How the 2007 financial crisis affected the Italian Economy, “too big to fail, too big to save”
Italy’s economy was able to stay afloat for a long time, before beginning to sink. However, in 2007 when financial crisis happened on Friday the 14th of September, the Italian economy finally sank below zero in terms of Gross Domestic Product (GDP) growth and has barely recovered since. “Italy’s economy has shrunk by around 10% since 2007, as it endured a triple-dip recession” (Das 2011).
The financial crisis of 2007 is regarded by many economists as the worst financial crisis pre the Great Depression in 1930. The financial crisis had several negative impacts on banks, financial institutions, households, businesses and the economy.
In this essay I’m going to discuss the impact the recession had on the Italian economy, focusing on economic growth, unemployment, country debt, banking collapse and budget deficit.Furthermore, I going to examine how a breakdown in market discipline played a role in triggering the financial crisis.
The financial crisis had a major impact on production in Italy with GDP and unemployment falling at an alarming rate. Immediately the financial crisis hit, unemployment, rose to “7.8%” and GDP decreased by “5%” in 2008 (Coletto 2010). According to the National Institute of Statistics (istat)
During the 2007 recession, confidence became low meaning Italy suffered from demand deficit unemployment, this is when individuals lose their jobs due to decline in the aggregate demand (AD). This results in a negative economic growth and output as there is no money circulating the economy. Therefore firms employed fewer workers as they produced fewer goods, due to lower consumer demands due to reduced disposable income and reduction in consumer confidence, some firms went bankrupt leading to more people being laid off. Firms began to minimise cost this meant firms were extremely unlikely to hire anyone as they keep laying people off. This resulted in a significant amount of the population were unemployed, reducing investment and consumption meaning a reduction in AD as consumption and investment are both components (C+G+I+(X-M). This makes the recession worse as there is little to no money in order to stimulate the economy.
Employment in 2009 declined by “380,000” (Coletto 2010), while the unemployment rate rose to by “1%” from 2008 (Coletto, 2010). The largest job losses affected workers on temporary contracts also known as “zero hours” contracts. From 2008-2009, the number of workers on fixed-term contracts decreased by “11%” compared to temporary contract workers dropped by “16%” (Coletto 2010). Unemployment among young Italians is above “27%” (Weissmann 2011), they are forced to sign short-term contracts, this means the labour force is not very productive and are not being utilised fully due to the state of the economy.
With the data I have provided you can clearly see the impact the financial crisis of 2007 is having on employment in Italy. Workers who are fortunate to keep their jobs are often forced to take wage cuts which means there is a further decline in consumer spending therefore a greater fall in AD,making unemployment worse.
Output and economic growth
The financial crises led to lower investment, therefore damaged the long-term productivity of the economy. The damage has been long term for Italy, has about “15%” (Das 2016) of Italian industrial capacity has been destroyed, reducing employment and growth potential. This makes it harder for Italy to recover from the aftermath of the 2007 financial crisis, with a lack of research and development to help improve productivity therefore helping to stimulate the economy.
Government spending and taxation
Governments saw a fall in tax revenue subsequently to the financial crisis, due to a lack of AD in the economy. This meant firms made less profit, therefore government received less revenue from corporation tax. Workers received lower wages, as firm cut costs therefore a reduction in income tax. Even worse, people were unemployed and still are, therefore aren’t legible to be taxed which leads to further reduction in income tax revenue. Households had lower disposable income while some had to sign up for unemployment benefits, this caused a rise in government spending on welfare payments.
It is “estimated $160 billion in taxes are uncollected each year, the third highest rate in Western Europe” (Das 2016). According to the World Bank, Italian corporate tax is around 65%, this has disincentives firms from investing as they can pay low corporation tax in a more stable economy such like Switzerland which tax rate is about 29%. I believe the money potentially generated from taxes could have been reinvested into the economy to help rebuild it, but due to employment issue and firms cutting cost, the government receives less money due to the impact of the financial crisis.
Effects on banking system
Italian banks are stuck with around “€150-200 billion of bad loans” (Das 2016) and are unable to sort out this problem, therefore, has exposed its inadequate capital and reserves. During the financial crisis, many banks suffered substantial losses, and some forced into bankruptcy like Lehman Brothers. Banks lost a large sum of capital as consumers lost confidence. Therefore consumer deposits, which was a source of fund for the banks fell due to a loss in confidence, meant fewer funds for the banks. The crisis affected banks’ future profits, as regulatory and capital requirements became stricter, meant a reduction in previous profitable opportunities. Such as securities loans which were off-balance sheet activities (FAOLA 2016).
Non-bank financial institutions such as pension funds, insurance, and finance companies are now subject to stricter regulatory requirements due to new regulations. This can be viewed as a positive as this means the investors are better protected if another financial crisis happens, therefore won’t lose as much compared to 2007.
Italy’s “total economy debt which includes government, household and business is around 259% of total GDP and has increased by 55% since 2007” (Das). Investors are concerned about Italy’s ability to cover its interest payments without gaining higher levels of debt. This has forced Italy to pay more for credit making it more expensive, and less appealing, for investors to lend Italy money as it less likely they would get their money back. There is a fear that is the Italian government may never be able to repay its old debt and the lack of credit available will limit any possible recovery from the crisis.
Reduction in tax revenues and rising government spending through welfare payments, since 2007 has caused an increase in the budget deficit, and total government debt. Italy saw an expansion in the budget deficit because they relied heavily on tax revenues from property and the financial sector. The fall in the property market hit tax revenues hard, meaning there was less money in the economy which made the recession worse as they relied heavily on the money received from properties but the market plummeted as well during the crisis.
Budget deficit usually increases as the government impose expansionary fiscal policy, in the hope of stimulating economic activity. Expansionary fiscal policy involves a reduction of taxation and increased government spending in order to increase AD to stimulate the economy. Italy’s budget deficit is currently at about “3% but government debt is estimated at $2.4 trillion” which equates to about “140% of GDP” (Das 2016). “Italy’s debt ratio is the second worst in the eurozone, behind Greece” (Weissmann 2011)This shows the state the economy of Italy is in right now.
Despite fiscal policy being implied you can see the effect the financial crisis had on the Italian economy as they are still struggling ten years on.
Prior to the financial crisis bank were not regulated throughly therefore could take uncontrollable risk which showed a lack of market discipline. If information was symmetrical between banks and investors and stricter regulation in place,possibly the financial crisis could have been avoided.
I understand market discipline as free market forces which help limit the risks taken by banks regarding investment from stakeholders and who they loan money to.
(Crockett 2001) identified four requisites for effective market discipline which are information in order to understand the risk, ability to process the information, incentives to want to rein in undue risk taking and power to exercise discipline over bank .These four requisites are heavily linked to each other.
Investors in banks require adequate information in order to be able to assess the risks they are exposed to. Investors had asymmetric information as a result were unable to assess the risks, has banks disclosed minimal information to them. During the crisis investors realised they didn’t have enough information, this caused a dramatic increase in funding costs intensifying the crisis(Gorton 2008). Levels of high complacency was caused by banks underpricing risk or ignoring them all together consequently giving investors a false sense of security.
(Morris and Shin 2002) “show that greater disclosure may be harmful because it induces market participants to put excessive weight on the public information”.This resulted in limited information being provided during crisis, which resulted inability to asses the risk taken previously. If public information isn’t accurate this can further worsens market discipline as they rely heavily on this.
Investors require sufficient amount of information in a simple format, to be able process the information effectively in order to evaluate the quality of their investment. As a result of information between banks and investors being asymmetric this affected the ability of the investors to process their investment opportunity effectively. Therefore it becomes more difficult to evaluate risk when data is crowded, furthermore the fact that manager withheld also intensify the inability if investor process the information properly.Investors then turned to credit rating agencies when they were unable to process information, therefore credit agency help asses of riskiness and the debtor’s ability to repay the debt. Credit agencies were seen as the middle men as they gave financial institutions and investors information on the quality of the risk and potentially profit. An example of a credit agency is Standard & Poor’s.
However, due to credit agencies charging banks and other financial institutions in exchange to provide information on goods such bonds and collaterised debt obligations. Therefore when the financial crisis struck, the agencies had to figure out how to stay profitable and therefore began give positive ratings to many of these good, even though they knew were high-risk and poorly performing which made the crisis worse.
(Thakor 2015) “analytically predicts that mandatory disclosure for financial institutions might be inefficient and make banks more fragile”. Therefore, it may still have a negative impact if the bank disclosures the information or not as people withdrawing their money might crumble bank but on the other hand investors don’t lose their money incase another financial crisis strikes.
Debt investors evaluate the risks compared to potentially profit that could be gained. Therefore market discipline can be eroded if there a huge difference between the risks the banks are taking versus the risk the debt investors are willing to take. Government letting specific banks to collapse would result in astonishing high economic cost, therefore meaning these banks can’t fail. Government intervention takes place which provides guarantees for these large banks, meaning they are covered for specific losses. Banks who are insured against all or some losses, this incentivises them to take more risks than your average banks, therefore this has an opposite effect of trying to rein in risk as they have more roam for error and are not held accountable.
Investors have the power to regulate the bank, they have the capacity to influence manager in multiple ways depending on what type of holders they are either equity or debt. Equity holders have the capability to directly influence managers through voting against their proposed actions in shareholder meeting, compared to debt holders can only indirectly influence managers by demanding higher returns to hold the banks debt, this increase the price of taking risks and make managers less adventurous. Investors regulate banks to guarantee their investments are cherished and risk tasking is restrained. Leading up to the financial crisis this wasn’t done enough therefore resulting in taking extreme risk.
Market discipline plays a key role in the financial sector, as lack of market discipline played a huge contribution to the build up of the financial crisis. As a result of asymmetrical information provided by the banks, this influenced investors to take more risks with their investment. Disclosure of information meant investors couldn’t assess the risk properly and government intervention meant banks took bigger risks as they knew they were going to get bailed out.
Market discipline cannot be singled out as the only factor that could have prevented the financial crisis from happening but I believe the collapse of the economy was caused by a breakdown of the market discipline and lack of banking regulations in place as many executives were focused on achieving sales and bonus target rather than planning for long term performance and sustainability.