Between 2009 and 2012, the eurozone experienced a sovereign debt crisis that threatened to tear its monetary union apart.
Lenders to European financial markets lost faith in the fiscal sustainability of several member states and started demanding higher yields to compensate for heightened risk. Borrowing costs soared. The affected sovereigns quickly found themselves unable to repay the debts they incurred during the Great Recession in the late 2000s. A negative feedback loop pushed Greece, Portugal, Ireland, and Cyprus to the brink of a euro exit. Domino effects between Europe’s so-called periphery and core put Spain and Italy at risk as well.
Could such a scenario repeat itself, now that the eurozone has woken up to new major global threats? Post-pandemic stagflation, a currency in free fall against the dollar, and most importantly the fiscal cost (more government borrowing) to protect households and businesses from soaring energy prices all threaten to bring Europe to its knees once more.
Italy could be the starting point for another debt crisis. At 150% of its GDP, Italy’s public debt has reached its highest level on record. The country’s economy is being battered by the European Central Bank’s shift to a more restrictive monetary policy to fight inflation. Last week, the European Central Bank increased its three key interest rates by 75 basis points, the largest increase since 1999. Italy faces a cold winter. Over 40% of its energy is derived from Russian natural gas. To date, the country has made little effort to find alternatives to Russian gas.
The collapse of the Italian coalition government of Mario Draghi, a former ECB head, also triggered a political crisis. On Sept. 25, Italy will hold parliamentary elections. Giorgia Meloni’s Brothers of Italy party is leading the polls. If she wins, she will look to form a right-wing government, backed by two other parties, the League and Forza Italia. Polls suggest she is heading for a majority coalition in Italy’s two houses of parliament. The Brothers of Italy party has been described as neo-fascist and ambivalent about the European Union. Importantly, Matteo Salvini’s League party, which would form part of the coalition, opposes sanctions against Russia.
Until now, Italy has been kept afloat by large-scale European Central Bank purchases of Italian government debt under its Pandemic Emergency Purchase Program. In 2020 and 2021, the ECB bought the entirety of the Italian government’s net debt issuance. Unfortunately for Italy, the ECB’s bond buying under that program has ended as part of the bank’s shift toward a more restrictive monetary policy to deal with Europe’s inflation problem.
Over the past several weeks, Italy’s heightened political uncertainty has led to a large sell-off in its government bonds. Those bonds’ yields approach 4%, more than 2 percentage points higher than German government bond yields. Recognizing that such a sell-off could precipitate another debt crisis, the ECB has introduced a Transmission Protection Instrument. The ECB can again buy large amounts of Italy’s bonds as needed to keep Italian interest rates at a reasonable level. But it can only do so if a number of strict conditions are met.
Among them are the need for the ECB to be satisfied that the country is managing its public finances properly and that its public debt is on a sustainable path. Those conditions might be difficult for a populist government which has as one of its own goals, reducing the power of the EU bureaucracy.
The political, economic, and energy conditions are ripe for another sovereign debt crisis in the eurozone which could easily spill over into talk of the disintegration of the EU.
James Rogan is a former foreign service officer who later worked in finance and law for 30 years. He writes a daily note on finance and the economy, politics, sociology, and criminal justice.
