The Italian Crisis

By Tim Parker | August 11, 2011 AAA
The Italian Crisis

Just when we think we're past another eurozone economic crisis, another country makes the news and this time, it has had a dramatic effect on the U.S. investment markets. We've heard from Greece, Spain and Ireland, and now we have another player in this ever expanding economic puzzle, Italy. We've all heard of Italy and we remember from grade school that it's the country that looks like a boot, but many underestimate the global reach that Italy holds.

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Italy has the eighth highest quality of life and is the 23rd most developed country. The economy is largely driven by family-owned small and medium sized businesses manufacturing and exporting products to other countries. Italy's economy has been one of the weakest in the eurozone. Where the eurozone has an average growth rate of 2%, Italy is less than half of that.

Those numbers aren't what have the world worried. Italy's debt burden is 120% of its gross domestic product. This means that it owes more than the value of all goods and services produced in the country in a year and its budget deficit is 4.6% of its gross domestic product.

These facts are causing investors to worry and when investors worry, bond yields go up and stock markets go down, and although the European Central Bank has helped to lower bond yields by purchasing large amounts of Italian bonds, how long this will stop the economic bleeding remains unknown. When consumers don't pay their bills on time or some other event causes their credit rating to go down, they often have to pay higher interest rates, known as the coupon in bond terms. This has been the reality for Italy for quite a while now.

Finally, Italy's economy is four times larger than Greece and Ireland's economies combined. It would be close to impossible to provide any type of bailout for Italy, not to mention that a piece of the funding provided to Greece came from Italy. Just because the European Central Bank purchased Italian bonds doesn't mean that the country's long term financial security is assured. The ECB may have won a battle but until Italy's debt is under control, the war cannot be won by a eurozone financial bailout.

The only silver lining to this dark cloud comes from the fact that the Italian crisis is different from Greece because much of the debt is owned by Italians which, in theory, allows for more flexibility on the terms of the payment. However, PIMCOs Mohamed A. El-Erian said, "Working closely with its European neighbors, Italy must urgently restore calm to its financial markets."

How much systemic risk has the European crisis caused? As of August 8, the U.S. stock market is down 9% making it one of the most violent declines in history and although the debt ceiling debate was largely blamed at the beginning, countries like Italy have become a big player in the global markets. Are there others to come?

Lower Your Debt
What should the United States learn from countries like Italy? For those who were shocked to read that Italy's debt to GDP ratio was 120%, the United States is at a critical level too. The majority of economists, politicians, and citizens are calling on the United States government to drastically reduce spending to more sustainable levels. Bloomberg reports that at this rate, the United States debt will surpass GDP in 2012.

Although many disagree with the recent U.S. debt downgrade by Standard and Poor's, it cannot be denied that the United States is dangerously overleveraged. Noted consumer activist, Dave Ramsey said this about U.S. debt:

"If the U.S. Government was a family, they would be making $58,000 a year, they spend $75,000 a year and have $327,000 in credit card debt. They are currently proposing BIG spending cuts to reduce their spending to $72,000 a year."

No Place for Politics
In a story that has much more important pieces to consider, an interesting fact making many media articles concerning Italy is that it's finance minister doesn't work well with other members of the government. The media has offered speculation inferring that this strained relationship may be one reason that this large scale economic problem may have escalated. The Italy crisis - the rising of borrowing rates and the plummeting of its stock market has come about, in part, because investors have lost confidence in the Italian government.

The United States proved through the debt ceiling debate that the political climate isn't one of cooperation and compromise, and this strained relationship was one factor mentioned when the U.S. debt rating was downgraded. Investors gauge their level of risk, in part, by how confident they are in the management. Italy, as well as Greece and other countries are proof of that. (For many emerging economies, issuing sovereign debt is the only way to raise funds, but things can go sour quickly. See How Countries Deal With Debt.)

We're on Our Own
If the United States were to find itself in an economic crisis similar to the eurozone, there isn't a country with the resources to offer a bailout. The United States has the largest economy in the world; the second largest, China, is nearly three times smaller.

It Could Happen
Largely because of the size of its economy, Italy is considered an anchor country for the eurozone. Although the situation with Italy will most likely not reach the magnitude of the Greece crisis, the fact that its economy has found itself in this state after years of warning may prove that the size of a nation's economy doesn't shield it from the possible effects of overspending. (Sovereign debt can play an important role in providing international diversification to individual investors. Check out The Risks Of Sovereign Bonds.)

The Bottom Line
Italy falls under the category of "too big to fail, too big to bail." This fact is what is keeping investors, politicians and other world leaders watching Italy very closely. Those same people are watching the United States as it works through its own fiscal crisis in the form of the debt ceiling debate. Don't be fooled. The debt ceiling debate may be over for now, but much work remains for the United States' debt. According to Standard and Poor's, another downgrade may be as little as two years.

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