The euro zone's third-largest economy is suffering from a recession, lack of demand and increasing debts and Jim O'Neill, the former chairman of Goldman Sachs Asset Management, has some unconventional ideas on how to help the country.
In a piece written for Brussels-based think tank Bruegel, O'Neill -- who is famous for coining the term "BRICs" to denote emerging market powerhouses -- said that the euro area's largest economy Germany could help Italy and the rest of the euro zone by giving countries more leeway on fiscal rules and creating consumer demand.
Italy "needs Germany's help," O'Neill states in the piece published on Wednesday, "not just through greater fiscal flexibility, which is essential, but also through a rise in euro-area inflation back to the European Central Bank's target of below, but close to, 2 percent. "It will be almost impossible for the euro area to do this [reach an inflation target of around 2 percent] unless Germany itself sees consumer price inflation rise to that rate or higher," O'Neill wrote.
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Rather than insisting on fiscal deficit rules or "letting demand fall so low that Europe misses its inflation target by a mile," O'Neill says he has a "crazy idea" on how Germany could come to Italy's rescue.
"I imagined a kind of Germanic rigidity. How about a zero-tolerance approach to inflation that falls below target?" he states. "Perhaps German citizens should pay an extra tax each year the country experiences inflation that is below but not close to 2 percent -- with the penalty increasing in proportion to the shortfall? The proceeds could be distributed to countries with a cyclically adjusted fiscal deficit of less than 3 percent and less-than-trend GDP growth. Come to think of it, perhaps Italy could impose a punitive tax on German tourists?," he adds.
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"I know. That would be crazy. But would it be any crazier than insisting on an arbitrary fiscal deficit rule, unadjusted for the economic cycle -- or letting demand fall so low that Europe misses its inflation target by a mile, and in a way that condemns Italy and others to endless recession? I'd say it's a close call," O'Neill concludes.
Euro zone inflation remains well below the European Central Bank's target of 2 percent. Consumer prices rose by 0.4 percent year-on-year in October but marked only a slight rise from September's 0.3 percent, according to official statistics published by Eurostat at the end of October. Annual inflation in Germany unexpectedly slowed in October to 0.7 percent from 0.8 percent the month before.
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Joining the single currency and adopting euro zone fiscal rules was a big mistake for Italy, according to O'Neill, who wrote that Italy's "persistent lack of growth in nominal GDP [is] itself partly due to an overvalued currency and tight budgetary restraint."
This, he says, has prevented the country from being able to remain competitive and has contributed to its subdued economy and large amount of debt.
Italian public debt grew to 133.8 percent of gross domestic product (GDP) in the second quarter of 2014, according to Eurostat's latest data with government debt totaling 2.1 trillion euros. In the second quarter this year, the country unexpectedly slid back into recession too.
Making matters worse, its 2015 budget could push the country right up to the European Commission's budget deficit limit of 3 percent of GDP.
While France and Italy pushed for a relaxation of deficit limits, the main exponent of euro zone austerity and fiscal discipline Germany opposed to such a move. In the end, France and Italy modified their budgets, making more budgetary cuts which are likely to be approved by the Commission.
- By CNBC's Holly Ellyatt, follow her on Twitter @HollyEllyatt. Follow us on Twitter: @CNBCWorld