The sweet life sours

The Italian crisis in three parts

Can it really be only seven months since Italy was crowned “country of the year” by one British publication for turning itself, in the words of another, into a “model European”?

Gushing editorials about an Italian renaissance under Mario Draghi – press-ganged into the prime minister’s office 17 months ago – were ridiculous even then. Sure, he exercised the natural authority that 30 years of high-level public service can bring to crowd-controlling six squabbling government parties. But it was the rapid invention of Covid vaccines and the purchase of Italian public debt worth €280 billion by his former employer, the European Central Bank, that restored stability to Rome.

The Italian political class and financial markets have turned this exhausted 74-year-old economist into a life-size Saint Christopher pendant. Just having him around means the parties can either do nothing or do harm with impunity. Unfortunately, Draghi’s short stay at the Palazzo Chigi will soon be over and they will be home alone in a new world of persistently higher inflation, rising interest rates and an end to the ECB’s debt guarantee.

This last point will take time to sink in. Isn’t the ECB putting together a new “anti-fragmentation instrument” to ensure that the spread between the interest rate on Italian and German government bonds doesn’t widen too far? Yes it is, but only temporarily to allow short-term interest rates to rise as they normally would to offset inflation that is expected to exceed 8% this year and 4% next. As short rates peak, the need for the instrument will fade.

The ECB guarantee is over and, whether or not Draghi’s resignation is accepted next week, his Keystone Cop left-centre-right government will collapse soon enough. And this will signal the beginning of a crisis that will be the most serious test yet of the EU’s economic and political resilience. Managed well, it could transform Italy’s economy, mature its politics and advance the federalisation of the euro area. Mismanagement will mean a repeat of the 2010-15 Greek crisis but on a much grander scale.

At the end of my 24/2 post on the ECB’s unique burden a month ago, I foolishly teased something on the “bigger theme” of Italy’s public debt sustainability. Since this bigger theme is far too big to cover in one post, I’m breaking it into three:

1. The economic vulnerabilities that led Italian governments to accumulate debt one and a half times bigger than the economy and why they are unwilling to remedy them.

2. The coming but utterly avoidable national solvency crisis and how it will play out.

3. The elections, la casta, and political myopia.

Rich man, poor man

First things first: Italy doesn’t have a public-debt problem. It has a growth and distribution problem. Italy is a rich country and could easily service the debt its governments have incurred over four decades if the economy grew more quickly and taxes were collected.

The Bel Paese suffers from what John Kenneth Galbraith termed “private opulence and public squalor”¹. Government could shrink to meet the revenues Italians are prepared to pay for it or the state could be made more efficient, holes plugged in the tax system, and the economy’s trend growth rate hiked.

A few years ago, I landed at Pescara airport on my way to the resort of Termoli on the Adriatic coast. The airport services the whole Abruzzo region and 600,000 passengers a year. It was early evening but the bus service to the railway station had terminated while the taxi rank was empty save for the fleet that turned up to collect locals who had pre-booked. Obviously no Uber or Lyft, and this in an area with high unemployment and involuntary part-time work. The next day, it was sunny but out of season in Termoli so hundreds of deckchairs and parasols sat unused across the beach. Having failed to find someone to pay for their use, I sat on one of the loungers and waited. Eventually, someone came but only after being called by an angry neighbour upset that the loungers earmarked for enjoyment a month or two later by their “owner” had been squatted. Since this offer to exchange money in return for using spare capacity was so unusual, the concessionaire’s employee had to make up a daily rate for his marginal gain. Meanwhile, in a Roman restaurant steps away from the senate building, an Italian colleague finished his meal and asked for the bill. When it arrived, it was for a third of the amount due. Normally, the correct amount would have been settled in cash with the supplier and consumer paying a fraction of the value-added tax. Everyone’s a winner, except the state of course.

These micro tales capture three roots of Italy’s perma-crisis: idle capacity, rent-seeking², and lost tax revenue. Against this economic backdrop, from the mid-1970s until 1992, successive Italian governments expanded the welfare state but failed to fund it with a stable revenue base. Persistent budget deficits and a rise in interest costs caused public debt to grow from 54% of gross domestic product (GDP) in 1980 to more than 115% in the early 1990s.

In 1992, a currency crisis mixed with a political revolution forced parliament to pass a credible budget that stabilised the lira and the debt. But it was only when Romano Prodi’s centre-left administration set its heart on adopting the euro in 1999 that interest rates collapsed and the government ran huge primary surpluses – revenue exceeding spending with interest-rate costs stripped out – to eat into the debt.

Their place secure inside the monetary union, governments found these primary surpluses hard to sustain. In the post-lira decade before Lehman Brothers collapsed in 2008, it was Italy’s chronic economic failings that were storing up problems for the future: low growth in GDP and productivity combined with declining competitiveness. When the global financial crisis hit, the debt-to-GDP ratio soared over 130% and the economy was unable to grow out of it.

To stave off financial contagion from Greece, Ireland, Spain and Portugal, Silvio Berlusconi was removed from office and replaced with another technocratic Mario: Mario Monti. The Italian bond market survived (with a lot of help from the ECB) but credibility was only restored by the kind of fiscal austerity that compounded both the debt and the political crisis. This wasn’t Monti’s fault. He had plenty of ideas for raising Italy’s potential growth rate but, as usual, his proposals were lobbied to death. His and succeeding administrations found it easier to fall back on tax hikes and spending cuts to manage a growth problem. As a result, it is estimated that austerity lopped a cumulative four percentage points off GDP between 2008 and 2017 so increasing the debt-to-GDP ratio – just in time for a pandemic to strike and raise it to 150%.

This is the big myth about Europe’s sovereign-debt crisis – the idea that the periphery (and the Greeks especially) were forced into self-defeating austerity to generate sustained primary surpluses in return for cheap or – in the Greek case – deferred loan repayments. In fact, fiscal austerity was often a choice; it was politically easier to raise taxes on the wider population than to overhaul labour and product markets, close tax loopholes for or sell assets owned by small but powerful pressure groups.

Taking on the lobbies

The Economist picked Italy as “country of the year” because “a broad majority of its politicians buried their differences to back a programme of thoroughgoing reform” under Draghi. That was never true. The Adelphi sages fell for that oldest of Roman tricks: the announcement of reforms rather than their passage and implementation.

To qualify for pandemic-recovery grants and loans from the EU budget, the government is supposed to improve the capacity of the public administration to manage the funds and deliver a series of reforms to raise growth and productivity. Yet, after 17 months in office, the Draghi government can boast of only one serious reform – that of the judicial system. Accelerating Italy’s protractedly slow civil-justice system is essential but it is also relatively easy since no one likes lawyers.

Italian governments know they over-tax the things that make economies grow (labour and capital) and under-tax property and consumption. Yet, at 21% of GDP, the gap between what the Italian treasury should raise through VAT and what actually comes in (the “VAT gap”) is second only to Greece in the EU and compares to 7-9% in Germany, France and Spain. As for shifting some of the tax burden onto property, look what happened when Draghi proposed a mere “mapping exercise” to update Italy’s property register since its valuations are more than 30 years out of date. This would not be followed by an increase in property taxation, he promised, unless parliament took a decision to do this using the updated valuations after 2026. The right threatened to bring down the government unless even this was watered down.

This was an act of statesmanship compared to the coalition’s infighting over beach concessions like those in Termoli. Having ignored an EU law for 16 years to ensure all public-sector concessions should be awarded openly, for limited durations and at a market price, the Draghi cabinet accepted it had to do something in return for €200 billion in pandemic-recovery funds. Italy is the mothership of beach concessions, with 30,000 spread across half the coastline – often charging hefty daily fees while paying pennies to local government. Concessions last decades and pass through generations of families with little incentive to grow or innovate. A business with annual turnover of €15 billion is paying just €100 million to the state³. Unbelievably, as war broke out on the EU’s eastern border, Draghi’s government almost fell over this issue as once again the Lega and Forza Italia rallied to rent-seekers’ defence.

It’s the same story with taxi drivers who are now blocking routes in Rome, Milan and Naples over a bland article in Draghi’s tame competition bill, which proposes allowing “the use of web applications” to connect “passengers and drivers". Previous attempts to liberalise this market – first in 2006 by left-wing minister Pierluigi Bersani and then later by the Monti government – failed due to drivers’ resistance backed up by political support. With licences costing close to €200,000 (and €300,000 in Florence), the drivers’ ire is understandable but the general welfare is harmed by a small group with sunk costs. For this reason, I’ve always had a soft spot for the radical proposal from Jacques Delpla and Charles Wyplosz for a one-off bond issue to buy out acquired rights then start again in every market from liberal scratch.

Rent-seeking and tax inefficiency meet in the form of “tax expenditures” – government revenues foregone due to preferential treatment of sectors, activities, or regions using allowances, exemptions, credits or deferrals. Totalling 16% of GDP, Italy’s tax expenditures are among the highest in the developed world. Close those and the debt problem is solved.

The trouble is, of course, that behind every loophole is a lobby. Roberto Perotti ploughed through them for a centre-left government, identified up to €2 billion that could and should be closed because of their perverse distributive effects and lack of a convincing economic rationale. Even better, closing them – idiocies like tax deductions for vets’ fees for people earning more than €100,000 or VAT exemptions for funeral homes – was politically feasible. Or so he thought. “I saw several politicians turn white in the face when reading the first pages of this dossier (none of them even reached the halfway point). Obviously nothing came of it".

Through a handful of changes to the tax system, action to tackle rent-seeking, and investment in digital and scientific education, the Draghi government and its successors could restore debt sustainability. They know what they have to do but they don’t dare. The consequences of inaction will be much much worse.

Part 2: The lipstick walks

Part 3: Gradually then suddenly

1. The Affluent Society (1958)

2. Rent-seeking happens when people or firms use their relationships with the state to obtain privileges or generate excess profits.

3. Tobias Jones (no relation) - author of my favourite book on Italy - has written a very good piece on beach-concession politics here.