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While it is highly unlikely, as I pointed out in a recent message, that France will leave the Eurozone and thus become a critical factor in ringing down the curtain on the single-currency project, the risks emanating from Italy are distinctly more troubling, although at least in the near term these are not overwhelming either. The problem is that the Apennine Republic does not have a whole lot of benefits to show from belonging to the Club. It failed to make the necessary adjustments right after adopting the euro in 1999, and the economy has performed badly ever since, hobbled by too many small, unproductive businesses that are not growing. It is today barely above the level at which it was then. How much of this is attributable to Eurozone membership alone is hard to tell, as the intervening period has seen many other important developments, from China’s entry into the WTO to the emergence of intricate global supply chains, dramatic technological changes, the replacement of many workers by machines, and the growing habit of multinationals to outsource services. Italy has been much slower than, say, Germany to adapt, especially in loosening up its hamstrung labor market, and the country now has a serious competitiveness problem.

Labor costs in Italy have increased by roughly 15 percentage points more than those in Germany. This has left the national unemployment rate stuck at over 11%. Living standards today are one-tenth below what they were a decade ago. The public-sector debt has ballooned to the second-highest in the Eurozone, at over EUR 2.5 trillion or 133% of GDP. Italian banks have upwards of EUR 360 billion in non-performing loans on their books, depending on how one counts, which is tantamount to an eyebrow-raising 18% of their total portfolios. The banks also hold very large piles of government debt, totaling more than 10% of their overall assets. Following a now deeply ingrained pattern, gross domestic product inched up a mere 0.9% last year, on the heels of a gain by 0.8% in 2015. The government is forecasting growth of 1% for 2017, but this may well turn out to have been too optimistic an expectation. Demographics are working against the country as well, as a vast tax-and-transfer welfare state is facing lengthening life spans and one of the lowest birthrates in the world. Such gimmicks as the government’s effort to promote “Fertility Day” on September 22, seeking to encourage Italians to have more babies, will hardly remedy this problem.

Added to these impediments is now a great deal of political confusion in the wake of Prime Minister Matteo Renzi’s failed effort to bring in constitutional reform and his resignation as PM as well as head of the Democratic Party (PD). The country is currently run by a caretaker government under former Foreign Minister Paolo Gentiloni, who is a competent manager, but in effect only a stand-in until new elections can be arranged. Not that political instability is anything new in Italy, which has had no fewer than 62 (sic!!) governments since WWII. But all of the leading parties are currently divided. The front-running Five Star Movement of the comedian Peppe Grillo, which has been calling for a plebiscite to be held on ditching the euro and re-establishing a national currency, is torn between hardliners and moderates, troubled by tensions over the party’s mismanagement of the City of Rome. The radical anti-immigrant and anti-euro Northern League is trying hard, but not very successfully, to form an alliance with Forza Italia, headed by the former PM Silvio Berlusconi. In the PD, a leadership battle is under way in which Justice Minister Andrea Orlando is challenging Renzi’s attempt to reclaim power.

As matters look now, no party is likely to win the 40% of votes in elections that are required for receiving bonus seats. Chances are, whenever the balloting is held it will result in a minority government or a hung parliament in which small parties will be able to punch well above their weight, sparring in fragile coalitions that will be sorely tempted to blame all the country’s difficulties on the euro, instead of pushing ahead with the difficult and painful reforms needed to give the economy more momentum. Of the three large party groups, only the Center-Left PD is pro-euro. There is, therefore, a risk that at one stage or another the anti-euro forces will gain the upper hand with the argument that most of the problems would go away if Italy just had, once again, a currency it can devalue. Some say that this is not a real danger since the Apennine Republic is notoriously adept at muddling through whatever difficulties it encounters. Others hold that peril slumbers in the possibility that Italexit becomes a self-fulfilling prophecy if there is a run on Italy’s banks and its government’s bonds. This latter argument is strengthened by the fact that the public debt is already more than double the EU ceiling of 60% of GDP, and still rising, and by the fragile state of the banking system.

My own instincts lead me to support the “muddling-through” theory, at least for now. Clearly, leaving the Eurozone would confront Italy with monumental problems. Creating a new currency and introducing it as functional legal tender could not be done in secret and would take months, during which foreign and local investors and private citizens would liquidate all assets they have so that they can take them out before devaluation happens. Redenomination of debt would lead to a massive default and lock Italy out of the international capital and credit markets for a long time to come – while the country must borrow to cover its yawning budget deficit and refinance maturing IOUs. There would be countless bankruptcies among banks stemming from a rash of depositors withdrawing money. Insolvencies would also mushroom among private companies with foreign liabilities that are not matched by foreign assets.

While Italexit would be extremely messy and damaging, however, this is not to say that it absolutely, positively cannot happen. In a worst-case scenario – some time down the road – a confluence of (1) an unsustainable deterioration in public finances, (2) severe tremors rattling the banking system, (3) a persistently weak economic performance, and (4) misguided political machinations could make the unthinkable possible. This is a long shot, to be sure, but until Italy begins in earnest to deal with its underlying problems it will be an outside possibility of which one should not totally lose sight. After all, while the euro could survive a Greek exit, Italy is too large to be bailed out by the rest of the Zone members. Were it to slide into a full-blown economic and financial crisis and default on its mountainous public debt, the common currency could not continue to exist in its present form.

Global Perspectives by Dr. Hans Belcsak