One has to pity Italy. It has become the sickest of the "sick men" of Europe. Following its parliamentary election last month, over the next year Italy will have no effective government to address the country's chronic economic problems. This does not bode well for Italy's longer-run prospects for remaining a viable member of the euro currency arrangement. It also does not bode well for the rest of the European Union, with which the Italian economy is so inextricably linked.
With each passing year, Italy's economic and financial situation has come to resemble more and more that of a troubled emerging market economy. Indeed, Italy now has the dubious distinction of having a public debt to GDP ratio of over 100 percent, which is by far the largest among the major European economies. As a result, Italy makes highly indebted emerging market economies like Brazil and Turkey with debt to GDP ratios in the 55-65 percent range appear to be the paragons of fiscal rectitude.
Despite the strictures of the Maastricht agreement, Italy has consistently run a government deficit in excess of 3 percent GDP. It has done so despite the fact that it can still finance its budget deficit at interest rate levels that are not materially different from those at which other Euro member countries borrow. Italy's disappointing lack of progress in complying with the Maastricht budget criteria holds out little prospect for Italy bringing its public debt situation under control anytime soon.
A further feature of the Italian economy that has to remind one of a troubled emerging market is Italy's present lack of economic dynamism. Over the past five years, the Italian economy has virtually stagnated, while over the past three quarters it has for all intents and purposes been mired in recession.
At the heart of Italy's present economic malaise is the over-regulation of its economy, which stifles investment and initiative. Continuous wage increases have outpaced Italy's productivity growth. Such excessive wage increases relative to a country like Germany have resulted in a loss of international competitiveness on the order of 15 percentage points. To further complicate matters, the structure of the Italian economy, with its heavy reliance on small and medium-sized enterprises, makes it the most vulnerable among the larger European economies to the full winds of Chinese competition.
Italy's present economic predicament comes in the fact that, being a member of the euro exchange rate system, it lacks the traditional macro-policy tools to stimulate its economy in a manner that might allow it to effectively tackle its chronic public finance problem. No longer having a currency of its own, Italy cannot resort to exchange rate depreciation to restore its lost competitiveness. Nor can it lower domestic interest rates since these are now set by the European Central Bank (ECB) on a Europe-wide basis. And the ECB sets interest rates with a view to keeping European inflation below 2 percent without too much regard for Italy's particular circumstances.
Lacking the traditional levers of monetary and fiscal policy to revive its moribund economy, the only real way out for Italy is to embark on a program of serious structural reform. The overarching objective of such a reform program should be to make the Italian economy more competitive and more hospitable to both domestic and foreign investment. This will necessarily involve fundamental changes to increase labor market flexibility that might allow the country to regain some of the competitiveness which it has lost over the past five years. Such reforms will also involve efforts to simplify a stultifying array of regulations that choke the economy at every level of government.
It might not be difficult to identify what Italy needs to do to remain a viable member of the euro exchange rate arrangement. However, after this month's closely contested parliamentary election, one cannot be too optimistic that Italy will tackle its deep economic problems in the absence of an economic crisis. After all, Romano Prodi enjoys only the slimmest of majorities in both houses of the Italian parliament. And, in order to govern, he is beholden to an unwieldy twelve-party coalition including two parties on the extreme left, which are not known to be champions of market-based reform.
For the moment, markets are displaying surprising forbearance about Italy's poor public finances and its longer run economic problems. Indeed, the Italian government can still finance its large budget deficit in the markets at rates that are not appreciably different from those at which the French and German governments borrow. However, if experience is any guide, the Italian government would be making a grave mistake if it were to count on continued market forbearance in the absence of clear indications that Italy were on the right road of reform.
Failure by Italy to reform in a timely manner would be most unfortunate for Italy's economic outlook as its cost of borrowing skyrocketed and its economy became further mired in recession. It would also be most unfortunate for the economic outlook of the rest of Europe with which the Italian economy is so closely integrated.
Desmond Lachman is a Resident Fellow at the American Enterprise Institute.