Downgrading Another Welfare State

And down goes another welfare state…:

Fitch Ratings has downgraded Italy’s Long-term foreign and local  currency Issuer Default Ratings (IDR) to ‘BBB+’ from ‘A-‘. The Outlook on the  Long-term IDRs is Negative. Fitch has simultaneously affirmed the Short-term  foreign currency IDR at ‘F2’ and the common eurozone Country Ceiling for Italy  at ‘AAA’.

Already before this, Italy was paying more than seven percent on its treasury bonds. This will bump up their borrowing costs yet another notch. And since the European Central Bank has promised to buy any EU member-state bonds denominated in euros, this will increase their commitment and their obligation to print even more money.

The downgrade of Italy’s sovereign ratings  reflects the following key rating factors: The inconclusive results of the Italian  parliamentary elections on 24-25 February make it unlikely that a stable new  government can be formed in the next few weeks. The increased political  uncertainty and non-conducive backdrop for further structural reform measures  constitute a further adverse shock to the real economy amidst the deep  recession.

It would be interesting to hear what the Fitch analysts have to say about what Italy has done thus far in terms of austerity. Effectively, they are asking for more of the same, obviously a bad idea.

There is actually a bit of irony in this. Without a “stable” government Italy will sail on as it is, and no new austerity measures will be implemented. This gives the economy a little bit of breathing space, which – at least in theory – could inspire a small recovery. That in turn would be good for future tax revenues and help toward reducing the budget deficit.

In reality, there is little to hope for here. Pressure from the EU will bring a new prime minister into office sooner rather than later, and regardless of who that person is, Italy will continue down its path of austerity. The only other option would be to leave the euro – an option that not even the Greeks could make use of. Therefore, we can expect more recession in Italy, which means weaker tax revenues, more demand for tax-paid entitlements – and thus a perpetuation of the budget problems.

That will surprise the Fitch analysts and somewhere in the future could bring about yet another downgrade. In fact, as the Business Insider reports, Fitch is already surprised by how poorly the Italian economy is performing:

Q412 data confirms that the ongoing  recession in Italy is one of the deepest in Europe. The unfavourable starting  position and some recent developments, like the unexpected fall in employment  and persistently weak sentiment indicators, increase the risk of a more  protracted and deeper recession than previously expected. Fitch expects a GDP  contraction of 1.8% in 2013, due largely to the carry-over from the 2.4%  contraction in 2012. Due to the deeper recession and its  adverse impact on headline budget deficit, the gross general government debt  (GGGD) will peak in 2013 at close to 130% of GDP compared with Fitch’s estimate  of 125% in mid-2012, even assuming an unchanged underlying fiscal  stance.

Nope. No peak there. Too many people have made too many predictions of peaks for the Greek government debt, and yet they were always overrun by reality. Expect the same to happen in Italy.

So long as the Italian government continues to try to defend its welfare state, it is going to run a deficit. So long as Italy runs a deficit, the EU and the ECB will demand more austerity measures. With more austerity, the current crisis will continue to get worse. How much worse is impossible to say: this type of crisis is historically new and has to do with the fact that the welfare state has matured, warped the economic incentives of a sufficiently large number of people and thus eroded its own economic foundation.

The Greek crisis is a perfect example of how open-ended this type of crisis is. It has been going on for five years now, the country has lost a quarter of its GDP and it is not over yet for them.