TheMarketForIdeas

Italy is one of the biggest economies within the eurozone, yet its debt burden now stands as one of the largest globally, surpassing 140% of its gross domestic product (GDP) in 2022. Italian debt spans multiple decades, with the country grappling with high levels of public debt since the 1980s, when the country’s debt-to-GDP ratio stood at around 60%, steadily mounting after that. The problem has evolved into a chronic predicament, persistently afflicting the national economy. The country’s heavy debt burden has caused the government to face higher borrowing costs, compounding the difficulty of reducing the debt over time. This situation puts the Italian economy’s stability at risk, as the slightest adverse change in the global economy can disproportionally hamper the country’s ability to repay its debts.

In this vein, Daniel Gros (2019), the director of CEPS, a European think tank, assesses that Italy is indebted to foreign entities to the tune of approximately 850 billion euros, which amounts to roughly 45% of total debt. While still less than half, Mr. Gors’s foreign debt share estimate is two times greater than the conventionally presumed level.

Since 2012, extensive debates and analyses have been conducted regarding the potential impact of Italy’s public debt risk on the stability of the eurozone. While some argue that Italy’s debt is sustainable and the risk of contagion to other countries is limited, others warn that the high level of Italy’s debt and weak economic fundamentals could trigger a broader crisis in the eurozone. In 2016, Joseph T. Salerno signalled, “Italy is on the brink of a full-blown banking crisis.” Economists such as Philipp Bagus (2010) have argued that this situation results from systemic issues inherent in the monetary and fiscal policies of the eurozone, which have stimulated excessive borrowing and public spending. However, Italy has not made any visible efforts to alter its fiscal policy.

This article aims to contribute to the ongoing discussion regarding Italy’s debt situation and highlight the European Central Bank’s (ECB) role. In this regard, we will combine theoretical analysis with elements of economic history. We will refer to the broader historical context, emphasizing the type of behavior stimulated by the institutional architecture of the eurozone and the fiscal policy pursued by the Italian state under these conditions. We will argue that the policy followed by the ECB has stimulated excessive public indebtedness. Additionally, to offer a bit of context, we will distinguish the current period, which has been under the aegis of EU institutions, from the pre-euro era, when Italy’s economic growth was spurred by a high savings rate fostered by economic freedom. 

Italy’s Public Debt: A Historical Perspective 

Italy’s long-term economic stability has been a source of anxiety in recent years. These concerns are due to the substantial level of public debt, which has reached worrisome proportions since before the global financial crisis of 2008. By 2022, Italy’s public debt reached nearly 140% of GDP, making the country one of the most indebted in the world. The gravity of the high public debt levels raises questions regarding Italy’s ability to meet its debt obligations. It also sends alarm bells ringing abroad when considering the potential spillover effects on the European Union and the global economy. An observation made by Salerno in 2016 reveals that the banking sector’s non-performing loans, amounting to €360 billion, represent a noteworthy 17% of Italy’s total outstanding bank loans, equivalent to roughly one-fifth of Italy’s annual GDP. However, the situation appears even bleaker when delving beneath the surface. GDP, a measure of a nation’s economic output destined for final consumption, possesses inherent deceptive qualities when it comes to the way it accounts for government expenditures. Although most statisticians typically consider government spending as a positive contributor to GDP figures, some economists make a compelling case that public expenditure should be considered value-eroding. “The biggest problem of the proposals is that they are the same old mistakes that never worked. Massive subsidies and political spending are not tools for growth but the recipe for stagnation and ultimately larger and more painful adjustments in the long term.” (Lacalle, 2018).

Italy exemplifies this pattern, grappling with economic stagnation since early 2000. Every instance of GDP growth spurred by public spending is met with subsequent contractions in the following years. Italy’s government spending constitutes over 54% of GDP, yet its economic growth has been lackluster. One could argue that the economy has become dependent on public expenditure while failing to achieve high economic performance in terms of growth. "By augmenting government expenditures, a greater share of resources is extracted from the private sector, where they compete to satisfy consumer demands, and are redirected toward the public sector, serving the political agenda. The expansion of the state’s ambit has resulted in a diminished [sic] productivity and a suboptimal quality of life compared to alternative scenarios" (Bagus, 2012).

Beyond the contentious efficiency of public fund allocation, Italy confronts the pervasive challenge of corruption. Daniel Lacalle (2018) reveals that "corruption costs Italy a reported €60 billion a year, which amount to four percent of its GDP". The rise in funds under political purview exacerbates patronage, caters to vested interests, and fosters perverse incentives. Given Italy’s dim prospects of extracting sufficient tax revenues from productive sectors to repay its debts, serious concerns emerge regarding the nation’s economic future and capacity to meet its debt obligations. Furthermore, as a cautionary note, the Italian government contemplates flouting EU regulations pertaining to bail-ins by rescuing banks without mandating bondholders to assume initial losses. These regulations stipulate that a bank’s bondholders, particularly those holding subordinate bonds, must endure losses before taxpayer funds can be deployed for bank recapitalization. The Italian government seems to be wavering when it comes to adhering to these regulations, as nearly half of the subordinate bonds, valued at approximately €30 billion, have been predominantly sold to households and individual investors rather than seasoned professionals. In the event of insolvency, these bondholders languish at the bottom of the reimbursement hierarchy. The Italian government endeavors to secure EU leniency in suspending bail-in regulations, positing that these retail bond purchasers lack financial acumen. 

Post-WW2 Italy: Rebuilding and Economic Transformation 

Italy’s post-war economic recovery stands as a noteworthy case study, showcasing its ability to emerge from the ruins of World War II and reestablish itself as a prosperous nation. A combination of factors drove the recovery process. Usually, praise has been laid at the feet of the government’s strategic approach, which prioritized infrastructure development and the creation of a conducive legal framework for business growth. Historians also emphasize the role played by international assistance, notably the Marshall Plan. However, the international aid program’s impact on Italy’s economic resurgence has often been exaggerated, as the country had already initiated its recovery trajectory prior to receiving financial aid.

Undeservingly little attention for Italy’s early recovery is given to the country’s transition back to a market-based economy following the war. Significant state intervention was observed during the war in several countries, including Italy, but some countries chose to liberalize earlier than others. The United Kingdom, for instance, lagged behind in terms of economic growth due to a desire among British politicians to maintain wartime economic controls. The belief was that if government planning had been successful during the war, it would also prevail during peacetime. Unsurprisingly, West Germany and Italy, which were far more affected by wartime destruction but chose to lift restrictions early on, registered economic growth rates that significantly outpaced that of the UK as the latter continued to grapple with state interventionism.

Economic freedom, defined as the ability of individuals and businesses to conduct economic activities without interference from the government or external forces, played a vital role in Italy’s post-war economic resurgence. The country experienced notable economic growth due to its relatively high level of economic freedom, which facilitated entrepreneurial development, innovation, and savings, consequently leading to increased productivity and overall economic expansion. In the aftermath of World War II, Italy witnessed a substantial surge in its national saving rate during the "economic miracle" of the 1950s and 1960s, with the country displaying a much higher savings rate than most other developed nations, reaching a level of over 20% of GDP in 1960. However, it is worth noting that this trend has since changed. Over the past decade, Italy’s saving rate has fallen below the average of developed economies.

The Italian government’s commitment to economic freedom was evident in its post-war policies, marked by the systematic liberalization of the economy and a reduction in government control over key industries. The government actively promoted private enterprise and entrepreneurship by creating a favorable fiscal and regulatory environment. This approach unleashed the entrepreneurial spirit of the Italian people, resulting in the establishment of new businesses and industries that drove economic growth. Italy’s post-war economic recovery is a testament to the power of economic freedom and entrepreneurship in fostering growth. While international aid might have played a role, the government’s commitment to liberalization, promotion of private enterprises, and creation of an enabling environment propelled Italy toward prosperity. As Italy faces contemporary economic challenges, it is essential to revisit and reinforce these principles to pave the way for future growth and stability. 

Italy Under the ECB: Monetary Policies and Public Debt Management 

Italy’s history is deeply intertwined with its European integration endeavors. Since the signing of the Treaty of Rome in 1957, following the aftermath of World War II, Italy has viewed its membership in the European Economic Community (EEC) as a means to stimulate economic growth and consolidate its position on the international stage.

The country’s relationship with the ECB has also been complex, often finding itself at odds with the ECB in matters concerning the management of its public debt. The ECB’s role is to maintain price stability and support economic growth within the eurozone. One of the key challenges the ECB faces is the impact of its monetary policy on the way member countries manage their public debt. The ECB’s various tools can alleviate or exacerbate the public debt problem.

Foremost among these is the ECB’s mandate to set interest rates, which significantly impact government and individual borrowing costs. Interest rates are the most important "prices" in an economy, typically reflecting society’s intertemporal consumption preferences. As Ludwig von Mises (1996) notes, in a free market, interest rates reflect the time preferences of economic agents: if individuals prioritize future goods, they tend to consume less, save more, and invest more, causing interest rates to decline. Artificially lowered interest rates distort all other prices, creating an increasing mismatch between what society desires to produce and what is produced. The longer this distortion in resource allocation persists, the larger the created gap in the structure of production and the more protracted the necessary adjustment to realign production with society’s true preferences. When the ECB lowers interest rates, it makes borrowing cheaper, stimulating economic activity and encouraging governments to accumulate more debt, leading to an economy plagued by error.

Another instrument available to the ECB is quantitative easing (QE), which involves purchasing government bonds on the open market. Through QE, the ECB can inject liquidity into the financial system and reduce borrowing costs. This can help governments finance their debt and stimulate economic growth. However, QE is an extraordinary and unconventional monetary policy approach with significant negative consequences. It exacerbates the public debt problem and increases the money supply, leading to inflation. The purchase of government bonds can lead to a squeeze-out effect, where private investors are pushed out of the market, reducing investment in the private sector. Additionally, QE distorts the structure of production and triggers misallocated investments and, ultimately, economic recessions. This misallocation can set off an unsustainable boom, where investments are made in projects that are not economically viable in the long term.

QE, along with other monetary policies, stimulates excessive public spending, often driven by political pressures rather than economic considerations. Thus, monetary policy is conducive to accumulating ever-increasing amounts of public debt. Loose monetary policy exacerbates this problem by facilitating government borrowing at low interest rates, creating a false sense of security and encouraging governments to engage even more in deficit spending. This can lead to a vicious cycle of debt accumulation, where government borrowing and spending cannot be driven back, after reaching a critical level, due to the need to service past incurred obligations. This is a far cry from a coherent economic strategy. As the case of Italy proves, the ultimate result of this economic policy approach is economic stagnation. 

Conclusion 

Italy’s transition to a market-based economy and the facilitation of its entrepreneurial capabilities have emerged as the primary drivers behind its economic progress, overshadowing the exaggerated significance attributed to the Marshall Plan in popular discourse. The substantial degree of economic freedom enjoyed by Italy has played a fundamental role in nurturing an environment conducive to cultivating entrepreneurial zeal, fostering innovation, and accumulating capital, thereby instigating heightened levels of productivity and fostering sustained economic expansion.

The stark disparity between Italy’s remarkable post-war recovery and the ramifications stemming from the policies enacted by the ECB accentuates the importance of prudently formulating and executing economic policies and the imperative of diligently assessing the potential repercussions of monetary interventions. A nuanced understanding of the underlying complexities and a steadfast commitment to vigilant evaluation remain indispensable in steering economic progress and safeguarding the welfare of nations. 

Bibliography 

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Photo source: Hoàng Vũ.