Why Italy, For All Its Faults, Is Key to the World's Economic Survival

Italy has two problems: Interest payments and Prime Minister Silvio Berlusconi.

Unlike Greece, Italy has a powerful economy. It is the third-largest in the Euro-zone, behind Germany and France. Northern Italy has a diversified industrial base. Its main focus is the production high-quality consumer goods by small and medium-sized enterprises, many family owned. It also has a thriving underground economy, which the CIA estimates could make up as much as 15 percent of GDP.

In December, Italy posted a state sector budget surplus of around $12 billion, compared to a surplus of $2.4 billion in the same month a year earlier. But ... Italy's debt burden of 120 percent of GDP makes it second only to Greece among EU nations. As a result at least 16 percent of its budget goes to making interest payments. Because of the strength of the economy -- even in the last few years -- investors have always been willing to loan the nation money.

It's not the deficit, stupid
It isn't this debt that has so many people worried about Italy. The fiscal deficits have actually been lower than what they were projected to be. As the International Monetary Fund reports, the problem is:

[a] mounting concern among investors about the two-way relationship between sovereign and financial risks, and about prospects for policymakers to craft a convincing and durable crisis resolution framework in the euro area. Without significant progress, there is a risk that market worries could become self-fulfilling, with consequences that could prove difficult to contain.

In other words, the markets are spooked the government can't deal with the deficit. That worry is driving up the cost of borrowing money to service the debt. In late July Italy's borrowing costs rosealmost a full percentage point from a month before -- pushing yields on 10-year bonds to the highest rate in more than a decade. To stop this, or at least to slow it, the European Central Bank has bought Italian bonds by the mega-bushel. Since mid-August the ECB has bought at least $40 billion.

The ECB is worried that if the cost goes up high enough then "market worries could become self-fulfilling, with consequences that could prove difficult to contain." Which is a very careful way of saying, "Italy is too big to fail. If it goes bust there's no rescuing it (or us)."

Just wait 'til next year
That's because of how much of the debt is held by non-Italians: $1.1 trillion in bonds as of March. This is more than the combined total of foreign-held bonds for Ireland, Portugal, Greece. So if Italy defaults a whole lot of dominoes are falling very hard with it.

So why does anyone with a lick of sense have doubts about Rome's ability to do something about its debt? Earlier this year it passed a bill to reduce the deficit by $65 billion but ... it then delayed $57 billion of those cuts until "next year." While that is typical for Italian politics it did not go down well with international investors. So in September the legislature approved a $74 billion austerity plan. Little wonder people have doubts about it.
If you ever want to feel better about politicians in the U.S. look across the ocean and be glad none of them are Silvio Berlusconi.

How do you solve a problem like Silvio?
The billionaire three-time prime minister owns the three-largest private TV stations and his appointees run all the public ones. He has been charged in an astounding number of corruption cases. These have included embezzlement, tax fraud and false accounting, and attempting to bribe a judge. In 2009, Berlusconi estimated that over 20 years he had made 2,500 court appearances in 106 trials, at a legal cost of $270 million. The lack of convictions is due largely to a range of extralegal maneuvers, including getting parliament to change the law when needed.
This year, Berlusconi was charged in a case he is having trouble getting rid of. He is accused of paying for sex with an under-age woman, nicknamed Ruby Heart-Stealer (there is never a boring day for Italian reporters), and then abusing his office to help release her after she was arrested on a theft charge.

Berlusconi is the personification of an Italian system which actively works to prevent economic growth in order to enrich the powerful. Its service sector is based on the Guilds of medieval Europe, which were designed to keep business closed to outsiders and innovation. Corruption is rampant - as in Greece people laugh at you if you pay your taxes. Italy's best and brightest people leave the nation and, because Italy has so little upward mobility, they are not being replaced by immigrants.
On these shoulders depend the fate of the world's economy.

Related:

• A Guide to What Happens When Greece Defaults
• What Comes Next for the EU: Three Scenarios
• Markets Terrified by Greek Attempts to Reassure the Markets About Bailout Plan
• Why China Won't Be Riding to Europe's Rescue Any Time Soon
• A Guide to the EU Economic Crisis, Part 1: Greece