Will Italy Start Another Round of European Sovereign Debt Crises?

Text size

About the author: Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

The last thing that a fragile world economy needs right now is another round of the European sovereign-debt crisis. Yet judging by recent Italian economic and political developments, that is what could very well happen as early as this winter. These dynamics will constitute a major challenge for a European Central Bank that is working to keep the euro zone together. It could also add to world financial market volatility.

Italy’s systemic importance is underlined by its very size. Not only is Italy’s $2 trillion economy some ten times that of Greece, its almost $3 trillion sovereign-debt market is the world’s third largest, following the U.S. and Japan. If in 2010 a Greek sovereign-debt crisis sent shock waves through the world economy, how much more so would an Italian sovereign-debt crisis do so today?

Italy’s main economic vulnerabilities are its mountain of public debt and its sclerotic economic growth. At around 150%, Italy’s public debt-to-GDP ratio is now the highest in that country’s history and the second highest in the euro zone, after Greece. Meanwhile, Italy’s per capita income today is barely higher than it was in 1999, when Italy joined the euro.

Up until recently, markets had not raised serious questions about Italy’s debt sustainability. With interest rates at ultralow levels, Italy’s debt servicing costs were not particularly high. At the same time, as part of its quantitative easing program, over the past two years the ECB bought €250 billion of Italian government bonds (equivalent to $250 billion today). That represented more than the entirety of the Italian government’s net bond issuance.

Now, markets are starting to question the sustainability of Italy’s debt. The spread between 10-year government bonds issued by Italy and Germany has widened to their highest levels since the pandemic began. They are doing so as the ECB has begun an interest-rate hiking cycle and has terminated its quantitative easing programs. Simultaneously, Russian President Vladimir Putin’s decision to shut down Russian natural-gas exports to Europe threatens to throw Italy along with the rest of Europe into a meaningful economic recession.

It hardly helps matters that Italy’s euro membership makes it difficult for that country to put its public debt on a better footing through budget austerity. If it had its own currency, Italy could resort to exchange rate depreciation to incentivize its export sector as an offset to budget belt tightening. But as a member of the euro, this is impossible. Budget austerity would instead be counterproductive, since it could have the effect of deepening the Italian economic recession.

To be sure, in principle the ECB can keep Italy afloat through resuming its Italian bond purchases on a large scale. It could do so for instance by activating its newly created, but yet to be fully defined, “transmission protection mechanism.” However, judging by comments from the German Bundesbank, it is inconceivable to think that the ECB could do so on any large scale without attaching economic adjustment conditions to such purchases.

These conditions make market volatility likely in the months ahead. It is far from clear whether Italy will be prepared to submit itself to an externally imposed adjustment program as a quid pro quo for ECB bond purchases. That is especially true because Italy will hold parliamentary elections on Sept. 25. A right-wing populist government is widely expected to come to power, replacing the caretaker government led by former ECB President Mario Draghi. 

It has long been said of the Italian economy that it is too large for the ECB to allow it to fail. Yet it is also said that Italy is too large for the ECB to keep bailing it out. It would seem that we will not need to wait too long to find out which of these two statements carries more weight, especially if Putin plunges Italy and the rest of Europe into a meaningful recession by shutting off its natural gas supply. In the meantime, we should brace ourselves for increased volatility in the Italian bond market. That turmoil could spill over to the rest of the world financial system as the Greek economic crisis did in 2010.

Guest commentaries like this one are written by authors outside the Barron’s and MarketWatch newsroom. They reflect the perspective and opinions of the authors. Submit commentary proposals and other feedback to ideas@barrons.com.