Italy’s 'this time it’s different' moment: With rejoinder by Giavazzi

Charles Wyplosz 15 August 2012



The recent article by Francesco Giavazzi is both depressing and déjà vu all over again.

  • In early 2010, when the situation started to deteriorate in Greece and some eggheads opinionated that an IMF program was unavoidable – the Greeks replied "we are not Latin America";
  • Half a year later, the Irish stated that they were not Greeks;
  • Then the Portuguese insisted that they were not Ireland;
  • Just a few months ago, the Spaniards claimed that they were not Portuguese.

Now guess what – the Italians remind us that Italy is not Spain.

As Reinhart and Rogoff (2009) have recalled, every country that faces a crisis always denies that it is fodder for IMF-style conditionality. In fact, you know that the point of no return has been reached the minute policymakers – or influential commentators – explain that their country is different.
And, yet, they are right. It is true that Italy’s fundamentals are clearly different from Spain’s fundamentals, which are different from those in Greece, Ireland and Portugal. What these countries have in common is that they have lost market access, at least at 'normal' interest rates.

The underlying economic mechanism is self-fulfilling market expectations, a.k.a. multiple equilibria. Rightly or wrongly, once markets conclude that a country’ situation is hopeless:

  • Interest spreads start rising;
  • Debt service becomes explosive; and
  • The situation eventually becomes hopeless.

Back in 2009, Greece did not have to get into a crisis. Nor did Korea in 1997, nor Mexico in 1986, nor Chile in 1982. In all these cases, the fundamentals were less than rock-solid, but they were not completely disastrous either. In each case, once the crisis occurred, hard-nosed observers, who had failed to predict what was to happen, went on drawing a list of alarming policy failures that fully justified the crisis and the harsh treatment imposed on the now-delinquent country.

What we know full well, at least since Obstfeld (1986) and Krugman (1986), is that a crisis can (but does not have to) occur when a country suffers from a vulnerability. We also know that, once a self-fulfilling crisis occurs, it tends to spread in a contagious way. Research has still to unearth cases when a country that moved into a bad equilibrium was able to recover to a good equilibrium.

Italy slipped into the bad equilibrium

Sometime early this year Italy moved into a bad equilibrium. This could have been avoided if there had not been crises in other Eurozone countries. Like Korea after the Thai and Indonesian crises, Italy is guilty by association. Like these countries, it has a vulnerability and thus susceptible to run into trouble (Wyplosz, 2010).

Italy’s vulnerability is its public debt. Italians are proud to note that their governments have been able to run primary budget surpluses since the early 1990s. The problem is that this has just been enough to stabilize the public debt, which has hovered around 110% of GDP since the early 1990s.

Debts that big are crippling; Reinhart and Rogoff (2009) claim that they stunt growth. Indeed, Italy’s economy has been stagnant for more than a decade.

  • Even before the crisis, Italy was well on its way to emulating Japan’s two-decade zero growth performance;
  • Now that the Eurozone is burning, there are many reasons to conclude that this dreadful scenario is no longer the pessimistic outcome – it’s the optimistic one.

As the recession spreads, tax revenues fall and the debt starts growing, at least in proportion to GDP. Mario Monti’s maiden round of fiscal austerity has accelerated the process.

Self-defeating austerity

As in every other Eurozone country already in crisis, or soon to join the fray – France is now a prime candidate - this policy was meant to reassure the markets. It has had the exact opposite effect. The markets have long concluded that debts will not decline until economic growth is back. The more governments tighten, the more likely they are to fall in the bad equilibrium. Monti’s limited structural reforms may deliver a limited boost, but this will take years to materialize. Meanwhile, the debt will grow.

The recession is opening up another vulnerability. It inexorability deteriorates the ability of past borrowers to pay up. The volume of non-performing loans is bound to increase steadily. Sooner or later, hitherto healthy banks will need government recapitalization, so the public debt will jump up. Those who hold this debt have every reason to be worried. This is how Italy is losing market access.

True, Italy is not poor. Its citizens and firms hold considerable wealth. Could it not be taxed in emergency? We know from the Latin American crises that, in times of crisis, wealth holders are prompt to move their assets away from the taxman. The Italian government too is wealthy, holding profitable state-owned firms and precious land and buildings. We know that selling out in the midst of a crisis takes the form of fire sales that are economically counter-productive (Krugman, 1998). While, we Europeans, are not Latin Americans – for whatever it means – the principles of economics know no geographical or cultural borders.

The dreadful inevitable

At the end of all this, the conclusion is unmistakable, simply because this dreadful process is so well known. In spite of all its admirable human and economic assets, Italy has moved to a bad equilibrium from which it is most unlikely to escape.

  • True, outrage is perfectly justified when waste of huge proportions is about to happen.
  • True, a few months away from general elections, the timing is particularly frustrating.

The temptation to deny and wait a bit more is irresistible. But waiting only raises the economic, social and political cost of the eventual crisis resolution.


Our best minds should not fall in this trap. Instead, we should all concentrate on how not to further repeat the errors of distant and more recent past. In particular, the Troika should imagine radically different conditions and the ECB should hasten its recently announced determination to do “whatever it takes to preserve the euro” by – in effect – acting as lender of last resort of governments and banks.

If not, the crisis will not end here. France is not yet there, but not that far away. And when that happens? Sorry my German friends, but the mast will sink with the ship.


Krugman, Paul (1996) “Are Currency Crises Self-Fulfilling?”, NBER Macroeconomics Annual: 345-506.

Krugman, Paul (1998) “Fire-sale FDI", prepared for NBER Conference on Capital Flows to Emerging Markets, MIT.

Obstfeld, Maurice (1986) “Rational and Self-Fulfilling Balance of Payments Crises”, American Economic Review 76(1): 72-81.

Reinhart, Carmen and Kenneth Rogoff (2009), This Time is Different, Princeton University Press.

Wyplosz, Charles (2010) "And Now? A Dark Scenario", VoxEU.




Topics:  EU institutions

Tags:  Eurozone crisis, EZ crisis, Italian bailout


On one thing, Charles Wyplosz and I agree: Italy is solvent.
-          It has a very high public debt ratio (123% of gdp) which makes its economy fragile, but the budget shows a primary surplus (3,6% of gdp this year;
-          Its banks are in decent shape – not full of real estate loans gone sour – because Italy never had a housing bubble.
The reason Italian interest rates are so high (close to 6% on ten-year bonds) is that the country fell into a bad equilibrium about a year ago.
This did not happen because economic conditions changed – the debt has been high since the late 1980s and growth has been close to zero for over a decade. Italy fell into a bad equilibrium because investors lost faith in the ability of Prime Minister Berlusconi to run the country.
Thus Italy can only exit the bad equilibrium if it is able to convince investors that it has put in place a government able and willing to solve its underlying problem, namely low growth. Mario Monti has started doing this. If he can continue running the country up to and after the next general election (which will take place not later than seven months from now) the problem would be essentially solved and Italy would shift back to the good equilibrium. But who wins the election remains highly uncertain. For this reason, the country remains stuck in the bad equilibrium.
Is there anything the ECB could do to help Italy?
If politics explains why Italy shifted to the bad equilibrium, it makes sense that only politics can shift it back. The ECB cannot do it. Using an international economic package to solve a domestic political problem is wrong-headed and thus unlikely to work.
This is way I do not believe that ECB purchases of government bonds can solve Italy’s problems. Of course they could if the central bank was prepared to cap Italian interest rates without conditions, but we know this is impossible.
Asking the ECB to intervene – and this was the main point of my article – could actually make the situation worse. Signing today a memorandum of understanding (MOU) with the EFSF – the condition the ECB is asking for buying a country’s bonds – would raise the issue of the legitimacy of a non-elected technical government. If Italy’s economic program is to be written by the Eurogroup and monitored by a troika, why do we need a technical government? Any old Prime Minister, even Berlusconi, could have done it. My prediction is that striking a deal with the troika will end Monti’s chances of continuing after the general election.
There is a virtuous path which would shift Italy back to a good equilibrium. The political parties competing in the Spring elections should jointly sign an MOU (ahead of the elections, not today) constraining the policies of whoever wins. At that point the parties could agree to keep Monti in office. After all, if the programme is pre-determined why not ask the best available person to implement it.
I am sure this would shift us back into the good equilibrium. Signing an MOU now would throw Italy off this virtuous path.
Francesco Giavazzi


Professor of International Economics, Graduate Institute, Geneva; Director, International Centre for Money and Banking Studies; CEPR Research Fellow

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