Italy's Growing Debt Woes Have Investors On Edge

The announcement Tuesday that Italy's Prime Minister Silvio Berlusconi has offered to resign after his government passes an austerity package comes at a time when the country's economic problems have been mounting steadily. The cost of borrowing has been soaring in recent days, with investors increasingly fearing the worst: default.

But how did the conditions grow so dire for the country? On the face of it, Italy is an economy that has plenty of strengths: It's the third biggest economy in the eurozone; it has a strong manufacturing base; and it exports a lot.

"The bottom line is that Italy is very far from having a Greece type of problem or a Greece type of situation. It's a solid country with a lot of resources," says Marco Simoni, a lecturer at the London School of Economics.

And yet economists have grown increasingly worried that Italy's troubles could drag down the entire European economy. Italy owes a lot of money: Its total debt is equal to about 120 percent of its gross domestic product, or GDP.

Lack Of 'Real Reform'

Simoni says much of Italy's debt stretches back to the 1980s, when the government went on something of a spending binge. The country has made periodic efforts to pay off its debts, but it's been hamstrung by a weak economy.

Simoni says Italy's notorious bureaucracy makes doing business there difficult.

"It's not only that taxes are high, but they are too high on business so they penalize economic growth rather than [support] it," he says.

A lot of vested interests in Italy benefit from the system, Simoni says, and the Berlusconi government has simply been unwilling to take them on.

"The number of reforms that the government has done in the last year, 12 months — real reforms in terms of changing the structure of something — is one," he says. "[A] reform [of] the university system last December."

Today, Italy's growth rate has slowed to a crawl and Alessandro Giansanti, a senior rate strategist at ING Bank, says the economy could contract 2 or 3 percent next year.

"The market now is expecting a double dip in the euro area, and the Italian economy is the market that will suffer most," Giansanti says.

A Vicious Cycle: Interest Rates Rise

As investors have lost confidence in the Italian government, the interest rate it must pay to borrow has been steadily rising. Gabriel Stein of Lombard Street Research says that as interest rates rise, Italy will have to begin doing something that can only exacerbate its growth problems: It will have to cut government spending.

"If they do not, you enter a vicious circle called the debt trap, where the debt simply rises without limit, and the cost of servicing the debt rises without limit — and, of course, that is a very, very rapidly unsustainable position," Stein says.

With the cost of borrowing rising, more and more investors are starting to worry about Italy's ability to pay its debts. By one estimate, if interest rates rise to nearly 8 percent, Italy will have to spend 20 percent of its revenue just servicing its debt.

And as conditions tighten, the specter of a default looms larger. About half of Italy's debt is held by Italians themselves: people and institutions that bought government bonds as an investment.

But the other half is held by foreigners, especially by big European banks. Simoni of the London School of Economics says a default by Italy would quickly spread throughout the financial system.

"We are very far from it, fortunately, but it is something that would put at risk major banks in Europe, therefore endangering the entire European economy, therefore endangering the American economy," Simoni says.

The announcement that Berlusconi will step down gave a temporary boost to the financial markets. Many investors have come to see the Italian leader as an impediment to reform. But Italy has entrenched problems that Europe will have to address if it hopes to truly contain the crisis.

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