What Happens if Italy's Economy Collapses?

How businesses and consumers in the United States would be negatively affected.


In the past, Italian politics were never taken too seriously. Former Prime Minister Silvio Burlusconi was better known as a womanizer than a lawmaker, and was plagued by endless scandals and legal problems. Yet he somehow managed to stay in power.

But the spectacle Burlusconi caused drew attention away from Italy's true problems: stagnant economic growth and an unsustainable level of debt. While Europe panicked about Greece's inability to pay its bills, Italy drew closer to the brink of economic ruin. No one was paying attention while Rome was burning.

[See 7 Problems That Could Derail the Global Recovery.]

This changed last week when investors began to take a close look at Italy's finances and realized the country was close to collapse. Markets around the world fell sharply. There was a growing concern that if Italy defaulted, it could bring the entire euro zone down with it. Germany and France quietly considered kicking Italy out of the monetary alliance.

The panic promoted Burlusconi to finally resign. His replacement: Mario Monti, a former European Commissioner who has appointed a new government charged with instituting harsh austerity measures meant to ease Italy's debt burden. For now, Italy's financial situation is fragile, but stable.

[See Who's Worse Off: Europe or the United States?]

As the European financial crisis has shown, nothing is certain. News could come out tomorrow that would throw investors into another panic over Italy or Germany, and France could grow tired of bailing out its neighbors. Anything is possible.

This uncertainty is not contained on European shores. If something catastrophic were to happen to Italy, businesses and consumers in the United States would be negatively affected as well. It's a doomsday scenario to think Italy would fail, but doomsday is no longer unthinkable.

Impact on consumers. The U.S. economy is in a state of fragile recovery. If something went wrong it Italy, there is a strong possibility that the U.S. recovery could fall apart and the country could slip into a dreaded "double-dip" recession.

[See 11 Ways to Prepare for a Double-Dip Recession.]

Douglas Elliott, a fellow at the Initiative on Business and Public Policy at the Brookings Institute, recently put the chance of a double-dip at 25 percent. If it does occur, all of the small gains the U.S. economy has made in recent months would be reversed.

For instance, unemployment, which has been trending down, would go up again, as companies cut spending to ride out the downturn. Those who have jobs would see wages flatten, and in some cases, fall. Benefits would likely be cut as well.

The chaos in Europe would also make buying things like cars and electronic equipment more expensive, as the value of the dollar would go up relative to other currencies. So while people would be earning less, the money they're making would be worth less as well.

Lastly, an Italian meltdown and the subsequent recession would have untold consequences on the psyche of American consumers. Workers in the United States have been repeatedly battered with bad news since 2007. Another "too big to fail" event might be the last nail in the coffin of consumer confidence.

[See Why Europe Still Deserves a Place in Your Portfolio.]

Impact on businesses. Businesses have been reluctant to spend since 2007, when the U.S. economy teetered on the brink. In recent months, however, businesses have been less reluctant to invest in new employees, causing a decline in the unemployment rate.

In a double-dip recession, business would again retract. Hiring would stop and other cost-cutting measures would be instituted. This problem would be especially acute at small businesses, which have smaller margins for error.

Without business growth, the cycle of retraction would continue. Business wouldn't spend and hire, so people would not have money to spend. It's a cycle that repeated itself from 2007 to 2010. Another recession would kick-start the cycle again.

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