The Italian Government Has A New Crisis

Germany isn't the only EU country where serious ongoing economic problems are leading to political gridlock. Italy's situation is no better, and arguably worse. This 'worse' aspect was pushed into the headlines yesterday by the resignation of Economy Minister Domenico Siniscalco. This is sending shock waves throughout the entire Italian political system. It still isn't clear at the time of writing whether the Berlusconi government can survive, especially given the gravity of the underlying problem which is the need to make severe budget cuts when Italy is in a prolonged recession and elections loom sometime next spring.

Essentially Siniscalco quit because of continuing government infighting over the 2006 budget and over the administration?s failure to force the resignation of Bank of Italy Governor Antonio Fazio following the scandal produced by accusations that he showed bias against Dutch bank ABN AMRO during a takeover battle for the Italian Banca Antonveneta SpA.

Both these issues are serious. The Bank of Italy problem may be getting most of the headline coverage, but the issues over the competitiveness of the economy and the state of the budget are possibly even more important. Italy's public debt currently stands at over 105% of GDP, (and the overall situation is described by some as 'worse than Botswana'). This years annual deficit will certainly be over the 3% SGP limit and Italy has already had an excess deficit procedure initiated against it by the EU Commission. Effectively the Italian government has been given two years to enter a path of serious structural deficit reduction. This is what produces the recurring political crisis.

Italy is also facing a campaign for a referendum on the question of a return to the Lira lead by Berlusconi's coalition partners in the Northern League. It isn't entirely clear where Berlusconi himself actually stands in all this, indeed in a party rally on July 28 he described the euro as a 'disaster' for Italy.


Also it is important to note that Siniscalco's resignation comes after a long battle with the EU's Eurostat over the fiability of Italy's official statistics, and Siniscalco, it seems, has not been entirely excempt from criticism in this affair: maybe he just decided enough was enough. Basta. And I entirely endorse the sentiment.

Update: The Economist now has a general outine of the issues posed by Siniscalco's departure, and this article from Reuter's describes the incredible staying power of Antonio Fazio. Fazio it will be remembered was also under fire in an earlier 'houshold name' Italian scandal: the Parmalat affair. On that occassion he 'saw off' Siniscalco's predecessor Giulio Tremonti (who is incidentally stongly tipped to replace Sinascalco).

The IMF WEO report cited in my post on the German deficit aslo has this to say on Italy:

"The IMF staff?s assessment of present budgetary policies, particularly in the largest countries, suggests they fall far short of meeting this requirement, with most showing little improvement or a deterioration in 2005?06; in particular, in Italy, significant?and as yet unidentified?adjustment will be required to reduce the general government deficit to the authorities? target of 3.8 percent of GDP in 2006. This will pose a key test of the revised Stability and Growth Pact procedures, and it will be important that the additional flexibility they allow is not used as an excuse to postpone adjustment altogether."

As they say "it will be important that ....not used as an excuse", but Siniscalco's departure hardly inspires confidence that the opportunity won't be seized.

Update 2: Reuters has just announced that Tremonti will be the next Italian Economy Minister, in which case it might be just worth reading this piece from International Herald Tribune just to bring everyone up to speed on the fact that it was Tremonti who was instrumental in ousting former WTO head and then Foreign Minister Renato Ruggiero following the scandal which occurred on the day the euro was to be introduced in Italy. It will be recalled that Ruggiero was sacked after saying he was "filled with sadness" by his fellow ministers' lack of commitment to the new single currency and to European integration. The fellow minister he was referring to was, of course, Giulio Tremonti.

Just to rub it in, lets go back to early January 2004:


While Ruggiero, a europhile diplomat and former head of the World Trade Organization, has pushed for a continuation of strong, pro-European policies, others like economy minister Giulio Tremonti have adopted a more eurosceptic stance.

Berlusconi is also trying to encourage his country to be more enthusiastic about the euro, which was introduced in 12 countries on January 1. It lags behind other countries in the eurozone with only 10 percent of cash transactions being carried out in the euro, the most recent figures reveal.

Long queues formed outside banks, stations and post offices during the introduction of the coins and notes, and citizens complained about a shortage of the currency. The figure compares unfavourably with other nations. The average figure in the eurozone is 20 percent with some individual countries being as high as 50 percent.

But one EU spokesman said it was not surprising that Italians were using the new currency less, as fewer cash dispensers were converted ahead of the changeover and many businesses chose not to receive euros in advance.

Berlusconi's office tried to calm nerves by issuing a statement which hailed the creation of the euro and stressed the prime minister's pro-European credentials

Coup de Grace for Italy, or for the SGP?

Well I got it wrong (or so it seems). Someone has 'leaked' to the FT the news that Italy will be 'given two years grace' on the deficit problem. If this is confirmed I suppose it shows that the Commission fears more the Italian voters than it does the international financial markets. Obviously a 'to the letter of the law' application of the revised SGP would present Italy with hard economic decisions (which she will face anyway), but not applying it tests yet one more time the credibility of the EU's institutions. It depends I suppose which you think is more damaging in the long run.

Here's a short extract from the FT article:

"The move, to be announced on Wednesday by the European Commission, offers some breathing space to the embattled government, on Monday confronted with worrying evidence of a prolonged recession.

A survey by Confindustria, the employers' association, indicated that industrial production in the first half of the year had fallen 0.7 per cent from the preceding half-year.

Production also declined narrowly this month from May, pointing to a possible third consecutive quarter of declining gross domestic product and therefore keeping the economy in recession. The numbers offered a fresh glimpse of the scale of the task facing Silvio Berlusconi and his government in reviving Italy's ailing economy and turning around the state's budgetary crisis. Rome has already admitted that it will breach the stability pact's deficit ceiling of 3 per cent of GDP this year, and probably next year as well.

In Lira, or in Euros?

Even if it is a debatable question whether or not the Iraq war is bogged down in a quagmire, Italy's economy evidently is. And no-one has even gotten round to offering a plan 'b', not even Tony Blair himself. So the silence is deafening, and this simply leads to increased speculation. Berlusconi only pronounced publicy on the issue last Tuesday, nearly three weeks after Maroni's referendum call. Latest on the list of those taking a long hard look is Bloomberg's Mark Gilbert, who has dug out an old paper by legal expert on international financial systems Hal Scott.

The key points:

``Countries have kept their own payment systems, government debt instruments, central banks, and the lion's share of their foreign-exchange reserves,'' wrote Hal Scott, professor of international financial systems at Harvard Law School, in a 1998 paper. ``It is almost as if the EMU countries have hedged their bets on EMU by retaining the key institutions needed to re- establish their own currency and monetary policies if need be.''

Scott's paper, titled ``When the Euro Falls Apart,'' went on to ask ``would foreign law, if applicable, such as the law of the U.S. or Germany, enforce the re-denomination or provide instead that the contracts must be honored in euros or are breached if not honored in euros? This is far from clear given the lack of precedents.''

As Gilbert notes:

"The thing about sovereign debt, though, is that the sovereign can do just about anything it likes on its domestic debt, because it enacts the laws that govern those securities. That's how Russia was able to stop paying the $40 billion it owed investors in 1998, and Argentina could default on $95 billion of bonds in 2002 and settle its accounts at 25 cents on the dollar."

Stephen King, head of global economic research at HSBC Holdings Plc in London, togave the following analysis to Bloomberg reporter Sebastian Boyd earlier this week:

"For Italy the choice is increasingly stark. The first choice would be an aggressive tightening of fiscal policy, large tax increases followed by cuts in public spending, and I don't really see the political will for that at the moment. The second choice would be some kind of bond default. The third choice would be an implicit bond default, by creating a system under which it could leave the euro. That would be very difficult to do.''

More or less I agree with this outline. My guess is that choice one will be tried and found to fail. Maybe then some attempt will be made to have a go at number 2. This failing, as it would, we will finally get round to option three.

I watched Argentina systematically from the late 90's on. In Argentina terms my best guess is that we are more or less in 1998 (the default came in 2001). The count down has commenced.

Italy: Devaluation or Deflation

Italy is in recession. There is nothing extraordinary about this, as Donald Rumsfeld notoriously said 'stuff happens', and economies do have their ups and downs. But this recession is a little different, since it is structural and not cyclical. For the Italian economy to return to a better trajectory something has to be done, but what? Morgan Stanley's Vicenzo Guzzo offers two alternatives: devaluation, or deflation (actually the way he puts the alternatives it sounds to me more like a case of: "with which instrument would you prefer I cut your throat sir, the stanley knife or the chain saw"?).

"If Italy intended to restore the pre-1999 competitiveness level, it would have to experience a 25% currency depreciation. While the euro is now down over 5% from the start of the year, such a large correction appears unlikely at this stage. In addition, the economy has steadily lost ground also vis-?-vis its euro area trading partners, as the breakdown of the trade data suggests. Euro depreciation would provide no oxygen on that front. In order to return to pre-1999 competitiveness levels, Italy would have to abandon the current exchange arrangements. To put it bluntly, it would have to drop out of EMU. A 25% devaluation is equivalent to what the economy experienced between 1991 and 1995. Exports scored double-digit gains in the aftermath of the realignment, but domestic demand fell heavily and debt services costs hit 12.5% of GDP. In a replay of those years, Italy would either default on its debt or run toxically tight fiscal policy. This is simply not an option, in my view."

So Italy is caught. To devalue it would have to leave EMU. But then even if it could and did, it would go bust. So, on Guzzo's reading, the only remedy left is substantial deflation, that is an ongoing reduction of wages and prices which would enable competitiveness to be restored. This sounds very much like the 1930's and an Italy stuck with a modern version of the gold standard. It also sounds like going through a recession which could turning out lasting for a number of years, even if this was politically feasible it would be extraordinarily painful for many of those most immediately affected.

This, of course, is a question which is widely treated in the textbooks. So would anyone like to suggest a rival 'escape strategy'?