One has to be surprised at the equanimity of both U.S. policymakers and world financial markets about the deepening Italian economic crisis. This is particularly the case considering that, unlike Greece, Italy is too big an economy to fail for the euro to survive and too big and costly an economy for its European partners to save.
It is also troubling that, unlike Greece, Italy now has a populist government in place that is openly flouting the rules of the European Union. This would make it all the more difficult for its European partners to save even if there might be the political will to do so for fear of sending the wrong message to other EU countries.
{mosads}In gauging Italy’s systemic importance to the global economy, one should bear in mind that its economy is approximately 10 times the size of that of Greece and that it is the eurozone’s third-largest economy.
Equally important is the fact that after the United States and Japan, Italy has the world’s third-largest sovereign debt market with more than $2.5 trillion in outstanding government debt.
It is difficult to conceive of a scenario where an Italian debt default would not trigger a European banking crisis. Were that indeed to occur, it must be expected to have global economic and financial market ramifications.
Sadly, Italy has all of the preconditions for another round of the sovereign debt crisis. It is not simply that with a public-debt-to-GDP ratio of over 130 percent, it is the eurozone’s second-most highly indebted eurozone member country.
Rather, it is also that the country suffers from a sclerotic and uncompetitive economy as well as from the shakiest of banking sectors that all too likely will soon be in need of a government bailout.
One indication of the weakness of the Italian banks is a non-performing loan ratio that remains well in excess of 10 percent of their balances sheets.
Another is the fact that these banks now hold more than €400 billion in Italian government bonds. That creates the most dangerous of doom-loops between the government and the banks.
Common sense would indicate that Italy needs some combination of faster economic growth and greater budget discipline to put its public debt on a more sustainable path. Such a combination is all the more urgent in light of the prospective tightening in the global credit market cycle and the approaching end to the European Central Bank’s government bond-buying program.
Apparently Italy’s populist government has an alternative view of basic public finance logic. Rather than committing itself to an economic reform program that might put the Italian economy on a faster economic growth path, the Italian government seems intent on rolling back the modest labor market and pension reforms of the previous Italian government.
Similarly, rather than committing itself to budget deficit reduction, the new Italian government seems to be intent on delivering on its costly election campaign promises even though this might mean running up budget deficits in flagrant violation of the eurozone’s budget rules.
As an indication of the Italian government’s disregard for the eurozone’s rules, it has announced lavish public spending plans that will involve an increased budget deficit of 2.4 percent of GDP for 2019.
In defending its budget largesse, the Italian government has been engaging in the most wishful of thinking that somehow Italy will grow its way out of its debt problem.
Never mind that its budget policies have already resulted in a spike in long-term Italian interest rates to their present level of 3.4 percent, which is bound to deal the Italian economy a serious body blow.
Never mind as well that investor and consumer confidence will all too likely be negatively impacted by the prospect that the country is now on a collision course with its European partners and that Italy will be facing a less favorable global economic environment than it has to date.
Rudi Dornbusch, the late MIT economist, never tired of warning us that a crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.
Judging by the reckless budget path that the new Italian government has chosen for itself and by the markets’ slow reaction to these developments, Professor Dornbusch’s dictum might be all the more relevant in the presently unfolding Italian economic and political drama.
One can only hope that U.S. and global economic policymakers are ready for a full blown Italian economic crisis when it eventually occurs.
Desmond Lachman is a resident 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.