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Italy’s — and Europe’s — problems aren’t going away

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No surprise, the crisis in Europe is still with us. Over the weekend, there was some airy optimism that the new technocratic government in Italy, led by economist Mario Monti, might be able to mop up the debt mess that Silvio Berlusconi left behind. But this morning, the markets remain unappeased. Investors once again appear gloomy about the fate of Italy — yields on five-year bonds at a recent auction rose to record highs. And that, in turn, portends gloom for Europe. But why is this happening?

Alessia Pierdomenico/Bloomberg

One big reason for pessimism is that Italy faces some serious structural problems that won’t go away with a new leader, however wonky and competent he might be. Gavyn Davies’ has a nice breakdown of Italy’s debt challenges over at the Financial Times. To prevent an implosion, Italy first needs some deep-pocketed entity to backstop its debt, placate the markets, and give Italy time and space to carry out longer reforms. Yet the deepest-pocketed entity around, the European Central Bank, seems unwilling to play this role.

Instead, the ECB has been buying up Italian bonds sporadically, while telling everyone that it hates doing so. “It’s a stupid way to do it,” says Paul De Grauwe of Belgium’s University of Leuwen. “The ECB is sending a signal to the market that as soon as it stops buying, bond prices will go back up — which tells investors that it’s better to sell today than tomorrow. The ECB is maximizing the probability that its strategy will fail.” De Grauwe thinks the central bank should, instead, make clear that it’s in the market to stay and will do whatever it takes to keep interest rates on Italian debt at manageable levels. And yet, for reasons explained in this post, the ECB is reluctant take this tack.

Second, even if the market panic subsides, Davies writes, Italy still needs to “embark on a credible plan to earn a primary budget surplus of over 5 percent of GDP for several successive years at least.” The last time Italy was able to do this was in the late 1990s, when the economy was roaring and revenues were steadily rising. This time around, by contrast, the E.U. is forecasting a recession and many European countries (like France) are imposing austerity measures that could slow Europe’s growth even further. Maintaining big budget surpluses during a regional downturn would be a truly herculean feat for Italy at this point.

Oh, and third Italy needs to improve its long-term competitiveness, to grow its way out of debt. Ideally, Italy would get a little more inflation to chew away at its high labor costs. But the European Central Bank is resolutely against higher inflation. So Italy will likely resort to policies to improve labor-market flexibility — making it easier to fire workers, say. Yet, as Paul Betts writes, Italy’s economy is notoriously resistant to change. And Davies adds that “many of the most essential labour market reforms will certainly add to unemployment and deepen the recession in the short run, making the budget problem even more difficult.” The very “cure” for Italy’s woes might just exacerbate the crisis.

That’s just a long way of saying that we shouldn’t expect Europe to disappear from the news anytime soon.

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