Berlusconi's Ouster Won't Avert Italian Default, Euro's Collapse

Ousting Silvio Berlusconi won’t make Italy’s fiscal mess any easier—with or without him, its debt is impossible, and Italy is headed for default.

Italy’s problems are fundamentally different than some other troubled countries, such as Greece. Like others its social benefits are too generous but substantially curbing those won’t bring its books into balance. It is simply too late.

Italy’s budget deficit is about 3.6 of GDP—less than half of the U.S. gap, but its total debt, amassed over many years, is 130 percent. That is an amount well above what economists consider manageable even for a country, like the United States, that can print money, and it is even worse for one like Italy without its own currency.

Although the final act of the Berlusconi government was to craft austerity measures that will lower the deficit to less than a very 2 percent or about 25 billion euro, it must borrow in 2012 $300 billion—a massive 19 percent of GDP—in private capital markets to repay maturing debt. Italy is simply not growing fast enough in a Europe crippled by crises in Ireland, Greece, Spain, and Portugal for private investors to take that bet.

If Italy’s nominal GDP were growing at a modest 4 percent and the interest rates it paid on new debt were 5 percent or less, it might manage its way out, however, neither is likely. In recent days, investors have demanded record rates, well above 6 percent, to purchase existing Italian debt, and even at those rates private demand is thin.

The European Central Bank has had to purchase substantial amounts of Italian bonds, and the rate on 10-year Italian debt still pierced 6.7 percent.

Next year, the Eurozone is likely not to grow in real terms, and Italian nominal growth (real growth plus inflation) is unlikely to much exceed 3 percent and is more likely to be nearer to zero. With such low nominal growth, interest rates on Italian debt much below 5 percent would be needed to keep Rome afloat. Even at those rates, the ECB would have to take a lion’s share of Italy’s new debt issues.

The Germans won’t like such purchases, and those are not likely to happen. Even if Berlin went along, the ECB then would be compelled to monetarize significantly more of other European sovereign debt, and the inflation that followed would unravel the myth of stability and unity that justifies the euro.

Italy is too large for Germany, France and the smaller prosperous countries to rescue. Large purchases of Italian debt by France would surely result in the loss of a AAA rating it already doesn’t deserve, push up further French borrowing costs, and put Paris’ finances into a negative feedback cycle. With Europe imploding, even Germany’s finances would not look quite so pristine.

The only sane option Italy really has is to earnestly implement austerity, drop the euro, remake public and private debt in the reestablished lire, and let a falling value for lire in currency markets impose a haircut on private creditors. Under that scenario, the losses investors took from devaluation would be much less than the losses they would endure in the chaos that Italy’s finances could unleash.

Peter Morici is a professor at the Smith School of Business, University of Maryland and former chief economist at the U.S. International Trade Commission. Follow him on Twitter@pmorici1.