Super Mario’s Italian economic challenge


At a time of considerable economic distress, Italy could not have dreamed of a better prime minister than Mario Draghi, the highly capable and internationally respected former head of the European Central Bank (ECB). However, as long as Italy remains stuck in the euro, it is doubtful that even Draghi can breathe economic life into Italy, the sick man of Europe.

In a semblance of a final throw of the dice to avoid a snap legislative election, President Sergio Mattarella has turned to Draghi to form a new Italian government. He did so in the hope that Draghi’s well-deserved international reputation as a miracle worker will allow him to succeed in restoring Italian political stability and reviving its economy. After all, during the Eurozone sovereign debt crisis in 2012, it was Draghi who single-handedly saved the euro with his famous remark “the ECB will do whatever it takes”.

It would be an understatement to say that Draghi will become Italian Prime Minister at a time when its economy is at its worst. Even before the COVID-19 pandemic chose Italy as the European epicenter, the country’s economy had yet to recover to its pre-2008 economic peak. Following the pandemic, the country’s economy, dependent on the tourism, is now 12% lower than it was 12 years ago.

The pandemic has also dealt the most severe blows to the country’s public finances. The country’s public deficit soared to around 10% of GDP, its highest post-war level. Meanwhile, the country’s public debt-to-GDP ratio has soared to around 160%, its highest level in the country’s 150-year history. Needless to add, the dismal state of Italy’s public finances once again raises serious questions about the country’s long-term ability to service its debt.

Draghi’s basic economic challenge will be similar to that of Mario Monti, who was the country’s technocratic prime minister between 2011 and 2013. Like Monti, but under far worse circumstances, Draghi will have to figure out how to promote economic recovery while restoring the economy. order in the country’s degraded public finances. Like Monti too, he will have to find how to achieve this feat while Italy remains stuck in a European straitjacket.

Having abandoned its currency for the euro, Italy can no longer indulge in currency depreciation to offset the negative demand effect of fiscal tightening. This puts Draghi in an impossible position, especially given the massive amount of fiscal corrections the country now has to make. If Draghi were to engage in large-scale fiscal austerity, he would risk deepening the country’s already deep economic recession. Yet, if he did not commit to fiscal austerity, the already very high level of Italian public debt would continue to rise.

Currently, the ECB is keeping Italy’s economy afloat by standing ready to buy unlimited Italian government bonds as needed to keep the country’s borrowing costs low. Draghi’s only real hope is that the ECB will continue to do so indefinitely. But that may be too much to expect from the ECB unless Italy undertakes serious reforms of its ossified economy.

Unfortunately, to date, Italy has sorely lacked the political will to undertake such reforms. It is unlikely that a Draghi government composed of the same political figures as before will regain this political will.

Draghi succeeding in doing something that no recent Italian leader has succeeded in doing will be of the utmost importance for the global economy given the country’s systemic importance. Not only does Italy have an economy about 10 times larger than that of Greece. It also has the third-largest sovereign bond market in the world, and it’s hard to see how the euro could survive if Italy were to fail.

In 2012, at the height of the eurozone sovereign debt crisis, defying all expectations, Draghi pulled a rabbit out of a hat to save the euro. For all of our good, we have to hope he has another very big rabbit in his hat to save Italy from defaulting on its great mountain of public debt, which is sure to send ripples through the global financial markets.

Desmond Lachman is a resident scholar at the American Enterprise Institute. He was previously Deputy Director of the Policy Development and Review Department at the International Monetary Fund and Chief Emerging Markets Economic Strategist at Salomon Smith Barney.

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