Updated: Jan. 13, 2012

Italy, rich in art, cuisine and ancient history, went from being the “sick man of Europe’' to its third largest economy, only to see its future imperiled by stagnant growth, political paralysis and investor fears over the mountain of debt it has piled up over the years.

In a sense its economic troubles date back to the late 1990s, when the country’s manufacturing was overtaken by competitors in Asia. Its patronage-based politics and rule-bound labor practices changed little, but a flood of cheap money that followed the introduction of the euro helped keep the system going.

Then came the global financial crisis in 2007, which shrank Italy’s economy by more than 6 percent. Growth resumed in 2010, but was snuffed out in 2011 by the rising debt crisis, and the International Monetary Fund predicts “another decade of stagnation.”

At roughly 120 percent of G.D.P., its growth-hobbling government debt is second only to Greece’s among euro zone members. Although it has run a budget surplus, minus debt costs, for several years, the Italian government now spends 16 percent of that budget on interest payments — a bill that began to rise in the summer of 2011 as investors and creditors began to fear that Italy cannot escape Europe’s debt crisis.

As a result, the country has increasingly taken center stage on the debt crisis, as the amount of Italy’s debt held by foreigners — nearly 800 billon euros — is more than that of Greece, Ireland and Portugal combined. The debt problem is being compounded by the country’s economic slowdown — in December, the government’s minister for economic development proclaimed that Italy had already entered a recession. 

The crisis did what Italy’s liberal parties could not — end the reign of Prime Minister Silvio Berlusconi, whose government had moved too slowly to implement fiscal reforms to assuage either the markets or France and Germany, the heavyweights of the euro zone rescue efforts.

Mr. Berlusconi stepped down on Nov. 12, 2011 after a $75 billion package of deficit reduction measures were adopted, ending an era in the country’s history. His successor was a former European Commissioner, Mario Monti, who was asked to lead a cabinet of technocrats until the economic situation is stabilized and new elections are held.

In December, Mr. Monti unveiled a radical and ambitious package of spending cuts and tax increases, including deeply unpopular moves like raising the country’s retirement age. The measures are meant to slash the cost of government, combat tax evasion and step up economic growth, so the country can eliminate its budget deficit by 2013.

He won a vote of confidence on the package in the Assembly on Dec. 16, but only after it had been weakened in response to complaints from the right and the left. It was passed by the Senate the next week, but Mr. Monti felt the need to make it a vote of confidence, to fend off scores of modifications proposed by the Northern League, once a pillar of Mr. Berlusconi’s center-right coalition and now the loudest opposition party.

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Bowing to pressure from the right, the Monti government dropped some elements of the $40 billion package of spending cuts and revenue increases, including a wealth tax and the speedy liberalization of closed professions like taxi drivers and pharmacists, a plan that drew protests from their powerful guilds. It also scaled back a newly reinstated property tax on primary residences.

After protests from the left and labor unions, some counting more pensioners than workers among their members, Mr. Monti reinstated inflation increases on low-level pensions that he said would make the measures more equitable.

Mr. Monti has said he wants to make Italy more equitable — especially for young people and women, whom he has called a “wasted resource” — and to help the economy grow. But even as he pledged to address labor reform and other structural changes in the coming weeks, he has run up against a wall of vested interests.

For the most part, the new austerity package is based on tax increases. It would reinstate a property tax on first homes, which Mr. Berlusconi had eliminated as an election promise in 2008. It would also impose a 1.5 percent tax on revenues brought into Italy under an earlier tax amnesty, and add taxes on cigarettes and gas, which is close to 1.70 euros per liter, or more than $8 a gallon.

The governor of the Bank of Italy, Ignazio Visco, said that the measures would increase Italy’s tax burden to 45 percent, a level that businesses say is unsustainable.

On the day of the vote of confidence, the minister for economic development, Corrado Passera, said the Italian economy was already in recession, and Confindustria, the industrialists’ organization, said it expected the Italian economy to contract 1.6 percent in 2012, rather than grow .2 percent as it had previously expected.

Mr. Monti has told Italians in no uncertain terms that such changes are essential for Italy to bolster its anemic growth, stave off recession and pay down its staggering public debt, which is $1.9 trillion, or 120 percent of gross domestic product, in order to stabilize the Italian economy and protect the euro.

In late December, Italy’s short-term borrowing costs were halved at an auction of government bills, reflecting a huge infusion of low-cost, long-term liquidity into euro zone banks by the European Central Bank. But its long-term borrowing costs remained just under 7 percent, a level regarded by most economists as unsustainable.

To make matters worse, in January 2012, the ratings agency Standard & Poor’s downgraded Italy’s debt by two steps. A downgrade makes it costlier for a country to pay down its debt, as investors demand that the government pay higher borrowing costs to compensate for risk.

Behind Low Growth

Before the global economic crisis of 2008, Italy had been paying down its sizable government debt for close to a decade, and was running a budget surplus if those interest costs were excluded. But the debt crisis that arrived in 2011 focused new attention on impediments to growth.

Italy’s entrenched political and patronage system, overly generous pensions and job protections, along with an excessive web of competition-killing red tape, are often cited as the primary culprits in a dismal economic record that is seem as the root cause of Italy’s troubles.

According to forecasts from the European Commission, Italy’s gross domestic product will grow only 0.1% in 2012, down from an earlier projection of 1.3%, and will expand only 0.7% in 2013. Economists have long argued that Italy needs to carry out serious structural reforms to stay competitive.

In an interview on national television on Jan. 8, 2012, Mr. Monti discussed a package of growth-enhancing measures — in particular, loosening the powers of professional guilds and changing labor laws to encourage hiring and firing — that he planned to unveil at a meeting of European Union finance ministers.

He said that his government of unelected technocrats was determined to force various entrenched interests — from labor unions to professional guilds to public employees — to give up their privileges, and that it was uniquely qualified to push through the changes because it had no natural constituency to protect.

But even a change in leadership — and a $40 billion package of austerity measures, including tax increases and a sweeping pension overhaul — has not calmed markets. The day after his television interview, the differential in yields between Italian and German sovereign debt rose to more than 5 percentage points, before dropping slightly, a sign of a lack of investor confidence in Italy and, perhaps, in the euro zone leadership.

Italian officials do not believe they can or should be expected to solve their problems entirely on their own. In a newspaper  interview, Italy’s new minister for economic development, infrastructure and transport, Corrado Passera, said that unless Europe came to an agreement on how to shore up the single currency — like allowing the European Central Bank to become a lender of last resort, as the Federal Reserve is in the United States — the crisis will continue.

The Berlusconi Factor

From 1994 to 2011, Italy’s political life was dominated by Silvio Berlusconi, the idiosyncratic billionaire and three-time prime minister. But Mr. Berlusconi’s power steadily leaked away as the nation seemed to have finally tired of his well-publicized dalliances. Politically, he lost his touch.

In December 2010, he avoided the collapse of his government when he barely survived a vote of confidence. The razor-thin majority shown in the vote meant that Mr. Berlusconi no longer had the margin to govern.

Mr. Berlusconi, faced a dizzying number of trials. In February 2011, Milan prosecutors filed a request to try him on criminal charges related to prostitution and abuse of office; he was accused of paying for sex with an under-age woman, nicknamed Ruby Heart-Stealer, and then abusing his office to help release her after she was arrested on a theft charge.

By July 2011, tensions had emerged between Berlusconi, and the finance minister, Giulio Tremonti, who has been praised for maintaining control of the budget deficit, and investors reacted by driving up rates on government borrowing. Soon after, Parliament rushed to pass an austerity bill that aimed to reduce the country’s budget deficit to 2.3 percent by 2014.

Background

Encyclopedia Britannica describes Italy as “less a single nation than a collection of culturally related points in an uncommonly pleasing setting.” However concise, this description provides a good starting point for the difficult job of defining Italy, a complex nation wrapped in as much myth and romance as its own long-documented history. The uncommonly pleasant setting is clear: the territory on a boot-shaped peninsula in the Mediterranean, both mountainous and blessed with 4,600 miles of coast. The culturally related points include many of the fountains of Western culture: the Roman Empire, the Catholic church, the Renaissance (not to mention pasta and pizza).

But Italy, united fully only in 1870, has long struggled not so much with its identity as with the concept of itself as a single unit working toward common goals. It has been central to the formation of the European Union, and after the destruction of World War II, built itself with uncommon energy to regain a place in the global economy. But distrustful of authority after centuries of decentralized and often arbitrary rule, Italians tend to feel loyalty locally: to region or town or, most commonly, to the family itself.

The fragmentation has revealed itself in politics. Since World War II, more than 60 governments have risen and fallen, and politicians have had little success in winning agreement on structural changes to make government work better and keep a once-robust economy growing.

Amid a marked economic slowdown in recent years, many Italians have described their frustration at the lack of change with no clear model in sight as a malaise. Still, Italy’s 58 million people enjoy one of the world’s highest standards of living, and the nation remains a gold standard for fashion, high-end cars and motorcycles, furniture, tourism, design and food.

Italy is also home to the Vatican city-state, the center of the Roman Catholic church for nearly 2,000 years. In 2005, after the death of the popular and long-serving Pope John Paul II, the German cardinal Joseph Ratzinger was elected Pope Benedict XVI.

Stagnant Economy

Since the economic crisis began, Italy has regularly turned up on the informal list of Nations That Worry Europe. While its finances are not as precarious as those of Greece, Portugal or Ireland, because it is far larger — the Italian economy is the seventh largest in the world — its troubles are more frightening. As a recent report by UniCredit, a European banking group, put it, Italy is “the swing factor” in the crisis, “the largest of the vulnerable countries, and most vulnerable of the large.”

Public sector debt amounts to roughly 119 percent of Italy’s gross domestic product, nearly identical to Greece. And like Greece, Italy is trying to ease fears in the euro zone and elsewhere with an austerity package, one intended to cut the deficit in half, to 2.7 percent of G.D.P., by 2012.

But there are differences. The Italians, unlike the Greeks, are born savers, and much of the Italian debt is owned by the Italians. That means that unlike Greece, which will be sending a sizable percentage of its G.D.P. to foreign creditors for a generation to come, Italy is basically in hock to its own citizens.

To understand why so much of Italy, is stagnant or worse, requires a bit of geopolitical history and a look at the highly idiosyncratic Italian business culture. It is defined, to a large degree, by deep-seated mistrust — not just of the government, but of anyone who isn’t part of the immediate family — as well as a widespread aversion to risk and to growth that to American eyes looks almost quaint.

It has economists worried not about a looming fiasco so much as a gradual, grinding decline of Italy’s economy.

Economists see a country with a service sector dominated by innumerable guilds, which don’t just overcharge but also raise the barriers to entry for the millions in ill-fated manufacturing jobs who might otherwise find work as, for instance, taxi drivers. They see a timid entrepreneur class. They see a political system in the thrall of the older voters who want to keep what they have, even if it dooms the nation to years of stasis.

They see a society whose best and brightest are leaving and not being replaced by immigrants, because Italy has so little upward mobility to offer.

The Debt Crisis

Italy’s borrowing costs rose in late July 2011 almost a full percentage point from a month before at an auction of 10-year bonds, to the highest rate in more than a decade, in another troubling sign that the latest rescue package for the euro zone had not eased investors’ concerns.

The country appeared to be headed toward a vicious cycle — if the interest rates it paid rose too high, its debt would become unaffordable, a prospect that was leading the market to push up interest rates. In response, on Aug. 7, the European Central Bank said it would “actively implement” its bond-buying program to address “dysfunctional market segments,” a statement interpreted as a sign that it will intervene to prevent borrowing costs for Italy and Spain from growing unsustainable.

Scrambling to fend off a crisis, the Italian government on Aug. 12 approved $65 billion in additional emergency austerity measures over the next two years, including tax increases and cuts to local government in an effort to balance the budget by 2013. But that plan began to unravel at the beginning of September, when it was subject to so much backtracking and political wrangling that European leaders raised the pressure on Italy to deliver as promised.

The Italian Senate delivered on Sept. 7, passing a package that would trim 54 billion euros ($76 billion) to balance the budget by 2013, according to the Finance Ministry. To ensure passage after weeks of bitter political fights, the center-right government of Prime Minister Silvio Berlusconi resorted to a confidence vote in the Senate, meaning that a majority “no” vote would have not only scuttled the bill, but also brought down the government. The measures passed 165 to 141.

On Sept. 14, Italy’s lower house gave final approval to a $74 billion austerity plan, giving a boost to the weak government, which won a confidence vote on the plan earlier in the day.

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