The Deleveraging Mirage: A Careful Look at Italy Today

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Europe’s most distressed countries should see their debt peak in a year or two, before descending to more manageable levels by 2020. Or at least that’s what the IMF, the European Commission, and the credit rating agencies all claim. Coming on the heels of the 2012 crisis, this is a heartening forecast—but a pretty surprising one, too. Just what is it based on? We’ve examined these institutions’ various scenarios for Italy and Spain, whose mounting sovereign debt burden loomed large in 2012, and for France, where the sovereign debt outlook raises a whole host of questions. Our assessment is as follows:

  • All these projections are marred by overly-optimistic assumptions about these countries’ structural growth outlook and their ability to sustain highly restrictive fiscal policies. This makes subsequent revisions to the projections a foregone conclusion. 
  • Italy is a case in point: the projected growth rate is so fanciful that the country stands virtually no chance of deleveraging as hoped. More conservative forecasts would preclude the prospect of Italy stabilizing its debt in the next few years. They would show rather that by 2020, its debt-to-GDP ratio should verge on 140 percent.
  • Spain seems to be in a better position to achieve such stabilization in the near term. Not only is its debt-to-GDP ratio 30 percentage points lower than Italy’s, but its potential output is apparently on the way up. Italy’s isn’t.
  • Despite recent setbacks, France still seems to have the means to reverse its debt trajectory. If we assume average real GDP growth of 1.2 percent a year between 2013 and 2020, the country should be able as of 2015 to reduce its debt level just by maintaining a primary budget surplus.

What emerges from this analysis is that Italy is the exception—and unquestionably the most vulnerable of the large eurozone economies. This suggests that we’re in for further bad news once today’s widespread projections come up for revision. Which they probably will after the Italian elections, especially if—as is likely—the new government lacks the leeway needed to convince investors that it can and will do something about the country’s huge debt overhang.

After a Summer Break, The Carrot and the Stick

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After several weeks of major uncertainty, investors hailed the ECB’s promises of late July, and the month of August provided a welcome lull. The two key questions are how long it will be before they start demanding follow-through on those promises, and just what the much-awaited measures will entail. By requiring Spain and Italy to request assistance from the EFSF rescue facility before agreeing to purchases of their government debt, the European leaders will only drive the EU even further into the morass it has been mired in for more than two years. And a growing number of countries in the region will inevitably get dragged down in the process. Unfortunately, those leaders show little inclination to do otherwise.

Spain: Spiraling Downward in Greek Fashion?

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The current approach to managing the sovereign debt crisis is so absurd that it will wind up destroying the European Monetary Union—perhaps even faster than anyone dares to imagine today. With the economy in free-fall since mid-spring, pressing ahead with fiscal adjustment programs means exposing Europe’s crisis-ridden countries to major risks.

Spain’s creditors initially greeted the new austerity plan unveiled by the Rajoy administration with a sigh of relief. Immediately after the prime minister’s announcement, long-term interest rates fell by a substantial 20 bps to 6.60 percent. The pledges offered by the Spanish government in exchange for greater flexibility in meeting the deficit reduction targets set by Brussels seem to have convinced observers. What probably made the biggest impression were the promises to overhaul public administration, with the number of local government councilors to be cut by 30 percent, and at the same time to raise the value-added tax rate by three percentage points.
Yet there are serious grounds for concern about whether Spain can overcome the crisis in this way. 


From High Hopes to Despair: The Missing Metric in the European Monetary Union

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It all started out with high hopes. The idea was to build a united Europe that would enhance well-being all around. A sharing Europe that gave the continent’s least developed countries an opportunity for fast-track convergence with the wealthiest countries. And lastly, a peaceful Europe—because the combined economic strength and weight of its members would ensure lasting cohesion.

In the first several years, those hopes appeared to be more than well-founded. When Spain joined the EU in the mid-1980’s, the country’s living standards lagged 25 percent behind the French-German average. Within less than fifteen years, the ensuing boom had lifted Spanish per capita income by 50 percent, making up for nearly half of the initial differential. Over that time span, massive foreign investment drove industrial expansion and exports quadrupled in volume, with 75 percent going to other EU Member States. The labor force also increased from 11 million to 15 million, while year after year, EU structural transfers, of which Spain has long been the leading recipient, helped the country gradually build up infrastructure to the level required to secure long-term growth.