Neil Macdonald: Why Europe is broken

Claudio Giudici pilots his Toyota Prius through the congested streets of Florence, his exasperation showing as he explains for the third time why open markets and competition are bad things for Italy.

"History teaches us this history of economics," he says. "With more taxi drivers, we will have only more poor people, nothing else."

Florence, like Rome, has an acute shortage of taxis. And Giudici and his colleagues in Italy's taxi guilds mean to keep it that way, despite what the country's newest prime minister, Mario Monti, has to say about that.

The way they see it, there are only so many paying passengers at any time. Increase the number of cabs, and more drivers will be divvying up the same pool of fares.

Ask Giudici whether competition is a good thing, and he says, "This is not the real question. The real question is progress. Competition sometimes is good, but many other times it's not good."

Guidici's opinion is important because in Italy what the cabbies want matters more than it does in most places. There is a taxi guild here, with branches in every city. Giudici heads the Florence one.

The guild, which is a polite term for a cartel, controls the number of licences and therefore the number of taxis, thereby guaranteeing drivers a steady flow of business.

The needs of the Italian economy, or the general public, or the millions of tourists, don't even enter into the calculation.

Such broader interests hardly ever do in this country. And that, for all Italy's beauty and sophistication, is its pathology.

But la casta, as Italians call their closed, inward-looking system has suddenly become the focus of much anxiety and even fear throughout the West, as it has shot Italy to the forefront of a momentous shift in economic, political and cultural power that is taking hold across much of Europe.

Here, the old post-Second World War order of things, with its social compacts promising ever-improving cradle-to-grave benefits and lifetime job security, is breaking down amidst declining birthrates, long-held protectionist instincts and, above all, compounding debt.

Until now, insolvent Greece, with its massive debts, bloated welfare state and cheery aversion to paying taxes, has grabbed all the attention, along with the other so-called PIGSPortugal, Ireland and Spain.

But Italy's problems may well dwarf them all. Remember, Italy is the eighth largest economy on Earth. The entire population of Greece is smaller than the Italian province of Lombardy.

What's more, it is generally acknowledged that if the so-called "euro-contagion" does not stop here, the euro may well unravel, with spectacular consequences.

Italians know very well their system needs reform; what few here seem to understand is that their country now has no choice; it has borrowed itself into a deep pit, and surrendered much of its sovereignty to a faceless international entity called the bond marketessentially the wealthy central banks, pension funds, family trusts and corporate entities that lend nations money.

Power has shifted emphatically. Italy no longer has control over its destiny. The dire warnings of the international left about the outcome of globalization have come true right here, right now, and here are the reasons why.

La dolce vita

For decades a manufacturing powerhouse capable of producing exquisite luxury goods and comestibles sought the world over, all the while famed for its relaxed, self-indulgent lifestyle (la dolce vita), Italy is staggering toward a financial abyss and threatening to drag the rest of the developed world along with it.

The most obvious problem is debt. Italy owes nearly $2.6 trillion, about 120 per cent of its GDP. Of that, the government will need to refinance about $428 billion this year.

If Italy has to pay more than six per cent in interest for a sustained period on that new lending, it may well default, or provoke a 2008-style financial meltdown that would reverberate through an interconnected world.

But debt is just one of Italy's pathologies. Its real problem is growth, or lack of it. The Italian economy has been flat for nearly 15 years.

Its smug, protected manufacturing sector is being eaten alive by far more competitive economies such as China and Germany.

And a great deal of that is attributable to the web of protections, preferences, monopolies, favouritism and outright corruption that Italy has fashioned over the centuries to deal with competition, or, more accurately, to avoid it as much as possible.

Building a train station

"We are afraid of competition," says Italian economist Giuseppe Ragusa. "It's difficult to say but that is the tendency of the Italian people. We fear competition.

"If you think about it, there is something to it. In a competitive system there is the winner. Also there is the loser. Until they see a plan for the people who are going to lose from a more competitive system they are not going to be willing to go for a more competitive system."

The taxi guild is just one good example. There are 27 other guildsnotaries, pharmacies, lawyers, truckersalong with a long list of other professional organizations, all of them clinging to protections they've enjoyed for years.

And then there is the constipated, bloated Italian bureaucracy, which seems dedicated to one supreme goal: perpetuating la casta, the system everyone knows really runs the country.

Italy has nearly a thousand members of parliament, compared to 535 members of the U.S. Congress. They all enjoy cars and drivers and jaw-dropping lifetime pensions.

Even better for the political class, many seem to be no-show jobs, the politician turning up for work only when called upon to protect a special interest.

I asked Sergio Rizzo, the crusading Corriere de la Sera journalist, to characterize la casta for me.

"I'd answer with this example," he replied. "When they decided to build a train station in Rome, they had to include 38 different players in the decision making.

"Each of the 38 people had veto power. Each one wanted three copies of the project. Each project was made up of 1,000 sheets of paper, so they had to make 38,000 times three photocopies.

"At the end of deciding how to build this station, a process that lasted two years, these 114,000 photocopies were left behind. So the city of Rome had to take care of them.

"We took two years to decide how to build a station with 38 people wasting their time and spent 450,000 euros on photocopies and spent 22,000 euros to burn them.

This is a snapshot of Italy today."

Why change now?

Rizzo puts forward other statistics: Opening a business in Italy, on average, costs 5,012 euros ($6,565) for the necessary government permits, and involves 62 days of jumping over 16 different bureaucratic hurdles.

In Great Britain, the equivalent would be 381 euros ($499), four days, and five procedures. In the U.S., 167 euros ($218), four days, and four procedures.

It is, ironically, true that this system has produced the Italian quaintness that millions of vacationers seek out every year; there are no Starbucks here, or Wal-Marts.

There are also fewer supermarkets than anywhere in Europe. Italy is a charming country of small businesses. Inefficient and probably unsustainable small businesses.

If the bond markets that lend Italy the money it needs to keep refinancing its debt have their way, all that will change.

But why now? La casta, and the guilds, and the bureaucracy, have all been around for centuries. Italian governments have been addicted to borrowing ever since the Florentine and Venetian city-states invented banking and bonds (yes, the bond market was created here, in the 14th century).

So why is Italy's back suddenly against the debt wall?

The answer is in its decision, 10 years ago, to drop the lira and join the eurozone.

In doing so, Italy surrendered a key sovereign powercontrol over its monetary policy.

No longer can the government simply expand the money supply by printing more lire, in the process cheapening its exports and tourism, and beggaring its creditors.

The power to print euros lies solely with the largely German-controlled European Central Bank, one of the most conservative central banks in the Western world.

The other bleak reality is that Italy borrowed the money.

And now, having given up such a crucial policy tool, it must either keep borrowing, no matter how ruinous the interest rate, or revolutionize its economyto shed all the protectionism and become competitive, practically overnight.

Can it pull it off?

Technocrat in power

Prime Minister Mario Monti is a clearly brilliant man, but it's almost as if he strives to be dull and un-Italian, answering questions with long, didactic answers, which is what you would expect from a renowned economics professor.

Monti is no politician. He is not even elected.

Last year, after the bond markets became fed up with the coruscating Silvio Berlusconi, and began demanding an unsustainable seven-per-cent-plus return on 10-year Italian bonds, the Italian president asked Monti to form a temporary "technocratic" government to try to rescue the nation from the failure toward which it was heading.

Since then Monti has enacted stunning reforms, cutting spending and raising taxes.

He has curbed Italy's generous public pensions that enabled shockingly early retirement (in the past, women could take early retirement from public service after 15 years. For men, 20 years). And he has gone after the monopolies and guilds, taken on organized labour, and challenged la casta.

He has also insisted on ending another cherished Italian tradition: tax evasion. His tax inspectors have taken to pulling over Ferraris and Porsches, then asking their drivers how it is they can afford such cars on claimed incomes of less than 30,000 euros a year.

These inspectors also visit restaurants high and low, looking for any sign of cash transactions, which are pervasive, but now illegal.

Officials have been murdered in Italy for less. Certainly Berlusconi understood that. He may have been the only elected Western leader in modern history to advise his citizens that tax evasion is OK.

'No choice'

I met Monti in his spectacular official chambers in Rome. We spoke for more than an hour.

Niall Ferguson: a contrary view

There are some people who have a much more cheerful view of the euro crisisexperts who believe much of the crisis is being generated by a mass media hungry for a simple narrative and drama.

This group of euro-believers is a rather small club. Many of them are political leaders such as Germany's Angela Merkel or France's Nicolas Sarkozy, who are probably duty-bound to paint a rosy picture.

One notable, unaligned believer, however, is Niall Ferguson of Harvard University's Centre for European Studies.

A celebrated economic historianhis bestselling books include Colossus: The Rise and Fall of the American Empire and The Ascent of Money: A Financial History of the World Ferguson tends to take the very long view of economic crises.

This one is serious, he allows, and there is no easy way out for Italy, which faces a future of crippling unemployment and wrenching changes. "There is no policy option that keeps the post-war welfare state functioning," Ferguson says, flatly.

Still, "personally I don't think that one needs to be too apocalyptic about this," he told me recently. "One of the fascinating things about this crisis has been the excessive pessimism of people in North America who previously never gave a thought to the euro. Mostly this pessimism is ill informed."

"It would be a bit too much to pretend that one can change a way of thinking and living for the whole country in one year or a little more," he began, before making it clear that that is exactly what he is attempting.

"It's important for my fellow citizens to realize that some changes in their mindset are needed."

I put it to Monti that, to an outsider, it seems as if someone here sat down and deliberately wrote a series of laws and regulations meant to kill competition and stifle growth.

"Well," he replied. "That is not just an image. That is exactly what took place for many years in Italy."

Monti's stolid determination has made him wildly popular in the rest of the world. He is welcomed enthusiastically at the White House, the Elysee Palace, and in official Berlin. He is seen as the man who may, just may, stop Italy's slide.

But he is also blunt about who is truly in chargethe bond markets.

"They are very powerful," he says. "If they want Italy's economy opened up, well then, Italy has no choice."

These bond traders, he says, "also have the luxury of not coming individually and to be singled out for saying that, because it's the anonymous power of the financial markets."

Their power is that if they don't like what a government is doing, they just won't buy that government's bonds. Or, if they do, they will demand ruinous interest rates.

"We proceeded for many years under the assumption that tax policy and fiscal policy were manifestations of national sovereignty," Monti says, "until we discovered that this was no longer the case, because we had ceded that to the marketplace."

Labour's move next

At this juncture, however, "Super Mario" Monti's popularity appears to be waning, as his reforms start biting into Italian society. Basically, no one wants to be the first to give up privileges and, just last week, heacknowledged that he won't meet his austerity targets until 2015 at the earliest.

Already, the taxi guild has thwarted his efforts to break their monopoly. Pensioners, truckers, lawyers and unionized laborers have taken to the streets.

For organized labour, Monti is trying to take away the absolute lifetime job security conferred by the famous Article 18 of its labour law, which basically makes it impossible to fire anyone for any reason.

Article 18 is organized labour's greatest triumph, and the country's biggest unions have answered Monti by threatening to shut down the country.

As Susanna Camusso, the head of Italy's biggest union, told me, stone-faced, "I wouldn't take it for granted that the current accepting climate in Italy will continue.

"The government cannot cancel the right to work, which is fundamental to the society we live in."

As an economist, Monti knows very well he is playing with nitro.

Harsh government cuts during a recessionand Europe broadly is in a recession can drive an economy off a cliff. Greece's economy shrank 10 per cent in a year.

If you believe the International Monetary Fund, Italy's economy will shrink almost two per cent in 2012.

"It's not in the short term a recipe for expansion," says Monti, deadpan.

Shorting Europe

High above Manhattan, as his team of "quants" out on the trading floor pore over their multiple computers, placing and hedging massive bets, John Taylor watches every detail of Monti's efforts.

Taylor's academic sidehis doctoral thesis was on the relationship between Italy's government and its economyhopes Monti succeeds.

Further, he hopes Monti will succeed without having to impose what Taylor calls "the American solution"transforming Italy into a low-income profusion of big-box stores and cookie-cutter chains that may compete well in the global economy, but may also kill the soul of one of the world's most esthetically creative societies.

But his business side is betting Monti and his economic team will fail. Italy's debt is growing much faster than its GDP, and that way lies disaster, he calculates.

So Taylor's currency hedge fund, FX Concepts, the largest such fund in the world, is betting against the euro"shorting" it, in the parlance of Wall Street.

If the euro plummets or unravels, Taylor makes a fortune.And for that, he has been denounced as "evil" by European leaders and intellectuals.

He smiles. "I know, I know. I made the mistake of saying the euro was like a chicken with its head cut off."

But it "has had its head cut off," he goes on, "and it cannot survive. That's unfortunately the truth. At least the truth as I see it, right? So the euro is dead."

Taylor believes joining the euro and giving up monetary policy was an act of lunacy by European countries. "The markets have made a judgment I totally agree with, that the eurozone can't work."

Bonfire of the vanities

Taylor is willing to make another bet, too: that European governments, pushed to the wall, will try, in King Canute fashion, to legislate free markets worldwide.

In fact, he predicts a latter-day Bonfire of the Vanities, the event ordered by the medieval Italian cleric Girolamo Savonarola in 1497.

Disgusted by the debt-fuelled wealth being accumulated in 15th century Florence, Savonarola ordered the destruction by fire of luxury goods in the Piazza de la Signoria.

Savonarola paid for his fanaticism. The powers of the day, the Vatican and the Medici family, had him tortured, defrocked, hanged and burned on the very spot of his famous bonfire.

Taylor predicts European governments will try to do the same thing by, in effect, simply burning bonds; and that they will pay a price for it.

"Very, very stupid," he says of those European politicians who would outlaw shorting or suggest defaulting on loans. "Nobody would invest in Europe anymore."

In Washington, at the American Enterprise Institute, economist Desmond Lachman agrees.

He predicts Monti's austerity will shrink the economy, drying up revenues and necessitating even more austerity.

As revenues shrink, he says, Italy will be less able to service its debt, and the bond market will demand ever-higher interest.

Lachman says the rest of Europe will eventually have to decide whether to bail out in perpetuity Italy, and probably Spain, where the financial picture is even worse.

He has even calculated how much it will take to "protect" Italy and Spain from the bond markets for two years: $781 billion for Italy, and $441 billion for Spain, a total of $1.22 trillion.

The problem is that the money is simply not there.

But if Italy fails, says Lachman, it will provoke the equivalent of the 2008 near-meltdown, but without the accompanying bailout: stock markets will plummet, savings will evaporate, some banks will fail, and the euro will unravel.

"We are living through the most significant financial event of our lives," he says, with a dour smile.

The firewall

Not too far from Lachman's office, Christine Lagarde is on a singular mission: trying to prevent precisely what people like John Tayor are betting will occur.

She talks of assembling a trillion-dollar-plus "firewall" to stop the euro contagion at Italy. But she also argues that it will never be needed.

Her logic is circular: If the financial markets know such a massive pool of money is available for Italy and Spain, they will remain confident, and will not demand unsustainable interest, and so the fund will not be needed.

Lagarde is self-possessed and calm, usually dressed in black, radiating gravitas, her silver hair a statement in itself. A central player in this crisis, she is one of the most powerful people in the financial firmament.

Last August, she says, she would have predicted Italy would need a bailout. But Monti's reforms have comforted her. All the more reason to believe the firewall will be unnecessary, which makes it all the more important, she says.

The IMF is one of those organizations that demand austerity in return for its help. But Lagarde knows the dangers.

"It's a very difficult point you are asking. How much austerity is too much austerity, that it actually kills growth? And that's exactly what we are trying to focus on," she says soothingly.

But ask her about the power of the bond markets, or the people who are betting against the euro, and her tone turns martial.

"That is the point of the firewall . . . to have a line of defence that can actually be used as a deterrent and if necessary as munitions to fight those who are, as you say, shorting Italy."

Lagarde as much as confirms Taylor's fears that bondholders may simply be forced to accept huge losses, as they were in Greece: "At the end of the day, a sovereign is a sovereign and can actually decide what rules apply and what the principles will be," she says.

Perhaps. In any event, Lagarde's firewall is aspirational. The IMF and the eurozone countries have a few hundred billion, but nothing approaching the stunning amount of money required to protect Italy and Spain.

Where are the children?

The village of Montemassi is a thing of beauty. Carved out of Tuscan rock atop a hill, it has persevered for a thousand years.

It has survived invasion and domination by the hated Siennese, and the mayor, Giancarlo Innocenti, loves showing visitors the boulders the people of Montemassi dropped on the heads of Siennese soldiers trying to climb their hilltop tower in 1328.

The Siennese eventually cut the top off the tower, and things have been bad ever since, says Innocenti.

But Montemassi today faces what may be its greatest challenge: The town is dying, like so many others across Italy are dying, because the population is not replacing itself.

A nation requires 2.1 live births per adult female for a sustainable population. Italy's birth rate is 1.2.

Playgrounds are empty across the country. Schools are being transformed into old age homes. The bishop of Genoa has called the phenomenon "cultural suicide."

In Montemassi, there are a few hundred adults, and 20 children. Almost all of them girls, for some reason no one understands.

But Innocenti understands very well what the consequences are. The postwar deal, simply described, is that the retired generation is supported by the working generation, which is in turn likewise supported when it retires.

In Italy, as elsewhere in the West, the baby boomers are already retiring in waves. But the new generation is much smaller, much more indebted, and much less able to shoulder the cost of the welfare state's generous promises.

So the promises are being broken. Social compacts are being abruptly rewritten. The deal has changed retroactively and, to many here, unfairly.

After Sunday church services, Montemassi's ancient town square empties quickly.

Thirty years ago, says Innocenti, it would have been filled with people loitering and gossiping and socializing. Now, he says, "it's an architectural curiosity."

The view from elsewhere

Innocenti hopes immigration can make up the difference. But the town priest in Montemassi grimaces at that suggestion: "Children are being born to immigrants and maybe one day this town will belong to people from other nations," he says.

"In 20, 30 years, it will be full of people from elsewhere. And maybe the bell tower and the cross will disappear, and some other symbol will take their place."

In Florence's Piazza della Repubblica, children delightedly board the carousel that twirls and sparkles in the fading light of early evening. The carousel has been in the square for a hundred years. It is, literally, old Italy.

In the surrounding streets, people stroll the ancient cobblestones, visiting tiny butcher shops and cheese shops and bodegas and the "tavolacaldas" that sell delicious hot food to go.

Most of the shops in Florence are unique. Few are franchises.

In the spectacular, art-laden piazzas of Rome, people sit outside bars sipping hot chocolate so thick it seems like sweet mud.

Nothing like this exists anywhere in North America, or most places in Europe, for that matter. Italy remains singularly magnificent.

Sergio Rizzo, the journalist, compares Italians to a large family whose children are unruly, disobedient, and stubborn. But when they work together, he says, sweeping his hand at the cityscape behind him, look what they can do.

In a Manhattan skyscraper, John Taylor shrugs. "These guys are naked before the world right now."