Italy’s ‘this time it’s different’ moment: Reaction to Giavazzi

By Charles Wyplosz

Some maintain that Italy and Spain risk losing market access for their sovereign bonds despite drops in yields. A recent Vox column by Francesco Giavazzi suggested that Italy could and should avoid a bailout. This column argues that in spite of all its admirable human and economic assets, Italy has moved to a bad equilibrium from which it is most unlikely to escape.

The recent article by Francesco Giavazzi is both depressing and déjà vu all over again.

  • In early 2010, when the situation started to deteriorate in Greece and some eggheads opinionated that an IMF program was unavoidable – the Greeks replied “we are not Latin America”;
  • Half a year later, the Irish stated that they were not Greeks;
  • Then the Portuguese insisted that they were not Ireland;
  • Just a few months ago, the Spaniards claimed that they were not Portuguese.

Now guess what – the Italians remind us that Italy is not Spain.

As Reinhart and Rogoff (2009) have recalled, every country that faces a crisis always denies that it is fodder for IMF-style conditionality. In fact, you know that the point of no return has been reached the minute policymakers – or influential commentators – explain that their country is different.

And, yet, they are right. It is true that Italy’s fundamentals are clearly different from Spain’s fundamentals, which are different from those in Greece, Ireland and Portugal. What these countries have in common is that they have lost market access, at least at ‘normal’ interest rates.

The underlying economic mechanism is self-fulfilling market expectations, a.k.a. multiple equilibria. Rightly or wrongly, once markets conclude that a country’ situation is hopeless:

  • Interest spreads start rising;
  • Debt service becomes explosive; and
  • The situation eventually becomes hopeless.

Back in 2009, Greece did not have to get into a crisis. Nor did Korea in 1997, nor Mexico in 1986, nor Chile in 1982. In all these cases, the fundamentals were less than rock-solid, but they were not completely disastrous either. In each case, once the crisis occurred, hard-nosed observers, who had failed to predict what was to happen, went on drawing a list of alarming policy failures that fully justified the crisis and the harsh treatment imposed on the now-delinquent country.

What we know full well, at least since Obstfeld (1986) and Krugman (1986), is that a crisis can (but does not have to) occur when a country suffers from a vulnerability. We also know that, once a self-fulfilling crisis occurs, it tends to spread in a contagious way. Research has still to unearth cases when a country that moved into a bad equilibrium was able to recover to a good equilibrium.

Italy slipped into the bad equilibrium

Sometime early this year Italy moved into a bad equilibrium. This could have been avoided if there had not been crises in other Eurozone countries. Like Korea after the Thai and Indonesian crises, Italy is guilty by association. Like these countries, it has a vulnerability and thus susceptible to run into trouble (Wyplosz, 2010).

Italy’s vulnerability is its public debt. Italians are proud to note that their governments have been able to run primary budget surpluses since the early 1990s. The problem is that this has just been enough to stabilize the public debt, which has hovered around 110% of GDP since the early 1990s.

Debts that big are crippling; Reinhart and Rogoff (2009) claim that they stunt growth. Indeed, Italy’s economy has been stagnant for more than a decade.

  • Even before the crisis, Italy was well on its way to emulating Japan’s two-decade zero growth performance;
  • Now that the Eurozone is burning, there are many reasons to conclude that this dreadful scenario is no longer the pessimistic outcome – it’s the optimistic one.

As the recession spreads, tax revenues fall and the debt starts growing, at least in proportion to GDP. Mario Monti’s maiden round of fiscal austerity has accelerated the process.

Self-defeating austerity

As in every other Eurozone country already in crisis, or soon to join the fray – France is now a prime candidate – this policy was meant to reassure the markets. It has had the exact opposite effect. The markets have long concluded that debts will not decline until economic growth is back. The more governments tighten, the more likely they are to fall in the bad equilibrium. Monti’s limited structural reforms may deliver a limited boost, but this will take years to materialize. Meanwhile, the debt will grow.

The recession is opening up another vulnerability. It inexorability deteriorates the ability of past borrowers to pay up. The volume of non-performing loans is bound to increase steadily. Sooner or later, hitherto healthy banks will need government recapitalization, so the public debt will jump up. Those who hold this debt have every reason to be worried. This is how Italy is losing market access.

True, Italy is not poor. Its citizens and firms hold considerable wealth. Could it not be taxed in emergency? We know from the Latin American crises that, in times of crisis, wealth holders are prompt to move their assets away from the taxman. The Italian government too is wealthy, holding profitable state-owned firms and precious land and buildings. We know that selling out in the midst of a crisis takes the form of fire sales that are economically counter-productive (Krugman, 1998). While, we Europeans, are not Latin Americans – for whatever it means – the principles of economics know no geographical or cultural borders.

The dreadful inevitable

At the end of all this, the conclusion is unmistakable, simply because this dreadful process is so well known. In spite of all its admirable human and economic assets, Italy has moved to a bad equilibrium from which it is most unlikely to escape.

  • True, outrage is perfectly justified when waste of huge proportions is about to happen.
  • True, a few months away from general elections, the timing is particularly frustrating.

The temptation to deny and wait a bit more is irresistible. But waiting only raises the economic, social and political cost of the eventual crisis resolution.


Our best minds should not fall in this trap. Instead, we should all concentrate on how not to further repeat the errors of distant and more recent past. In particular, the Troika should imagine radically different conditions and the ECB should hasten its recently announced determination to do “whatever it takes to preserve the euro” by – in effect – acting as lender of last resort of governments and banks.

If not, the crisis will not end here. France is not yet there, but not that far away. And when that happens? Sorry my German friends, but the mast will sink with the ship.


Krugman, Paul (1996) “Are Currency Crises Self-Fulfilling?”, NBER Macroeconomics Annual: 345-506.

Krugman, Paul (1998) “Fire-sale FDI”, prepared for NBER Conference on Capital Flows to Emerging Markets, MIT.

Obstfeld, Maurice (1986) “Rational and Self-Fulfilling Balance of Payments Crises”, American Economic Review 76(1): 72-81.

Reinhart, Carmen and Kenneth Rogoff (2009), This Time is Different, Princeton University Press.

Wyplosz, Charles (2010) “And Now? A Dark Scenario“, VoxEU.

Charles Wyplosz is Professor of International Economics at the Graduate Institute, Geneva; where he is Director of the International Centre for Money and Banking Studies. Previously, he has served as Associate Dean for Research and Development at INSEAD and Director of the PhD program in Economics at the /Ecole des Hautes Etudes en Science Sociales/ in Paris. He is a CEPR Research Fellow and has served as Director of the International Macroeconomics Programme at CEPR.

This article originally appeared at VoxEU.

1 Comment
  1. David_Lazarus says

    I do agree with the conclusion, but the problem for investors is that herd mentality is so persuasive. Just look at the funds that bought into Facebook because it was so big that it could not be ignored and everyone else was seemingly doing so. If you bought in and it fell then because everyone else did then your performance against the market is no worse than anyone else. So herd mentality is hard to avoid. The same applies when sovereign crises occur. If you are late to the game you could lose money. 

    My thoughts are that people should look at Germany more closely. The problems of bad loans apply to German banks just as much as Greece. All the bailouts were to bail out foreign banks of which German banks are at the front of the pack in terms of bad loans. If there is a break up of the Euro the new Deutchmark could be so strong as to crush exports. The break up risk is significantly higher now because of talks of Grexit by Merkel and so EU trade is suffering. It is now only a matter of time that even deals between supposedly strong nations become questioned. The outcome could be exits and then massive losses by banks as trade deals collapse and offshore loans become unrecoverable as debt conversion to a much weaker currency will impose losses on all concerned. 

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