Italy and the euro zone

That’s all, folks

For the euro to survive, Italy must not fail. That will require leadership and courage

Nov 12th 2011 | from the print edition

ALTHOUGH it came after scandal, scheming and a truly dismal record as prime minister, Silvio Berlusconi’s resignation pledge was no more cathartic than any other of the remedies that the euro zone has so far concocted. The gesture was too little because Mr Berlusconi is so distrusted, after a total of eight and a half disastrous years in charge, that even now some fear he will find a way to hang on to office or stand again. It was too late because, by the time he promised to resign, Italy’s bonds were consumed by panic. At one point yields gapped up towards 7.5%—a level that would eventually pitch Italy into insolvency and long before that triggers a run on its banks.

When the world’s third-largest bond market begins to buckle, catastrophe looms. At stake is not just the Italian economy but Spain, Portugal, Ireland, the euro, the European Union’s single market, the global banking system, the world economy, and pretty much anything else you can think of. Greece is important because it sets precedents for the euro—over such things as debt write-downs and rescues (seearticle). Italy matters much more because it is so vast.

Presto panicoIt is clear now that Italy will be the crucible which tests the euro to destruction—or survival. Only a few weeks ago, that test still seemed avoidable. Now it is at hand. If the euro zone wants its currency to survive, it must stem the panic and make Italy’s vaudeville politics credible. Both acts are still within Europe’s compass. But with each lurch of the euro zone towards contagion, with each bungled change of government, and with each reluctant intervention in the financial markets, the task becomes harder and more costly. As the grim scene unfolds, you can almost feel the euro’s chances draining away.

The urgent task is to stanch the financial panic—if only to give politicians a chance to show that, now they understand the stakes, they can do better. This panic took hold on November 9th when, against the background of rising Italian bond yields, LCH Clearnet, a clearing house, raised its margin calls—meaning that anyone dealing in Italian bonds now needs to set more capital aside against possible defaults. That extra capital raised the cost of dealing in Italian government debt, causing a wave of selling as investors quit the market (see article).

Nothing can now prevent a debt crisis in Italy. Borrowing costs are set to remain well above their levels before the crisis. The finance industry will not soon reverse its extra margin call and even if it did, investors are not about to treat Italian debt as “risk free”. Ratings agencies will surely downgrade the country. If its debt is left to spiral down, Italy will be shut out of the bond markets. Its banks will become vulnerable, as their depositors and lenders conclude that they and the Italian state are likely to become insolvent. Contagion will spread across the euro zone. The end will come soon enough.

But Italy is not yet insolvent. Although the rescue plan set out by the euro zone last month is in tatters, the European Central Bank could still gain time by pledging to buy Italy’s debt in unlimited quantities and to protect European banks, as The Economist has argued. The signs this week were that the ECB had stepped in to ease Italian yields. But it has not yet made that vital public pledge to do whatever it takes, without limit, to create a proper firewall and stop the panic.

Use the interactive "carousel" to browse The Economist's Silvio Berlusconi cover stories

The truth is that the risks of the euro splintering really have mounted. Angela Merkel, the German chancellor, and Nicolas Sarkozy, the French president, acknowledged at the recent G20 summit for the first time that they might abandon Greece to its fate—a devastating shift from leaders who had always insisted that the euro would survive intact at any price. There is chatter that they are contemplating a new club of core euro countries that can live within the rules, and jettisoning the rest.

Such talk will make it harder for the ECB to convince markets that the euro is here to stay. But it may just put the fear of God into Europe’s politicians—indeed, that may be the idea. Ultimately, politicians are the only people who can put this right. If the ECB creates a breathing space, then politicians must use it to convince the world that the euro zone’s democracies have the capacity to deal with their debts and reform their economies—as set out in this issue’s special report on the future of Europe (printed early this week, before Mr Berlusconi’s news). If the politicians fail, so eventually will the euro.

The man who screwed an entire currency

While the fate of the euro was resting on Mr Berlusconi’s follically enhanced head, the chances of success were slim. He liked to portray himself as a pro-business liberal reformer but under him Italy has utterly failed to abandon a model that used lira devaluations to offset inflation and stagnant or falling productivity. Between 2001 and 2010 Italy’s unit-wage costs soared and its economy grew by less than any other country in the world, except Haiti and Zimbabwe. The Economist has long argued that Mr Berlusconi was unfit to govern, but even we have been shocked by how, as the euro crisis drew closer to Italy, he partied and politicked, brushing off the need for reform.

Without Mr Berlusconi, Italy stands a chance. Its stock of debt, though high, is stable. It suffered no housing boom or associated banking bust. Italians are good savers and government tax receipts not too dependent on finance or property. Before interest payments, Italy is even running a fiscal surplus.

Much of the talk in Rome is now of finding a technocrat to run a new government committed to reform—Mario Monti, say, who was a respected European commissioner. Such a caretaker government will have a part to play over the coming months. But reform needs to be sustained for years, and that requires democratic legitimacy more than anything else. So any technocratic caretaker should prepare for urgent elections that could produce a government for reform.

For the euro to survive, Italy must succeed. For Italy to succeed, its squabbling politicians must find unaccustomed reserves of unity and courage. That depends on ordinary Italians being willing to make sacrifices, the ECB backing Italy, and France and Germany standing resolutely behind the euro. It is a dauntingly long list of things to go right.