately is decent economic growth. Perhaps some Europe-wide upturn will be achieved through a combination of ECB boldness and German fiscal relaxation. But I wouldn’t bank on it.

The radical option is for Italy to leave the euro and allow a weak currency to generate an export boom, higher inflation, more taxes and an easier debt burden. I wonder how many more wasted years Italy can stand until it finally dawns on its leaders that this is the only way forward.

Roger Bootle is managing director of Capital Economics. His latest book, The Trouble with Europe, has just been published by Nicholas Brealey Publishing.

roger.bootle@capitaleconomics.com

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