Bear with me on this little story because it says a lot about the direction of Italy and the other banged-up Mediterranean countries on the eve of the European Union election.
My daughter Emma is 14 and attends a well-regarded Italian school in a buzzy but grubby part of Rome. Last year, the school was hit with at least two arson attacks. Someone – no one knows who – would pour an alcoholic fluid on one of the upper floors and light it. Each time, the school was empty, suggesting the arsonist had no desire to incinerate all the kids and teachers, and the damage was minimal.
Since September, there have been eight more arson attacks. The last one, two weeks ago, again set when the school was empty, did a lot of damage before it was doused. The school is now closed and the teachers have been scrambling to create makeshift classrooms in other schools and in offices nearby. The effort has been chaotic, frustrating, disruptive to parents and students and – this is the point – entirely avoidable.
In any civilized country, the second arson attack would have triggered something akin to a ruthless counterterrorist campaign. Priority police investigations and round-the-clock patrols would have been launched, surveillance cameras installed and evacuation practices ordered. Nothing of the sort happened, in spite of attack after attack after attack.
Typical Italy, some of us thought. This is a country that happily ignores danger signals and puts its crew on alert only at the last minute, when bulkheads are bursting and the ship is about to sink beneath the waves. Ditto Greece, Spain and, to a great extent, France, though Italy, the euro zone’s third-largest economy, embraces inertia and denial like a pouting mistress. Italy could still wreck the euro zone.
But isn’t the crisis over? It is, in the sense that the sovereign bond yields of the crisis countries have fallen relentlessly in the past two years, taking them down to their precrisis levels. Italy’s 10-year borrowing costs are now 2.9 per cent, not much higher than Canada’s 2.3 per cent. For Italy, that’s a drop of four full points from their level in 2011 and 2012, when the country was on the verge of the bailout whose crushing expense could easily have torn the euro zone apart. Remember, Italy is a Group of Seven country whose economy is about a quarter bigger than Canada’s.
Greece, the distraught victim of a six-year depression, and the recipient of two bailouts and a debt restructuring, is again raising its own debt and recently sold five-year paper at just below 5 per cent. Portugal has vaulted back into the debt markets too; its two-year bonds trade at just 1.2 per cent, roughly the same level as equivalent Canadian debt.
How can this be? A big thank you must go to European Central Bank president Mario Draghi, who, in the summer of 2012, promised to do “whatever it takes” to keep the euro zone intact. The promise was backstopped by a pledge to buy, in unlimited quantities, the debt of any country having trouble financing itself. The gradual end of the euro zone recession did the rest.
But like my daughter’s school, there are warning signs everywhere that all is not well. The bond yields in what were known as the “crisis” countries are not telling the truth; they seem to be entirely disconnected from the real economy. Take Italy, which is easing up on austerity and reform measures as its bond yields converge with those of the healthiest European economies. Italy’s economy is not growing. This week, fresh data showed that the economy slipped back into contraction territory in the first quarter. Another negative quarter – entirely possible – and the country will officially be back in recession.
Essentially nothing has been done to improve its competitiveness. Unlike Spain and Greece, its unit labour costs have not fallen since the start of the 2008 recession. Italy’s debt is now well beyond 130 per cent of gross national product, making it the world’s second most indebted industrial country on the planet, after Japan. With negligible growth rates, the debt will keep rising to the point it cannot be paid back.
If all this were not bad enough, Mr. Draghi, the saviour of the euro zone, seems to have lost his altruistic side. Inflation rates have plummeted in the region, to the point that deflation – falling prices – have gone from remote possibility to clear and present danger. Yet Mr. Draghi has not dropped interest rates or launched quantitative easing. Very low inflation or deflation can wreck countries’ debt-reduction plans because it prevents them from inflating their debts away.
To top it all off, the Chinese economy is cooling off, which is bound to cost Germany, France and Italy some export sales. If China devalues its currency, a move that would raise the cost of its imports, all bets are for Europe’s export-led recovery.
The warning signals abound, yet euro zone governments, especially those in the Mediterranean countries, take comfort in the low bond yields and ignore them. In the EU elections on May 25, the new band of anti-austerity parties stand to make great inroads. If they do, the reform efforts will again get diluted. The underperforming economies of Italy, Spain and a few others do not deserve their low bond yields. Sadly, it appears only a crisis will convince these countries to ramp up economic reforms.