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Keeping the eurozone intact

by Michael Spence

As the economist Mario Monti’s new government takes office in Italy, much is at stake — for the country, for Europe and for the global economy.

If reforms falter, public finances collapse and anemic growth persists, Italy’s commitment to the euro will diminish as the perceived costs of membership come to outweigh the benefits. And Italy’s defection from the common currency — unlike that of smaller countries, like Greece — would threaten the eurozone to the core.

Italy is a large economy, with annual gross domestic product of more than $2 trillion. Its public debt is 120 percent of GDP, or roughly $2.4 trillion, which does not include the liabilities of a pension system in need of significant adjustments to reflect an aging population and increased longevity. As a result, Italy has become the world’s third-largest sovereign-debt market.

But rising interest rates are causing the debt-service burden to become onerous and politically unsustainable.

Furthermore, Italy must refinance €275 billion ($372 billion) of its debt in the next six months, while investors, seeking to reduce their financial exposure to the country, are driving the yield on Italian 10-year bonds to prohibitively high levels — currently above 7 percent.

The need to refinance outstanding debt is not the only challenge.

Domestic and foreign bondholders, especially banks, have experienced capital losses, which have damaged balance sheets, capital adequacy and confidence. The trade and current-account deficits are large and rising, probably reflecting a loss of competitiveness and productivity relative to Germany and France, two of Italy’s largest trading partners. Moreover, economic growth has been slow for the past decade, and is not accelerating, which will make it difficult to lower the public-debt burden even with fiscal consolidation.

Italy’s low growth rates reflect several factors, including labor-market rigidities, public-sector under-investment in the science and technology base of the economy, limitations on competition in certain sectors, and an extended period of structural adjustment to the euro.

But Italy has significant strengths as well. Aggregate debt (government, household, nonfinancial corporations and financial institutions) is slightly more than 315 percent of GDP, similar to Switzerland (313 percent), France (323 percent), the United States (296 percent), and even Germany (285 percent) — all 2009 numbers.

Household debt is very low, less than 50 percent of GDP. Moreover, a long-standing pattern of high household savings, in the range of 17 to 30 percent of income, means that individual and household net worth is higher than in most advanced countries.

That is not all. The businesses and industries of central and northern Italy are efficient, innovative and globally integrated. And budget deficits were held in check during and after the crisis, unlike in many other advanced countries. Of course, while this was necessary, given the high initial public debt burden, it limited counter-cyclical stimulus and impeded growth.

Italy’s crisis comes at a time of heightened risk for key countries (for example, a hard landing in China, or persistently high unemployment in the U.S.). In assessing such risks, it is useful to focus on three variables: resources, competence and will.

Does a country have the resources to address the problems that it faces? Do policymakers have the experience and expertise to implement effective reforms?

Do the authorities recognize the need to act decisively and aggressively?

Resources come first. If resources are inadequate, the outcome will be bad, regardless of competence or will, unless there is some sort of external help. Likewise, political will is irrelevant without competence to turn it into effective policies.

It seems to me that, in several important cases, including Italy, the U.S. and China, there is a relatively favorable scenario and a much less attractive one, distinguished largely by the effectiveness of the policy responses. Unlike Greece, where resources are deficient (giving rise only to unattractive scenarios), these countries’ resources are adequate, but either competence or political will (or some combination of the two) is in doubt, although analysts’ assessments vary widely.

For Italy, that means that the health of its consolidated balance sheet can be used with reforms and parameter shifts in the pension system to restore fiscal balance and boost growth over time. Three things are required: a comprehensive reform program that meets the adjustment challenges head-on, political backing for that program, and time to implement enough of it to establish the credibility needed to lower the high-risk premium on Italian debt.

With the first two requirements dependent on Italy’s turbulent domestic politics, investors are increasingly unwilling to bet on the relatively favorable scenario, which means that Italy does not have time. Rising yields could undercut the fiscal-stabilization and economic-growth program before it can be fully implemented. As yields rise, the adequacy of the country’s resources becomes questionable or worse.

What is needed is a financial circuit breaker, in the form of a transitional lender of last resort. This would allow the reform programs to shift the balance of risk back toward the favorable scenario.

There is, however, a final risk factor. The type of determined intervention designed to prevent the runup in bond yields may not be forthcoming, owing to a concern within the eurozone core, led by Germany, that unconditional, aggressive action by a lender of last resort would undercut the incentive — and hence the political will — to undertake the required reforms.

The sequencing problem is obvious: A commitment conditional on reform progress will not bring back private investors immediately, because it does not reduce the perceived risk of substantial political obstacles to implementing the necessary measures.

Only bold and largely unconditional commitments by both the European Union and Italy can break this impasse. Absent either one, the risk of a sequential unraveling of eurozone public finances and a global economic downturn will remain.

Michael Spence, a Nobel laureate in economics, is professor of economics at New York University’s Stern School of Business, distinguished visiting fellow at the Council on Foreign Relations, and Senior Fellow at the Hoover Institution, Stanford University. His latest book is “The Next Convergence — the Future of Economic Growth in a Multispeed World.” © 2011 Project Syndicate