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Italy and the Future of the Eurozone

Author: Christopher Alessi
November 14, 2011

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The new Italian Prime Minister Mario Monti will lead a technocratic cabinet (Guardian) charged with reining in high public debt--120 percent of GDP--while reassuring international investors that the eurozone's third largest economy is able to service that debt burden. Monti's appointment followed the parliamentary approval of long-stalled austerity measures and Prime Minister Silvio Berlusconi's subsequent resignation on Saturday.

Markets initially responded positively (DerSpiegel) to Monti's appointment, but at a bond auction Monday, the Italian Treasury unexpectedly sold $4.1 billion of five-year bonds at 6.3 percent--the highest level since 1997--as stocks dropped (NYT).

What's at Stake

If Monti is unable to restore market confidence in Italy's ability to meet its debt obligations, yields on ten-year government bonds could rise above 7 percent as they did last week. This is an unsustainable rate that market analysts say could force Italy to seek financial aid from the EU. However, unlike with Greece, Portugal, and Ireland, the temporary eurozone bailout fund--the European Financial Stability Facility (EFSF)--does not have adequate resources to make a significant dent in Italy's $2.6 trillion public debt (LAT). Barred from market financing and unable to obtain EU assistance, Italy would inevitably default, signaling the breakup of the ten-year-old single-currency union.

Monti's government will be charged with implementing unpopular budgetary measures, including cutting high public spending, raising taxes, and reforming a rigid labor market that has impeded private growth and competition. The Berlusconi era encouraged fiscal irresponsibility, and now Italians know they must make sacrifices in order to get Italy's house back in order, writes Italian political analyst Beppe Severgnini in the Financial Times.

The Debate

Monti--like Lucas Papademos, Greece's newly appointed prime minister-- is widely respected throughout the EU, but analysts question the democratic ethos of installing an unelected technocrat as prime minister. Eurozone policymakers and market actors, rather than the Italian and Greek publics, have essentially engineered the transition from democratic to technocratic rule. European politics is being driven by balance sheets, rather than ancient democratic ideals, argues a Guardian editorial.

However, at least for now, there is "little public outrage" (FT) in Athens and Rome because the Italian and Greek publics have been disillusioned by the inaction of their elected leaders. "The democratic process is being put on hold, but Italians feel this is the right thing to do," Giuseppe Ragusa, an economics professor at Rome's LUISS Guido Carli University, told Bloomberg. The Monti-led government will give Italy a "critical foundation" (Reuters) to regain market credibility, says Norbert Aul, a strategist at RBC Capital Markets.

Policy Options

Despite political developments in Rome and Athens, many European policymakers and analysts say it is clear that a comprehensive EU plan to tackle the eurozone sovereign debt crisis agreed on late last month will no longer prove sufficient. EU leaders indicated they may be unable to leverage the EFSF from $600 billion to $1.4 trillion, if at all.

Ahead of yet another EU summit on December 9, officials are now debating new policy measures (Reuters) , including creating eurozone bonds and providing the EFSF with a banking license, or empowering the European Central Bank to take a more active financing role by becoming a lender of last resort. The FT's Wolfgang Münchau argues that eurobonds are the only way to shore up the EU's sovereign bond markets and assure investors of the "existence of a functioning financial sector."

Background Materials

"The Future of Italy," Foreign Affairs

Monti's Speech, Guardian Video

"Eight Reasons Why Italy Is a Mess," Foreign Policy

"Time to Euthanize Sovereign CDs," CFR's Center for Geoeconomic Studies

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