Italy’s Greek Tragedy

LONDON – The euro crisis is not yet over. After months of relative calm in the eurozone, financial markets are again gripped by uncertainty, owing to political instability in Italy and the banking crisis in Cyprus. Are the eurozone’s struggles finally becoming too much to bear?

Last month’s election plunged Italy into political deadlock. While the center-left coalition, led by Pier Luigi Bersani, won a comfortable majority in the lower house – thanks to the bonus that Italian electoral law grants to the largest coalition – it gained too few seats in the senate to govern effectively.

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Having ruled out a grand coalition with either the anti-establishment Five Star Movement or former Prime Minister Silvio Berlusconi’s center-right party, Bersani will depend on senators’ willingness to support specific measures. But this approach is inefficient and unstable.

As a result, Italy – and the European Union – is headed toward the kind of political and financial turmoil that followed Greece’s general election last May, when a similar failure to produce a parliamentary majority forced another election the following month. The crisis in Cyprus – which threatens to cause the country’s banking system to collapse and force Cyprus out of the eurozone – could make the situation even more difficult to manage.

Italy and Greece have a lot in common, beginning with institutional malaise. Powerful interest groups hinder competition in many sectors, often distorting markets for goods and services. And politicians are often accomplices to rent-seeking and nepotism.

Likewise, entrenched interests and weak institutions have generated chronic fiscal deficits in both countries, which have long struggled with high public debt and weak credibility. While they managed to reduce their budget deficits below the mandatory limit of 3% of GDP to gain eurozone membership, public debt remained above 100% of GDP in both countries – much higher than the 60%-of-GDP cap set by eurozone rules.

Moreover, their commitment to reduce the debt and balance the budget – on which their admission to the monetary union was based – proved to be far less meaningful than their European partners had hoped. Today, Italy’s public debt stands at 126% of GDP, and Greece’s hovers above 165% of GDP – though, at more than €1.9 trillion ($2.5 trillion), Italy’s debt is much larger than Greece’s €310 billion debt in absolute terms.

While the austerity measures that former Prime Minister Mario Monti’s government implemented are expected stabilize the debt next year, the process can easily be derailed – and not only by economic factors. Widespread anti-austerity sentiment was a major factor in Italy’s inconclusive election results.

In 2010, when Greece was on the brink of default, a bailout was technically feasible, albeit politically difficult. By contrast, the size of Italy’s debt prohibits a bailout altogether. As a result, if Italy became unable to refinance its debt, it would have to default – a scenario that, while unlikely, cannot be ruled out, especially if political uncertainty pushes bond yields to unmanageable levels.

The fact that roughly 60% of Italian debt is held domestically is encouraging. Unlike Greece’s debt refinancing, which hinged largely on persuading foreign investors to accept deep losses, Italy’s should, in principle, depend primarily on domestic investors. But, as Italy’s household savings rate has dropped, so have banks’ liquidity and scope for balance-sheet expansion, reducing the domestic market’s debt-absorption capacity.

Finally, both Italy and Greece face the challenge of restoring economic growth. Greek GDP has been shrinking since the global financial crisis struck in 2008, and it is projected to remain deeply negative until 2015-2016. Over the same period, Italy has experienced a double-dip recession, with GDP set to shrink by about 1% this year.

To increase labor productivity and gain competitiveness, Greece and Italy have three options – domestic devaluation (slashing domestic prices), intra-euro devaluation (raising prices in Germany), or an exit from the eurozone – all of which require a stable government. Indeed, strong leadership would be needed to negotiate deflationary measures with labor unions, to persuade Germany to accept some inflation, or to navigate Italy’s return to the lira.

Last year’s political impasse in Greece perpetuated the status quo, impeding the needed reforms. The same thing could happen in Italy – an outcome that is unlikely to please financial markets. If other eurozone countries, especially Germany, lose confidence in Italy’s ability to reach its debt-reduction targets, they could decide to limit their losses by cutting off financial support, effectively forcing Italy out of the eurozone. While such an outcome is improbable, it is not impossible – especially in the midst of Cyprus’s banking crisis.

Last July, European Central Bank President Mario Draghi declared that the ECB was prepared to do “whatever it takes” to save the euro – a resolve that Italy and Cyprus will soon test. But market intervention might not be enough to rescue the euro, which is steadily losing public support and destabilizing national politics.

If the euro is a political project, the eurozone cannot survive without political integration. Perhaps Italy’s latest government impasse will finally convince EU leaders that genuine political integration is the only plausible way to preserve the monetary union. But this may be the least likely outcome of all.