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Italy's Crisis: Neither Fiscal Profligacy nor Capital Flows

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Italy was one of the worst hit during the 2007–2009 global financial crisis (GFC) among the major advanced economies. By year-end 2009, Italy’s economy had contracted by 6.6 percent; significantly larger than the recessions in the euro zone and the United States, for example, which saw their GDPs shrink by 4.4 and 3.1 percent, respectively.

In the ensuing euro-zone crisis, its economy has contracted the second most over the past seven years, next to Greece, and unlike most other countries its GDP is still expected to remain smaller than its pre-crisis levels in five years. Despite its falter, Italy has one of the most resilient economies in the euro zone: although it has been shocked and shaken over the past eight years, did not suffer a banking crisis or the collapse of its real estate market. While the euro zone as a whole has been recovering since 2013, Italy has yet to see positive growth since the since the third quarter of 2011. The recession has been met with rising unemployment remaining in the double digits since the first quarter of 2012, currently resting around 12.5 percent. This is much higher than Italy’s pre-crisis average of just over 8 percent, while it remains significantly lower than several other euro-zone countries including Greece and Spain that have unemployment rates of 25.8 and 23.4 percent, respectively.

Perhaps the most troubling issue in a few euro-zone economies is that high levels of debt are still raising questions over medium-term debt sustainability. Italy has the second-largest debt-to-GDP ratio in the euro zone, after Greece, at over 135 percent; the ratio has increased by over 30 percent of GDP during the past seven years. A combination of weak fundamentals, political instability and sovereign yield volatility raised concerns over how large Italy’s debt would grow and the government’s ability to service its debt at various points throughout the crisis. The main question that will be explored in this paper is what caused Italy’s economy to fall so far and its debt to grow so large during the crisis?

We will consider whether the general arguments that have been put forward for the euro zone’s sovereign debt crisis apply equally to the case of Italy. One potential explanation for the cause of the euro-zone crisis is that governments practised overly generous fiscal policies that became unsustainable when global demand and financial markets were shocked. The argument that fiscal profligacy was at the heart of the economic ills of the euro-zone periphery was advanced by several Northern European analysts, particularly in Germany, who insisted that the periphery had been living beyond their means in the lead up to the GFC. Carlo Bastasin (2015) describes the German’s viewpoint as, “Debt levels were the consequence of irresponsible management by both public and private consumers, described by Germans as Defizitsuender, or “fiscal sinners” whose countries had become insolvent through their own mistake” (Bastasin 2015, 242). If fiscal profligacy is the problem, then fiscal austerity that cuts unproductive government expenditures will help secure sustainable debt dynamics and restore market confidence. Most economists, however, recognize that reckless fiscal expenditures might explain part of the vulnerability of some euro-zone economies, typically pointing to Greece and Portugal, but that there were several other explanations for the euro zone’s troubles.

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