European policymakers woke up to the realization that the continent’s third largest economy could be sucked into its ongoing debt crisis this week. Italy’s borrowing costs are mounting and doubts persist as to whether its parliament won’t water down a €40 billion austerity package.
Italy long seemed exempt from the fiscal woes of its fellow southern European economies but with European finance minister reportedly discussing a partial default for Greece, markets have started to question the longstanding assumption that Italy’s relatively modest budget deficit, its conservative banking system and high level of private savings can keep it out of trouble.
The country announced multibillion euro spending cuts last year, including public sector salary and hiring freezes and billions in cuts to local governments but implementation has been hampered by political paralysis at the top where Prime Minister Silvio Berlusconi barely survived a confidence vote in December.
With an unstable ruling coalition, union unrest and lingering corruption charges, Berlusconi’s government has not been able to balance its budget or stimulate economic growth. The unemployment rate has risen over 8 percent, the highest it has been since 2003. Italy’s public debt exceeds 120 percent of GDP.
Despite reform efforts in the recent past, Italy’s economy remains relatively uncompetitive. Cronyism, corruption and rigid labor laws are preventing the economy from recovering fast enough. The judiciary is far more political than is the case in the rest of Europe, forcing many companies to settle out of court while the prevalence of bribery and organized crime maintains the long standing imbalance between the industrialized north and the less developed, largely agricultural south of the country. Due to regulatory complexity and the high cost of conducting business, a high amount of economic activity remains in the informal sector.
Should Italy come into financial problems, it would be too big for Europe to bail out but there is no reason to assume that it could face the possibility of a default yet. Italy is in bad shape but its problems are far cry from the predicament of Greece or Ireland.