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Italy: The Bomb That Could Blow Up Europe

To anyone struggling to make sense of the euro crisis, the FT has some helpful advice—watch Italy:

Although Italy does not have Spain’s banks, Greece’s economy, or Ireland’s deficits, it is easy to forget how close to the edge Rome reached last summer under the erratic leadership of Silvio Berlusconi. It may not be an exaggeration to say that Mr Monti has about a month to ensure it does not happen again.

After those four weeks, Italy—like much of the continent—will go into a month-long hiatus. When leaders return in September, Italy will be re-entering campaign season, with Mr Monti’s year-long mandate near its end.

Without something to show for his efforts from this week’s summit, he may find it impossible to get long-needed reforms through his legislature. No wonder the normally mild-mannered economist let loose on Tuesday. “This will not be a meeting where we will give formal approval to pre-prepared documents,” he told the Italian parliament.

Italy is simply too big to rescue, and if it falls, it could take the whole Eurozone with it, given how closely linked it is to French and German banks and businesses. Nobody is more keenly aware of this than Italy’s technocratic Prime Minister Mario Monti, who has been working as hard as anybody possibly can to get reforms and changes through Italy.

Unfortunately, Monti is having a tougher time than many expected. Thus far he has not been able to get enough done to save the country, especially when it comes to desperately needed labor market reforms. The entire political class remains firmly wedded to the old system and has been able to water down or block the necessary reforms at every turn.

The more time passes without serious improvements, the more Monti loses his popular support and, with it, his grip on power. Elections are coming this fall, and parties are starting to compete, which means that support for painful new reforms is quickly dropping.

Meanwhile, international markets see that the reforms haven’t gone far enough, and investors are deserting in droves and demanding unsustainable interest rates for Italian debt. The failure of Monti’s reforms to bring down interest rates and stabilize things, plus the poor performance of the economy, is further weakening his political support.

Italy now faces a death spiral: The poor performance of early reforms and the poor economy are leading to a loss of investor confidence. This raises Italy’s interest rates, further reducing support for more reforms and further worsening the economy. Rinse and repeat, until the Eurozone crashes and burns.

Monti’s last hope is to get enough support from Germany to stop the speculative attacks against Italy. Unfortunately, Merkel has political pressures of her own, and may not be able to sell this at home even if she wants to. Even if she does manage to pull it off, there is no guarantee that the rescue plan will succeed—Italy is that big.

It looks quietly as if an increasing body of opinion in Italy, including industrialists and businessmen, believes that leaving the euro would not be totally catastrophic for Italy—or at least not for them. Investors are unlikely to be pleased with this news.

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  • Jim.

    So does Krugman still think Bond Market Vigilantes are “mythical”?

  • Felipe Pait

    Jim, yes, the vigilantes are completely mythical in the case of the United States and other countries that are able to issue their own currency. You would know that is what Krugman meant if you actually read him.

    What is catastrophic is the idea that what Italy needs is immediate labor market reform. Perhaps such reforms would be useful, but they have nothing to do with the present catastrophe. This blog should know better. The bloggers need to do their homework, or else it will be relegated to a home for old trolls. Which would be a pity because WRM clearly has a lot to contribute in long-term analysis.

  • Snorri Godhi

    “Italy is simply too big to rescue […]”

    “Monti’s last hope is to get enough support from Germany to stop the speculative attacks against Italy.”

    Dr. Mead, are there any limits to your tolerance of cognitive dissonance?

    Or do you have in mind some sort of “support” from Germany that does not amount to a “rescue”? if so, please be more specific.

  • Kris

    “Italy—like much of the continent—will go into a month-long hiatus”

    I’m not sure whether this is typical irresponsibility or good news.

    “Monti is having a tougher time than many expected”

    I will bite my tongue rather than insult “many”.

  • alex scipio

    Read a very interesting theory today: The ONLY way to save the euro is for Germany to leave. This would allow the rest of the countries to devalue their currencies, get out from under un-payable debt, and begin to restructure their nations, banking systems and lives….

    Something to think about…

  • Tom Richards

    Alex, there are some other countries that could (and probably would and should) leave with Germany in that scenario – Austria, Finland and Holland, for starters, would have no business in a super-weak southern currency. They could have a union of their own – the Neuro-Seuro solution. But since the point of European integration is basically to yolk Germany to France, it’s a non-starter politically.

    The Germans could in theory cave and allow the ECB to monetize the South’s debts, but I don’t think there’s any way the German electorate would be willing to stand for the ensuing inflation.

    The Euro’s cooked.

  • Eurydice

    And Berlusconi is waiting in the wings with his pro-lira platform. Under the lira, Italy managed just fine with its high public debt, high private savings, revolving-door governments and solid, unchanging bureaucracy.

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