Friday, November 18, 2011

Italy's Debt: A Hangover From Joining Euro

European authorities are treating Italy's debt problems as the product of a dysfunctional political culture. The chorus from Brussels and Frankfurt is that dispassionate technocrats, armed with help and advice from the euro zone, are needed to introduce essential reforms into a hidebound economic system.

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Italian Premier Mario Monti took his seat before a confidence vote Thursday.

But a closer look at the numbers reveals Italy's heavy debt burden isn't a result of recent government profligacy—certainly not compared with others around the world. Instead, it is in large part a consequence of policies introduced more than 30 years ago that laid the groundwork for the euro.

In 1979, European nations created the European Monetary System, the precursor of the euro zone. The EMS called on countries to keep their currencies trading within a fixed range of each other, with an eye toward limiting exchange-rate volatility and perhaps one day adopting a single currency.

That meant Italy, with one of the developed world's highest inflation rates, needed very high interest rates to keep the lira from falling against the German mark. In 1981, the Bank of Italy raised its discount rate to a peak of 19% and kept it above 10% until 1993.

This had a dramatic impact on Italy's public finances. Yields on 10-year government bonds peaked at over 20% in 1982 and averaged 14% between 1980 and 1993, way above inflation. (This does show Italy has paid current interest rates of about 7% before and lived to fight another day; the fear haunting investors today is that rates are unlikely to plateau at this level, but could rise frighteningly.)

Public debt exploded over that period, rising from under 60% of gross domestic product in 1980 to around 120% of GDP in 1994—very close to today's level. Interest payments rose from less than 4% of GDP to around 12% of GDP over the same time period.

Economists point to another reform adopted in 1981 that would anticipate the euro zone's monetary policy: The Bank of Italy was "divorced" from the Italian Treasury, and was no longer forced to buy bonds left over from Italy's debt auctions.

"The independence of the Bank of Italy, which started with the divorce, was the origin of the large public-debt burden," said Fabio Padovano, an economist at the University of Rome.

When Italian inflation levels surpassed 20%, as they did in the late 1970s and early 1980s, it was understandable that the Bank of Italy would want to keep interest rates sky high. But even after inflation had fallen to under 6.5% in 1986 and stayed there, the bank kept its discount rate high. The rate stood at 15% in 1992, despite average inflation of just 5%. Italian real interest rates—the difference between interest rates and inflation—were sharply positive long after inflation ceased to be a major problem, which meant the real burden of the debt on the economy climbed sharply.

The desire to limit devaluation of the lira within the EMS weighed heavily on Italian policy makers—even though the Bank of Italy had to accept multiple instances of lira devaluation since the start of the EMS. And in the 1980s, sky-high inflation wasn't a distant memory.

"People were scared, in a sense," Mr. Padovano said. "Italy had a history of negative real interest rates."

With the Bank of Italy no longer forced to buy debt from Treasury auctions, "interest rates had to be kept at a pretty high level to encourage people to purchase bonds," he added. "Like the European Central Bank, the Bank of Italy had to establish a reputation for being an independent institution."

This doesn't mean Italy's debt problems are totally unrelated to lax budgets and reckless Italian politicians. Back in 1975, Italy's budget deficit did spike to around 12%. Its primary deficit—the shortfall if you exclude interest payments—was over 7%. But since then, Italy's control over its finances has steadily improved.

Those numbers, however, hold the beginnings of a troubling trend: Interest payments began to account for an increasing share of Italy's deficit. By 1985, Italy's budget deficit was around 12% of GDP, but its primary deficit was less than 5% of GDP. Italy's primary deficit would continue to fall, until the government began running surpluses around 1992. These primary surpluses remained until the crisis hit in 2009.

The harm caused by high Italian interest rates extends beyond the impact to Italy's debt. High rates also hurt Italian growth. Italy recorded one of the world's highest growth rates in the post-war era, averaging over 5.5% from 1950 through 1973. But growth averaged just 2.1% from 1980 to 1993. Since 1995 and the country's last devaluation, Italian growth has been by far the slowest of the major European countries. With no economic growth, a high debt burden becomes harder to shake off.

Italian central bankers didn't face an easy choice in the mid-1980s after beating down inflation several years earlier: Had they cut interest rates, they would risk reigniting inflation and sparking a potentially disruptive currency devaluation. So, yes, the Bank of Italy—like the U.S. Federal Reserve—needed to raise rates sharply in the 1970s and early 1980s to squeeze inflation out of the system. But the country is now coping with the burden of economic policies that set the stage for the euro, policies that, in retrospect, may have kept interest rates too high for too long.

Write to Matthew Dalton at Matthew.Dalton@dowjones.com

exchange rate volatility, european monetary system, mario monti, high interest rates, confidence vote, inflation rates, european authorities, bank of italy, current interest rates, government bonds, single currency, same time period, german mark, debt burden, public finances, euro zone, dramatic impact, technocrats, political culture, debt problems

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