As the eurozone crisis grinds on into another year, the only substantive change is the name at the center of the storm. Worries about Ireland have largely subsided for the time being, but the situation in Greece is still parlous at best. Now the spotlight is on Italy; amidst a change in government, ongoing wrangling with France and Germany and coordination between multiple central banks, the worry now is whether commercial banks, insurers and investors will have to factor in the risk of a default in yet another country. (For more, check out How Countries Deal With Debt.)

TUTORIAL: Economics Basics

What went so wrong for Italy that the country and its citizens find themselves in this situation? And perhaps more to the point, what can be done to fix matters?

The State of Things
At the risk of oversimplification, Italy is the latest European country to find itself no longer in position of the benefit of the doubt when it comes to its solvency and liquidity. Italy actually has a relatively positive primary budget, but according to the Central Intelligence Agency World Factbook the country has a large public debt – totaling some 120% of GDP or 1.9 trillion euros.

Unfortunately, this is not a small or inconsequential country in the financial markets. Tiny Iceland and Ireland sent ripples through the financial markets, but Italy is the third-largest economy in the eurozone. Roughly half of that debt is held by institutions outside of Italy, and half of that is held by institutions in the eurozone. Although banks and insurance companies are loathe to disclosing their holdings, there is no serious disagreement that large amounts of Italian government debt are sitting on the balance sheets of major banks in France, Germany and Belgium, as well as banks outside the eurozone in countries like the United Kingdom.

Although some of the pressure on the Italian situation has eased in recent weeks (as reflected in interest rates and credit default swaps), Italy is ultimately too big to be saved by its European brethren. Even if Italy does not default, the risk is still high that European banks will find their capital positions under pressure yet again, which will in turn slow lending and slow business activity in the region. (To learn more, see More Pain Ahead For European Banks.)

What Went Wrong?
The problems in Italy today are largely the fruits of seeds planted some time ago. As was the case with Greece, Spain and Portugal, admission to the euro allowed governments to delay unpopular reforms. With access to lower interest rates and cheap euro debt, there was very little immediate need or incentive for Italian government officials to address long-festering issues of business competitiveness and structural reform.

With access to cheap money, the Italian government borrowed aggressively and used the borrowings to fund public largesse. While most investors were not all that worried at the time that Italy was not borrowing for long-term structurally sound reasons, that has changed drastically in the last few years and investors are no longer lackadaisical about the very same high debt levels as before.

Along the way, easy money eroded quite a bit of Italy's competitiveness. Wages are not competitive here on an international basis, and Italian workers are frankly overpaid relative to their productivity. Yet, various laws, rules and regulations make it difficult to hire cheaper workers, fire redundant or unproductive employees or replace them with automation.

At the same time, the population and workforce of Italy is aging. Not only have these older workers become less productive, but they also consume more public benefits.

Making matters still worse is the high level of tax dodging in Italy. Avoiding taxes is almost a hobby in some parts of southern Europe, and it is estimated that perhaps as much as 30% of Italy's economic activity is in this so-called "shadow economy." Consequently, Italy has been hamstrung by laws and rules that discourage business activity, has seen its public transfer payments steadily climb and simultaneously cannot collect the tax revenue it needs to support itself. (For more on Italy and the other PIIGS, check out How PIIGS Defaults Could Affect The Markets.)

What Can Be Done?
Given the size of its economy and the fact that there is a meaningful export-oriented manufacturing sector, Italy is arguably in much better shape than Greece, when it comes to working its way out of these troubles. That is not to say that it will be fast, easy or uncontroversial, but at least the path is available.

Economic liberalization is likely to be a key component to working itself out of this mess. Although privatizing some national holdings is an option, the key is in the private sector. Quite simply, it is too difficult to start a business in Italy and too difficult to run once it's started. This, by the way, is also a significant part of the reason that so much of the Italian economy is off the books – avoiding taxes is one reason, but so, too, is the flexibility offered by that sort of arrangement.

Said differently, Italian businesses need to be able to expand and contract (add or fire workers) as conditions dictate, need to be able to raise capital on reasonable terms and need to have a system with consistent and logical rules and regulations in place.

At the same time, the Italian government and its citizenry likely also need to accept cutbacks in government spending, particularly in areas like pension benefits and social spending. Along with decreased government spending, increased tax collection would also improve the liquidity situation of the Italian government. (For related reading, see The Euro: What Every Forex Trader Needs To Know.)

The Bottom Line
If the eurozone is to survive, Italy has to make some significant reforms. Simply put, Italy is too large to be saved by France and Germany, and that is assuming that those countries would have the willpower to do so. Although many countries try to claim (and maintain) distinctive cultures as a validation of different economic approaches, the reality is that Italy will have to make some accommodations to remain part of the eurozone economic system and continue to receive support from the likes of the Bank of England and the U.S. Federal Reserve.

The good news is that while these reforms will not be quick or painless, Italy has the opportunity to improve its financial situation and move on from this crisis. Unfortunately, it will take a great deal of discipline and political will to convince Italian citizens that the near-term decline in their quality of life is worth the long-term benefits, and/or an inevitable result, no matter what happens. If Italy begins making serious reforms, the market will likely respond with relief and lower interest rates and Europe may finally find the road back from the persistent sovereign debt crises. (For more information in Italy, read The Italian Crisis.)

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