The markets are too sanguine about Italy. The country’s politics and economics are messed up – and there are no easy solutions. And while Rome does have the European Central Bank as a backstop, it may have to get to the brink before using it.
Investors had jitters after last month’s election result, pushing 10-year bond yields up to 4.9 percent from 4.6 percent. But by last Friday they had fallen back to 4.7 percent. Investors have convinced themselves that some political solution will be cobbled together; that, if one isn’t, it doesn’t really matter; and that, if the worst comes to the worst, the ECB will pick up the pieces by buying the country’s bonds.
Mario Draghi, the ECB president, gave some support for the latter two ideas last week. He downplayed the risks to Italy’s fiscal position by arguing that much of the country’s belt-tightening was on “automatic pilot”. He also made clear that the ECB’s bond buying plan was still available for countries that followed the rules.
But messy politics and economics could make each other still messier. Months of political paralysis will squash investment and could dampen consumption. That will exacerbate the recession. Fitch Ratings – which downgraded Rome’s debt to BBB-plus from A-minus on Friday – thinks GDP will shrink 1.8 percent this year. A deeper recession, meanwhile, means a worse fiscal position. The ratings agency expects government debt to reach nearly 130 percent of GDP this year.
Political stalemate also means Italy won’t get to grips with its long-term problems. The country has barely grown in the last 20 years. Even Mario Monti’s technocratic government did little to address problems such as inefficient bureaucracy, red tape, cartels, a dysfunctional legal system and inflexible labour markets.