Political Ripples of EU’s Sovereign Debt Crisis

Eurozone leaders meeting for tomorrow’s summit are unnecessarily worried about contagion to Italy, but a growing sovereign debt crisis highlights the role of politics in the markets and the need to find common, EU-wide solutions, says expert Franco Pavoncello.

July 20, 2011 9:28 am (EST)

To help readers better understand the nuances of foreign policy, CFR staff writers and Consulting Editor Bernard Gwertzman conduct in-depth interviews with a wide range of international experts, as well as newsmakers.

With European leaders poised to hold an emergency summit (Reuters) Thursday on the widening eurozone debt crisis, officials remain concerned about possible contagion to Italy (NYT), the continent’s third-largest economy. Italian Prime Minister Silvio Berlusconi earlier this month sharply criticized his finance minister (CNBC), jolting markets and sending interest rates on ten-year Italian bonds to a record high of 6 percent (Bloomberg). Berlusconi moved to calm markets by pushing a €45 billion (FT) austerity package through Parliament, staving off a crisis. Moreover, Italy has been able to avoid a sovereign debt contagion because, unlike Portugal and Greece, it is not burdened by massive foreign debt, argues Prof. Franco Pavoncello, president of Rome’s John Cabot University. "The majority of debt in Italy is held by Italians, who will continue to buy Italian debt," says Pavoncello, who notes that political uncertainty is what undermined confidence in Italian markets. "With politicians at odds over how to solve the crisis, politics is back in the picture in terms of markets," he says. He predicts the sovereign debt fallout will force eurozone nations to adopt common political solutions, including euro bonds.

Why does Italy suddenly appear so vulnerable to the widening European sovereign debt crisis?

There are some long-term causes. This is a country with a very high public debt [120 percent of GDP], and a country that hasn’t grown for ten years--basically, it’s been a stagnating economy. These are background elements that certainly facilitated this skepticism, but the trigger was political. The markets felt that the government did not give guarantees of pushing through the [austerity measures] it was presenting. Berlusconi’s comments about his finance minister [Giulio Tremonti] weren’t encouraging to the markets, and the government itself has been significantly weakened in the past few months. So, people started dumping Italy more than shorting Italy. But then after the dumping of Italy came the shorting of Italy. The first move was by people who held Italian bonds. They just decided that the position of the government--and the political situation--wasn’t very reassuring for them; that led to dumping, and then everybody betting against Italy.

What can be expected of the austerity package that was passed last week?

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It will certainly help reduce the debt burden. Italy has a primary surplus [before interest payments]. So, this is not a country that has been undisciplined from that point of view. As a matter of fact, it comes right after Germany. It has a high debt that is creating problems for the surplus, and turning it into the negative. The kind of austerity that has been introduced, if followed properly, will lead to a balanced budget by 2014. 

This maneuver is full of cuts [targeting] the average middle-class family, but it doesn’t really do very much in terms of improving the competitive qualities of the country, and to re-launch the production capacity of the country. And that is really something that has worried the markets. In a more general sense, politics has reentered the picture in a way that it has not since the creation of the euro. After the euro was created, and Italy entered the euro, it was thought in government that things were going to be decided in Frankfurt--and that there wasn’t much of a difference that [domestic] politics could make in terms of the stability of countries. But now, with sovereign risk, and with politicians being at odds over how to solve the crisis, politics is back in the picture. The government we have in Italy today is problematic, because we have a prime minister who is riddled with scandals, a very weakened personality who has already declared that he will not run in 2013. And on the other side, there’s an opposition which hasn’t been able to put together a convincing alternative.

What are the implications of Italy’s weak productivity and competition in terms of the political and economic situation?

After Italy entered the euro, it was thought in government that things were going to be decided in Frankfurt--and that there wasn’t much of a difference that politics could make in terms of the stability of countries. But now, with sovereign risk, politics is back in the picture in terms of markets.

We have a very strict bureaucracy with a lot of red tape, which makes private enterprise difficult and time-consuming. There is a very stiff labor market: Companies with more than sixteen people cannot fire workers. This rigidity is compensated with the use of temporary workers, who are never hired--because people are afraid to hire, because after three months, they are stuck forever with whomever they’ve hired. There are all sorts of imbalances from that point of view that could be addressed. There is a growing, widespread popular discontent against the political class, which is perceived as not providing the answers, but enjoying the benefits. That [discontent] might really develop in a very substantial fashion. I have never sensed this kind of disconnect between the average Italian and the political class sitting in Parliament.

What could be the consequences of that disconnect?

Something will have to give. I wouldn’t be surprised after August to see an increasing volatility in politics. And we will be in a situation whereby spring 2012, we’re going to have a national election. I don’t see this government lasting another two years, given the atmosphere and the mood in this country.

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How do you see Italy’s vulnerability affecting the rest of the eurozone?

More than Italian vulnerability affecting the eurozone, it is the eurozone’s vulnerability that is affecting Italy. We are beyond the eye of the storm as of now, for Italy. So, I don’t think that we’re going to see a systemic breakdown in Italy that’s going to have a domino effect on Europe.

So you think that the recently passed austerity measures, despite their imperfections, have pushed Italy back from the brink?

It’s not just that; the country just doesn’t have the conditions to justify this onslaught, from an economic point of view. We’re not talking about a country with a 20 percent deficit or a 10 percent deficit here, or heavy foreign indebtedness. The majority of debt in Italy is held by Italians, who will continue to buy Italian debt. There has been a very prudent handling of public accounts, which leads to a situation of balance, of a primary surplus that then becomes negative because of interest paid. But this is not a country that in the past years has continued to indebt itself. In fact, it has continued to decline. The message that parliament gave, by voting in three days--for these policies and this financial law--was a very clear message.

What can be expected from the July 21 eurozone summit in Brussels, particularly with regards to a second bailout package for Greece?

There is a growing feeling that if people decided to marry--they have married--they have to pool resources together, and protect each other, create a block bond situation, where you don’t really need to see the inside of each single country. I’m not surprised that the talk about euro bonds is surfacing again. At the end of the day, there’s got to be the creation of a common agency for debt. Given where we are with the euro, I don’t see how else we’re going to move ahead, because you can’t expect people to ever say that as an option, for the next twenty years, they can work harder and harder to give money to foreigners.

At the end of the day, Europe will find a way to bail out Greece. But are we going to try to create a more widespread system of debt guarantees, which will lower the cost of borrowing money on the systemic level and give a chance to everybody to belong to the exchange system, so that we move ahead as a unit?  In one form or another, it is my belief that euro bonds will enter the picture. Europeans are not going to give up on the euro and the eurozone, and are not going to let it die; the cost of doing that would be enormous for those countries

What, then, are the implications of this sovereign debt crisis for the future of the European project?

What this crisis has generated is a fundamental question as to whether the eurozone experiment was correct, or was a terrible mistake and needs somehow to be eliminated. The sovereign crisis has raised the fundamental questions in the minds of the Europeans as to which direction they want to go--whether they want to deepen ties and integration among eurozone countries, or whether they want to just roll up the process, and find ways to get out of it. It has obliged Europeans to ask fundamental existential questions about themselves, as to whether they are indeed European, or whether they were just dreaming of being European--and, as such, turn back to being German, or French, or Italian.

It is my deep conviction that Europeans have been affected by this decade of Europe, and are starting to understand that what happens on the continent is everybody’s business. And that rather than going solo on the national level, it makes a lot more sense from a strategic and economic point of view to shoulder everyone’s responsibility and to create a common area of wellbeing and growth and protection, because the alternative is going to be very nasty in the long run.


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