The elefante in the room

The Spanish bank bailout may have taken some heat out of the European crisis, but it's likely to be short lived as Italy's debt trap reminds the world why it should never have been admitted to the EMU.

Spain is naturally the focus of all attention at the moment following the €100 billion bank bailout over the weekend, but the bigger problem for Europe is Italy, and it has been since the euro began.

Like Spain, Italy is now in a fully-fledged debt trap, where economic growth is less than the national cost of capital. Without the ability to devalue, Italy has no hope of turning this around.

It should never have been admitted to the European Monetary Union and now needs to be exited. The euro should have been the common currency of Germany, France, Belgium, Luxembourg and the Netherlands, and still should be.

Italy’s inclusion in the single currency deal between France and Germany was the key item of debate in 1996 and 1997 as decision time on the euro was approaching and the left-wing government of Romano Prodi was pulling out all stops trying to get in.

German Chancellor Helmut Kohl was dead against it because Italy’s 1995 budget deficit was 7.6 per cent of GDP, well outside the 3 per cent required, and its debt was 123 per cent of GDP – more than twice the level stipulated in the proposed rules.

Prodi and his treasury minister, Carlo Ciampi went into a frenzy of lobbying, both externally – in Bonn and Paris – and internally with the unions, which they had already persuaded to end the indexation of all wages.

In the end it seems to have been German manufacturers who turned the tide in Italy’s favour: they started lobbying Kohl to let Italy in because they were sick of the constant devaluations of the lira making Italian products – especially cars – cheaper than German ones.

And to be fair, Prodi and Ciampi brought down a draconian budget in 1998 that got the projected deficit down to 3 per cent of GDP. In fact, in the event Italy’s deficit for that year turned out to be 2.7 per cent of GDP. Italy could no longer be kept out on the basis of its budget deficit, although its debt was still well above 60 per cent.

As the BBC’s Robert Peston noted in last night's Four Corners program on the ABC, in the end the debt to GDP ceiling was simply waived for Italy and with Germany’s Bundesbank the only one still casting doubt over Italy’s fiscal sustainability, the EU voted Italy in on May 2, 1998.

But here’s the thing: in the 20 years leading up to the start of the euro in 2000, Italy’s and Germany’s industrial production expanded at the same rate, but since monetary union, Italian IP has shrunk while Germany’s has grown enormously.

Without the ability to devalue, Italy’s economic growth stagnated in the past 12 years. The fourth recession in a decade is about to start, and as tax receipts fall and unemployment rises, its budget deficit will blow out even further.

As Charles Gave of Gavekal Research said in a recent report: "With lower productivity and a higher cost of capital, one would have to be brain dead to put a factory in Italy, especially if one knows that the tax rate in Italy is going to go up to try to close the budget deficits (as if a tax increase ever led to a reduction in the deficit!).”

Italy is in a debt trap from which it can’t escape without an unlikely reduction in bond rates or an even less likely big increase in economic growth. Improving the liquidity, or even the solvency, of banks won’t solve the problem, nor, for that matter, will some kind of move towards European federalism, as Germany is urging.

Mutualisation of sovereign debt will simply paper over Italy’s lack of competitiveness. Even if Italy kicked off the sort of micro-economic reform process that Australia began with the floating of the dollar in 1983, it would take a decade or more to have any effect, by which time the country would be bankrupt.

Italy needs to do micro-economic reforms like the privatisation, deregulation, competition policy, freeing up the labour market and tax reform that basically took Australia 20 years to complete. Some things, like National Competition Policy, are still going. Once it has done those things, then it could be allowed to rejoin the euro.

For the moment though, Italy’s lack of competitiveness and its debt trap will take a back seat to the immediate question of whether the Spanish bank bailout was enough money.

With the IMF declaring that Spain’s banks need €40 billion in new capital, €100 billion seems like plenty. But ratings agency Fitch says the real figure could be up to €100 billion if the Irish pattern of real estate losses is repeated, and Barclays Capital has come up with a maximum figure of €126 billion.

As a result this latest bailout looks like continuing the trend of rapidly diminishing relief windows afterwards. This one may have lasted less than a day.

It won’t be long before the Italian elephant in the room raises its trunk and has a blast.

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