Photo Gallery: Italy's Decline

Foto: Luca Bruno/ AP

Basta 'La Casta' No End in Sight to Italy's Economic Decline

The Italian economy may be the third largest in the euro zone, but it is also plagued by inefficiency and continues to shrink. The country's political leadership has proven unable to implement badly needed reforms and the future looks grim.

The euphoria was evident. "We've done it!" Italian Prime Minister Enrico Letta tweeted earlier this month after the European Commission had provided his country with new financial leeway.

Letta had managed to convince Brussels that Italy would remain below the European Union's budget deficit limit of 3 percent of gross domestic product, if only by a hair, at a forecast 2.9 percent. The premier insisted that his country finally had the latitude to stimulate growth and promote new jobs, and that his administration had achieved "perhaps the most important result" of all time. That was at the beginning of July. Since then, politicians and lobbyists have been energetically arguing over how to take advantage of the new opportunity.

Former Prime Minister Silvio Berlusconi wants to abolish the property tax on first homes, which would cost €4 billion. And if the government were to refrain from a planned increase in the value-added tax, as has also been called for, it would forfeit an additional €2 billion ($2.6 billion) in revenues. Letta and the left, for their part, would like to invest €1.5 billion to create new jobs for young unemployed Italians.

The debate, and Letta's optimism, has temporarily obscured the difficult situation in which Italy finds itself. All the ideas under discussion for stimulating the country's economy will cost money -- and will require Rome to take on additional debt. Indeed, Standart & Poor's recently showed its lack of faith in the country when it downgraded Italian debt by a notch two weeks ago, a move which infuriated Italians .

The truth is that Italy, despite being the third-largest economy in the euro zone after Germany and France, finds itself in dire straits, having been in decline for years. Its GDP has dropped by 7 percent since 2007. The last few years, says Gianni Toniolo, an economics professor in Rome, represent "the worst crisis in (the country's) history," even more devastating that the period between 1929 and 1934.

Even More Pessimistic

Last fall, the situation looked to be improving, to the point that then Prime Minister Mario Monti promised that "things will improve next year." But those hopes have now faded. The government has reduced its growth expectations for the current year to minus 1.3 percent. The Bank of Italy, the country's central bank, is even more pessimistic, forecasting economic contraction of 1.9 percent.

But economic growth only tells part of the story. More than half a million industrial jobs have been lost since 2007, and 15 percent of the country's industrial capacity is gone, says Luca Paolazzi, head of research for Confindustria, Italy's leading industry association. Some sectors have lost even more capacity, with the automobile industry having declined by 40 percent. According to Paolazzi, Italy is experiencing an "unprecedented process of deindustrialization."

But why? Many products that are made in Italy are still in demand internationally, and not just Armani suits or the Fiat 500. Furthermore, Italy, like Germany, has been able to increase its exports in the last three years.

But while exports boosted domestic production in Germany, the same did not happen in Italy. Italian experts attribute this to the growing tendency to produce elements of export goods in Southeast Asia, Poland and Turkey. Many companies merely use plants in Italy to assemble parts made in factories abroad.

This is depleting the country's traditional industrial regions. Take, for example, Fabriano, a small city of 30,000 in the Adriatic region known for its "white goods," like refrigerators, ranges and washing machines. Fabriano used to be "a rich community, Italy's Switzerland," says Mayor Giancarlo Sagramola, "until the euro arrived."

Weeping and Praying

It used to be standard procedure for Italy to devalue its currency, the lira, to offset rising production costs. That, though, is no longer possible resulting in bankruptcy for some companies. Antonio Merloni SpA in Fabriano is one of them; it employed 5,000 people in its heyday.

To avoid this fate Indesit, another company based in Fabriano -- whose founders and principal shareholders are from the Merloni family -- shifted some of its production abroad, keeping only 2,900 of 6,500 jobs in Italy. In early June, the company announced plans to slash almost half of those remaining jobs.

Those affected by the cuts wept, prayed, wrote petitions and occupied the plant for a few hours. And the mayor knows what the latest bloodletting means for his city: even more unemployment and larger holes in his municipal budget. He doesn't even have the money to repair broken heating systems in municipal buildings, says Sagramola. Indesit employees fear that the recently announced layoffs will quickly be followed by the next step: the discontinuation of production of Italy altogether.

But what can protests, tears and prayers do against production and investment conditions that are simply no longer competitive internationally? Wages aren't the problem. They are 15 percent lower than Belgian and French wages and 30 percent lower than wages in Germany, according to a current Bank of Italy comparison. But according to Confindustria, the Italian economy faces a tax burden that is 20 percent higher than in Germany. And unit labor costs are about 30 percent higher than German levels, say central bank officials.

The banks, fearful of bankruptcies, are cutting back commercial lending. Even the government isn't paying its bills, with several hundred billion euros in current outstanding financial obligations. It is a dangerous situation, particularly for smaller companies.

Ever Deeper

Barring fundamental change, the country will go bankrupt, fear economists like Clemens Fuest, president of the Center for European Economic Research (ZEW) in the southwestern German city of Mannheim. The vicious cycle of recession, unemployment and steadily declining purchasing power is driving the Mediterranean  country ever deeper into crisis.

More than eight million Italians already live below the poverty line, including many who are still employed. The CGIA research institute in Mestre, near Venice, found that one in two small businesses was only able to pay its employees in installments. Three out of five companies are forced to take out loans to pay their high tax bills.

The efforts to introduce reform by the so-called government of experts, under economist and former European Commissioner Monti, did little to alleviate the problems. Monti, who took over the country from Silvio Berlusconi  in November 2011, proved adept at first aid, succeeded in bringing down dangerously high interest rates on Italian sovereign debt. He likewise pushed through a pension reform that increased the retirement age to 66. Monti also improved government revenues by raising taxes even further.

But the country's structural problems remained. They include, in addition to the tax burden, a bloated bureaucracy that obstructs almost all economic activity, an inefficient judiciary that deters potential investors with trials that can last for decades, a relatively low education level and a poor infrastructure characterized by potholed streets, an energy supply prone to failure, constantly delayed trains and outmoded communication networks.

As a result, Italy continues to fall behind internationally as a place to invest. It is now 44th in the World Competitiveness Center (WCC) ranking, below the Philippines, Latvia, Russia and Peru, and only slightly above Spain and Portugal.

Withdrawing from the Euro?

Improving the situation will be no easy task. In a 26-page report commissioned by the Italian president, four "wise men" from Italy's political arena recently listed the needed reforms. But few of their proposals were new. In its country report on Italy, the Organization for Economic Cooperation and Development (OECD) likewise included a large number of suggestions, such as labor market reforms. It also urged the government to reduce spending instead of constantly raising taxes. But it was to no avail.

A few days ago, Prime Minister Letta unveiled a thick package of reform proposals. But whether they will ever be implemented is questionable. Nothing is moving, the country is at a standstill, complains Bank of Italy Governor Ignazio Visco. He says the country is "already 25 years behind."

Italy's real affliction, though, is politics. "La Casta," as Italians dismissively refer to the leadership in Rome, is partly corrupt, partly ideologically pig-headed and mostly unwilling to compromise. Even the current administration seems incapable of pursuing reform.

The only reason the deeply hostile left and right joined forces is that there was no other solution after the elections in the spring. Berlusconi rejects what "the communists" want, and the left feels the same way about Berlusconi. Experts like ZEW President Fuest fear that the situation inevitably means that Italy's debt ratio will continue to rise.

Populists like Berlusconi and the founder of the "Five Star" protest movement, Beppe Grillo, are not the only ones advocating the most radical of all solutions for Italy's problems. The country has "a lot of vitality and great potential," says US economist and policy advisor Allen Sinai, but it can only benefit from these strengths "by withdrawing from the euro."

Translated from the German by Christopher Sultan