George Kerevan: Crisis proves that every cloud has a Silvio lining

Italy’s economy is a disaster waiting to happen and that inevitably means the end is nigh for its prime minister

IT IS too early to call the outcome of the constitutional quagmire in Greece, though I get scared when governments in Athens fire their entire military high command, in a bid to control the officer corps. Greek colonels and politics do not mix.

However, Greece is merely the warm-up, not the main act. That role falls to Italy. Last Friday, as the world woke to euphoric headlines pretending that the EU summit had brokered a deal to save the euro, the bond markets were indicating precisely the opposite.

On that morning, the cash-strapped Italian government tried to borrow money. Not only were there few takers, the interest rate for Italy went sky high. Yesterday it hit a record high. To pay pensions and civil servants’ wages is now costing Rome only a tad below the crisis 7 per cent rate that tells most prudent lenders to stop lending.

The proximate cause of the financial markets starting to boycott Italy can be summed up in two words – Silvio Berlusconi. Early last week, the Italian prime minister was dropping big hints he might quit office soon. But predictably, our Silvio used the Greek bailout deal to announce he was staying on till at least 2013. Banks and hedge funds duly panicked.

Everyone knows that the newly expanded European Financial Stability Facility (EFSF) agreed last week – even if it sees the light of day – is still nowhere near big enough to bail out Italy in addition to Greece. The Greek deal is not about saving Athens, but instead about building a financial firewall around Rome. George Papandreou may do his worst, but it is Silvio Berlusconi who can bring Europe’s economic walls tumbling down. And he’s doing his best to oblige.

Italy is a basket case with sluggish economic growth and a divided, dithering coalition government. Public debt is running at 120 per cent of GDP, the second-highest in the eurozone after Greece. Worse, Italy has the world’s third-largest stock of outstanding bonds, after the US and Japan. Once upon a time the exports of its luxury brands and efficient small engineering companies kept Italy’s economy buzzing, hiding the clientelism and public corruption of a state unreformed since Fascist times. But under Berlusconi’s whimsical rule, bloated government and entrenched interest groups have placed too big a burden on the economy.

Under pressure from Brussels, the Italian parliament has agreed to a series of measures designed to balance the budget by 2013. But there is a long way to go before these become a reality. Berlusconi is distracted by a plethora of sexual scandals in his private life while his coalition partner, the populist Northern League led by erratic right-winger Umberto Bossi, is opposed to the most difficult part of the reform package, raising the age of retirement.

The sands of time are running out for Berlusconi. On Tuesday, the Italian president, Giorgio Napolitano, made a thinly disguised threat to dismiss him and create a national unity government. On Wednesday, with the bond markets demanding their pound of flesh, Berlusconi convened an emergency Cabinet meeting in the hope of agreeing budget reforms. This theatrical charade produced little but platitudes leaving Berlusconi with nothing to offer other EU leaders now gathered in Cannes for the G20 summit.

Berlusconi has survived longer than any Italian prime minister since 1945. But a poll on Wednesday showed only 22 per cent of Italians still have confidence in him. Italy’s only hope of staving off a liquidity crisis is for Berlusconi to quit and a national unity government emerge (sans the loony Northern League). But what then? Italy and Europe both need a breathing space of several years to boost productivity, reform labour markets and get budget deficits under control.

Fortunately, there is a solution if only the eurozone members would take it. It has been there since the beginning and – I venture – will be resorted to eventually. Namely, to have the European Central Bank (ECB) in Frankfurt bail Italy out.

Because central banks can print currency, in the last resort they can provide a government with cash by buying its bonds. Ditto central banks can buy second-hand bonds from scared private lenders, keeping up the market value. So civil servants and pensioners are always guaranteed their incomes and the financial markets need not worry about a default.

Of course, if a central bank prints money in ordinary times (when consumer demand is high) you get rampant inflation. But that is hardly the case at the moment. The latest European manufacturing data suggests the EU is headed for recession.

If you want a good example of a country using its central bank to print money to (effectively) fund its government’s deficit, look no further than Britain. The Bank of England has already printed £200 billion since 2008, with another £75bn on its way. This has ended up subsidising the public bond market, keeping bond values up and interest rates low.

Why can’t the eurozone do the same? Because ECB is banned from printing euros to buy the sovereign debt of member states. This rule was imposed by the Germans as the quid pro quo for giving up their sainted Deutsche mark. Germany remains petrified since the hyperinflation of 1923, which impoverished the middle class and led directly to Hitler.

French president Nicolas Sarkozy has been trying to persuade German chancellor Angela Merkel to allow the ECB to start behaving like a central bank and bail out distress eurozone members directly. Technically the ECB would sell its own bonds (guaranteed because it can always print euros to pay creditors) and launder the cash to fund eurozone governments. To date, Merkel is saying “nein!”

But if the Greek crisis turns contagious, reinventing the ECB as a true central bank is the only option. Interestingly, the new head of the ECB, “Super” Mario Draghi, is Italian. When Berlusconi is driven from office, Draghi can expect a call from Rome.