Italy’s fundamentals aren’t worse than usual

November 10, 2011

By James Macdonald
The views expressed are his own.

The markets have come to the conclusion that Italy’s debts are unsustainable in the long term. They are therefore demanding a higher risk premium to compensate for the risk that they might not be repaid in full. So runs the conventional wisdom. However, the situation is not that simple.

In the first place it is not at all clear that Italy’s situation is especially worse than it was ten or fifteen years ago. The country’s debt first hit 120% of GDP in 1993, after the spending spree of the 1980s when budget deficits were regularly higher than 10% of GDP. In 1992 the deficit was 9.5% of GDP; and with interest rates on the debt of 10% or more, the country’s interest bill represented 12% of GDP. Throw in a discredited and dysfunctional political system, and the situation looked bleaker than it is today. Yet the country did not default. The old political parties were blown away, and a series of governments, both technocratic under Ciampi and Dini, and party-based under Berlusconi and Prodi, oversaw a period of fiscal retrenchment which brought the deficit to under 3% of GDP by 1997. Part of the improvement came through a fiscal squeeze which brought the primary balance from a deficit of 2% of GDP in 1990 to a 5% surplus by 2000. The rest was the result of lower interest rates. By the late 1990s Italy was able to borrow at around 6% — a rate that no one then considered unaffordable.

Over the past fifteen years Italy’s budget deficit has averaged 3.5% of GDP. It is currently 4.5%. Before the financial crisis erupted, its public debt had fallen to 105% of GDP. It has now risen to 120% of GDP again. Under normal circumstances a reduction of its budget deficit to 3% of GDP would be sufficient to stabilize the situation – a far smaller adjustment than was necessary in the 1990s.

So why has the market suddenly decided that the country’s position is untenable? It cannot be simply that Italy lacks a stable and convincing government. That has been the case for the majority of the postwar decades, and was certainly so in the early 1990s. Yet the country has shown that it can jettison discredited politicians when necessary, as it did in 1992, and as it is doing now.

A more compelling reason may be that the international climate is less benign than before. Italy’s growth rate has been sclerotic for years. But until recently the world economy was growing at a decent clip so that it could be hoped that “a rising tide lifts all boats.” Now, the future of uncompetitive economies looks bleaker.

However, the current climate is as much as anything else a case of self-fulfilling prophecy. One of the reasons that Italy’s position is looking worse than before is the rise in its borrowing costs. With public debt at 120% of GDP, a 4% rise in interest rates, which is what Italy has faced over the past year, will more than double its prospective budget deficit. A further negative feedback loop is provided by increasing margin requirements on its bonds as their prices drop and as trading volatility increases, thus making them less attractive to hold.

It could be said that in this, Italy is no different from any other borrower whose credit becomes suspect in the eyes of the market. Downward spirals are part of every sovereign and corporate default. Yet there is a more fundamental historical issue involved.

Before World War I, countries considered truly creditworthy borrowed on terms that are unrecognizable nowadays. The vast majority of their debts were in the form of perpetual annuities, where the government was committed to paying a fixed interest, but principal was repaid only when the borrower chose to do so. Such debt was referred to as “funded” because its service was incorporated entirely into the annual budget, rather as the monthly payments of a fixed-rate mortgage are part of a household budget. There was no need to borrow merely to maintain existing debt levels.

In 1900, for example, France had a public debt amounting to 105% of GDP; but over 96% of it was in the form of perpetual annuities, and less than 4% in the form of short-term Treasury bills. Therefore the country’s annual funding requirement was only 4% of GDP. The credit of a country with such a debt structure was virtually impregnable short of a world war.

Since those halcyon days, however, western governments have raised their debts on a far shorter-term basis. In it quite normal nowadays for public debts to have an average maturity of 5-6 years. This means that France, with a public debt of (only) 86% of GDP, now has an annual funding requirement equivalent to over 20% of GDP. It is in good company. Belgium Italy, Spain, and Portugal also have to finance 20-25% of GDP each year. The USA has a funding requirement of nearly 30% of GDP, thanks to the folly of the Treasury Department’s decision to stop selling the 30-year T-bond in 2001 in a misguided attempt to shorten the average duration of the debt.

The result is that the sovereign borrowers that the markets have been accustomed to think of as “risk-free” have become a little similar to banks. Their credit may be considered investment grade, even triple A, but in the end it is dependent on the continued confidence of their creditors. At any time, a ripple of suspicion about their long-term ability to repay their debts (not unreasonable given the relentless build-up of their off-balance sheet liabilities since the war) could set off a chain reaction which ends up with a self-defeating rush for the exits.

This is what is happening to Italy. It may not be the best credit among western countries, but its underlying position is little worse than in the recent past. If its debts are now suddenly considered unsustainable by the markets, then there are plenty of other governments in the potential firing line.

James Macdonald is an economic historian and the author of A Free Nation Deep in Debt.

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