Italy Hits the Iceberg

Perhaps it was already too late for Italy to avoid the financial downgrade that credit-rating agency Moody’s threatened at the beginning of this summer. It’s not as if people didn’t see it coming. Italy’s economy has been battered by rising debt and worsening credit spreads. A default or bailout is every European central banker’s nightmare scenario — it’s the economy "too big to save." Indeed, as Finance Minister Giulio Tremonti ominously warned in July, "If we don’t act now, then we will be like the Titanic, and even the first-class passengers suffered." Not to push the analogy, but Italy may have just hit the iceberg. It’s not necessarily sinking, though. The government in Rome can still try to exploit the pressure generated by the current financial crisis to jolt the economy out of its semi-stagnation, launching a bold and comprehensive program of structural reforms to increase productivity and growth, while driving down debt. But does anyone believe that embattled Prime Minister Silvio Berlusconi still has the will — or enough political juice — to do it?

Moody’s Oct. 4 decision to downgrade Italy’s sovereign debt to A2 follows a similar decision by Standard & Poor’s on Sept. 19 that knocked the country down to a single A rating; but Moody’s slash of three notches was in some ways more shocking. Both agencies also give Italy a negative outlook, which means that future downgrades are likely. Italy’s high and mighty have reason to worry.

The downgrades are based on three concerns. First is the sharp deterioration of the international economic outlook, particularly in Europe. This is obviously something over which Italy has no control, but which it’s more impacted by than other advanced countries because of its endemic low growth rates. Italy does not have the fiscal space or the flexibility to change monetary or foreign exchange policies to boost growth. Second, and compounding the problem, sluggish growth risks undermining the otherwise good fiscal results achieved by Italy in the past few years, particularly the primary budget surplus. Third is the political component: Growing frictions within the ruling coalition and its slim parliamentary majority have undermined the government’s ability to enact necessary but unpopular measures to front-load fiscal consolidation and break the numerous logjams that hamper growth. And political uncertainty is not going to disappear anytime soon; even if Berlusconi steps down, it is unclear who will be his successor or whether new elections will lead to a more effective government coalition.

Even if Berlusconi and Tremonti did see the Moody’s iceberg coming, it is unlikely that they could have turned the ship of the Italian economy in time to avoid it. This, however, doesn’t mean that they’re above fault. Italy should have taken immediate action to strengthen its economy and to try to distance itself from the contagion of the debt crisis in Greece and the other European peripheral countries. Specifically, Rome should have embraced the stern recommendations issued in early August by European Central Bank (ECB) President Jean-Claude Trichet and his incoming Italian successor, Mario Draghi, who requested that Italy act with urgency on several fronts, including liberalizing public services and professions, making the labor market more flexible, increasing the retirement age in line with international standards, and streamlining the public administration. These measures, as the ECB urged, should be part of a "comprehensive, bold, and credible strategy of reforms." Rome gravely nodded and promised to get to work, but the result was more of the same: lots of talking and only marginal improvement.

After some procrastination, the Italian government did push through Parliament a set of measures aimed at having a balanced budget by 2013, a plan that would allow the debt-to-GDP ratio to start to decline from its very high level. But the plan’s effectiveness and credibility have been questioned: Most measures don’t actually cut government spending but rather increase tax revenue, including a much-vaunted program to strengthen tax collection. (We’ll see what comes of that.) In any case, many of the structural reforms and growth-enhancing measures suggested by the ECB are missing.

The predicament that the Italian government now faces is like trying to fix the flaws in the Titanic’s construction as it’s hitting the iceberg: Sound the alarm, save the women and children, plug the holes — and while you’re at it, build more lifeboats, double-plate the hull, and make sure that those rivets aren’t subpar.

Markets are asking Italy to resolve long-standing problems that will take years to redress, even assuming its full commitment to the task. This commitment, however, is severely lacking now and in the foreseeable future. Berlusconi is under fire for nonstop sordid revelations about his private life; the current coalition government lacks any clear candidate to replace him; and the opposition is too fragmented and weak to offer a credible alternative. Even civil society seems unable to offer credible leaders. The only exception to this lack of leadership is the president, Giorgio Napolitano, whose moral authority has grown considerably in recent months but whose powers are strictly limited by the Italian Constitution. Napolitano, however, has never said that he’s eager to assume the premiership.

Under these circumstances, it is unclear who will be able to take those bold, comprehensive actions recommended by the ECB; Tremonti is preparing plans, but the political will to push them forward is lacking. This is due largely to Berlusconi — whose weakened stature makes it nearly impossible for him to take command of a fractious government. Meanwhile, Italy remains exposed to the spillover effects of the debt crisis, though its budgetary situation appears much stronger than those of most European countries. But the Moody’s downgrade doesn’t help. It’s now going to be more difficult — and it cost Italy a lot more — to enter credit markets and reassure bondholders.

To make matters worse, like with the Titanic’s sinking, the Carpathia is too far away to come to Italy’s aid. European leaders have been unable to decide on an effective strategy to cope with the debt crisis and contain its effects. The European Financial Stability Facility (ESFS) that is designed to assist countries dealing with the economic crisis is not yet operational, pending the ratification of the last of the 17 eurozone countries, Slovakia. Even assuming the ESFS does come online in the near future, most serious analysts doubt whether it has adequate resources; only $300 billion would be available to it, and most estimates hold that it will take more than $1 trillion to calm the restive markets.

Still, there’s a glimmer of hope on the horizon. There is no doubt that Italy — as well as a number of other eurozone countries — is navigating through very dangerous seas. But it’s not yet a foregone conclusion that it will go down like the Titanic. That said, if Italy’s politicians think that anyone but themselves will come and save them, then they might want to start taking swimming lessons now.