The euro crisis is back

Europe's Reality Check

By Robert Samuelson

The euro crisis is back. Actually, it never left. But there was an extended period, beginning last summer, when Europe's political, business and media elites convinced themselves the worst had passed. The European Central Bank (ECB) -- Europe's Federal Reserve -- had tranquilized jittery bond markets. Italy and Spain, the two countries that might trigger a new crisis, would be able to borrow at reasonable interest rates, because the ECB had pledged to act as a lender of last resort. Though debtor nations still faced hard times, matters were slowly mending. So it was said.

No more. Italy's latest election quashes this optimism. The outcome seems a mix of absurdity and anarchy. One new political party, headed by a professional comedian named Beppe Grillo, received 26 percent of the vote. The business tycoon and former prime minister, Silvio Berlusconi, repeatedly pronounced politically dead, rose from the grave and almost won. Between Berlusconi's center-right coalition and Pier Luigi Bersani's center-left group (victor in the popular vote), there are major policy disagreements and, therefore, not much foundation for forming a government with a parliamentary majority.

But Italians did send a message. "The election wasn't just anti-austerity. It was also anti-German," says David Smick, editor of The International Economy magazine. "Berlusconi's rhetoric was very anti-German. In Italian politics now, it's dangerous to appear being the lapdog of [German Chancellor] Angela Merkel." In one dazzling stroke, Italian voters rejected both Europe's main response to high government debt -- cut spending, raise taxes -- and the policy's most powerful architect, Germany's Merkel. If Italy needs to be bailed out, the negotiations already look tortuous.

The resentment of austerity is no mystery. The Italian economy has contracted for six consecutive quarters; it is now 7.8 percent below its peak in the third quarter of 2007, reports economist Martin Schwerdtfeger of TD Economics. In 2013, the economy will shrink another 1 percent, he forecasts. Unemployment in December was 11.2 percent, up from 2007's 6.1 percent (annual average). This, too, will probably worsen in 2013. The point: Italians haven't gotten much return on their austerity.

Taxes went up. The value added tax (a sales tax) is scheduled to rise from 21 percent to 22 percent; there's a new tax on homes. Welfare benefits went down. The eligibility age for pensions (once 65 for men and 60 for women) is being raised to 67 by 2022. And yet, the debt picture hasn't improved. Interest payments and a contracting economy (gross domestic product) mean that the debt burden is worsening, notes Jeffrey Anderson of the Institute of International Finance, an industry think tank. Debt rose from 120 percent of GDP in 2011 to 127 percent in 2012, says the Organization for Economic Cooperation and Development.

Without stronger economic growth, Italy can't generate jobs and the tax revenues to shave the debt. Even before the financial crisis, growth was dismal, averaging less than 1 percent annually from 2001 to 2008. What obstructs it, many economists argue, are protections for firms and workers that provide privileges for some but discourage -- or prevent -- expansion. One example is Article 18 of Italy's labor law that makes it hard for firms to fire workers. "If you can't fire, you won't hire," says Matthew Melchiorre of the Competitive Enterprise Institute, a free-market think tank. Firms have an incentive to stay small. Italy has the largest share of employment in micro-firms (under 10 workers) in the European Union, he says.

At least 28 service sectors -- taxi drivers, pharmacists, lawyers, accountants -- enjoy licensing and other restrictions that limit competition. Rome has 2.2 taxis for each 1,000 people, much fewer less than Paris (7.7) or London (8.1), says Melchiorre. Italy's recent government under Mario Monti curbed some of these restrictions but was stymied in enacting more sweeping overhauls. Some economists believe that major "structural" changes would accelerate growth, but estimates of how much are mostly guesswork.

The day after the election, the rate on Italy's 10-year government bonds rose from 4.5 percent to 4.9 percent -- a large one-day move. That's still well below last summer's peak of 6.6 percent, but if financial markets decide that Italy's situation is slipping out of control, it will slip out of control. Interest rates will rise; the debt burden will increase. At some point, Italy -- the eurozone's third largest economy -- might need a bailout. Spain -- the fourth largest -- might too.

The amounts required would dwarf the rescues of Greece, Portugal and Ireland. Agreement would be hardly guaranteed. As conditions for aid, the ECB and Germany have insisted on precisely the austerity and structural changes that Italian voters just rejected. Could Italy, backed by other debtor nations, force changes in old policies and, if not, what happens? Europe's future remains in play.