Super Mario’s Italian economic challenge

At a time of considerable economic distress, Italy could not have asked for a better prime minister than Mario Draghi, the highly competent and internationally respected former head of the European Central Bank (ECB). However, so long as Italy remains stuck in the Euro, it is doubtful whether even Draghi will be able to breathe economic life into Italy, the sick man of Europe.

In a seeming last throw of the dice to avoid early parliamentary elections, President Sergio Mattarella has turned to Draghi to form a new Italian government. He has done so in the hope that Draghi’s well deserved international reputation as a miracle maker will allow him to succeed in restoring Italian political stability and reviving its economy. After all, during the Eurozone sovereign debt crisis in 2012, it was Draghi who single-handedly saved the Euro with his famous “the ECB will do whatever it takes” remark. 

It would be an understatement to say that Draghi is to become Italy’s prime minister at a time that its economy is in the deepest of trouble. Even before the COVID-19 pandemic chose Italy as its European epicenter, the country’s economy was yet to regain its pre-2008 economic peak. Following the pandemic, the country’s tourism-dependent economy is now 12 percent below where it was some 12 years ago.

The pandemic has also dealt the severest of blows to the country’s public finances. The country’s public deficit has ballooned to around 10 percent of GDP, its highest post-war level. Meanwhile the country’s public debt-to-GDP ratio has skyrocketed to around 160 percent, its highest level in the country’s 150-year history. Needless to add, the dismal state of Italy’s public finances is once again raising serious questions about the country’s longer run ability to service its debt.

Draghi’s basic economic challenge will be similar to that of Mario Monti, who was the country’s technocratic prime minister between 2011 and 2013. Like Monti, but under very much worse circumstances, Draghi will have to figure out how to promote economic recovery while restoring order to the country’s battered public finances. Like Monti too, he will have to figure out how to pull off this feat while Italy remains stuck within a Euro straitjacket.

Having given up its currency for the Euro, Italy can no longer engage in currency depreciation to offset the adverse effect on demand of budget belt-tightening. This puts Draghi in an impossible position especially considering the very large amount of budget correction that the country now needs to do. If Draghi were to engage in large-scale budget austerity, he would risk deepening the country’s already very deep economic recession. Yet if he were not to engage in budget austerity, Italy’s already very high public debt level would keep on rising.

Currently the ECB is keeping the Italian economy afloat by standing ready to buy an unlimited amount of Italian government bonds as needed to keep the country’s borrowing costs low. Draghi’s only real hope is that the ECB will continue to do so indefinitely. But this might be too much to expect from the ECB unless Italy were to undertake serious reforms to its sclerotic economy. 

Sadly, to date Italy has woefully lacked the political will to undertake such reforms. It is doubtful that a Draghi government comprised of the same political figures as before will now find that political will. 

Draghi succeeding at doing something that no recent Italian leader has managed to do will be of the greatest importance for the global economy considering the country’s systemic importance. Not only does Italy have an economy some 10 times the size of Greece’s. It also has the world’s third-largest sovereign bond market, and it is difficult to see how the Euro could survive if Italy were to fail.

In 2012, at the height of the Eurozone sovereign debt crisis, defying all expectations Draghi pulled a rabbit out of a hat to save the Euro. For all of our sakes, we must hope that he has another very large rabbit in his hat to save Italy from defaulting on its large public debt mountain, which would be sure to send ripples through the world’s financial markets. 

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.