A looming Italian tragedy

Dr Oliver Hartwich
23 October, 2018

According to Karl Marx, history repeats itself – the first time as tragedy and the second time as farce. Looking at Italy’s looming debt crisis, he might have had it the wrong way around.

Remember eight years ago when everyone was worried about a Greek default? That small country on the periphery of Europe was going to bring down the Euro currency and the continent’s banking system. In hindsight, it was just a farce because the rest of Europe was always prepared to bail out the Greeks to prevent contagion.

With Italy it is a different story. Well, sort of. Just like Greece, Italy is a highly indebted country. Just like Greece, Italy is a country battling weak growth and competitiveness. Just like Greece, Italy is a country plagued by political instability.

However, there is one significant difference: Italy is much larger than Greece. It is too big to be bailed out. Unfortunately, that does not mean it is too big to fail.

And that would be a real tragedy.

To see how critical Italy’s debt situation has become, you only need to look at the yields on its 10-year government bonds. At the beginning of the year, they still traded at around 2 percent. As of last week, they had shot above 3.5 percent.

The reason for the rapid deterioration in Italy’s creditworthiness is obvious. Following elections in March, a new government took office in June. It is a populist coalition of the right-wing Lega party and the anti-establishment Movimento 5 Stelle. The glue that holds this strange government together is its scepticism of the EU, opposition to austerity and resistance to dictates from Brussels, and the Euro.

The new Italian government’s approach manifests itself in their budget plans, which it submitted to the EU Commission earlier this month. They smacked of fiscal alchemy.

Instead of reducing the budget deficit to just 0.8 percent of GDP as Italy had previously promised the EU Commission, it is now proposing to increase the deficit to 2.4 percent in 2019, followed by 1.8 percent in 2020 and back to 2.4 percent in 2021. However, Italy’s total government debt is supposed to fall from its current 131.2 percent of GDP to 126.7 percent.

The Italian government justifies this optimistic forecast with increased growth and tax revenue driven by tax cuts and higher welfare spending. It is the economic equivalent of righting the Leaning Tower of Pisa by prayer.

This is proving too much even for the EU Commission, which has been lenient with Italy for many years. On Thursday, Budget Commissioner Pierre Moscovici sent a harsh letter to Italian finance minister Giovanni Tria. It concluded that Italy’s plans amount to a “particularly serious non-compliance with the budgetary policy obligations laid down in the Stability and Growth Pact”. To underline how dissatisfied it was with Italy’s draft budget, the EU Commission gave the Italians a deadline of just four days to respond.

Italy’s government is on collision course with the EU but not just with them. Capital markets and ratings agencies are equally nervous about the state of Italy’s public finances.

The clearest indication of the markets’ views on Italy is the increase in bond yields. Beyond that, there are further indications of how little trust there is in the sustainability of Italian public debt.

Funded by central banks

Twenty years ago, Italian private investors held around a quarter of all government debt. Their share has dropped to just around 5 percent today. Conversely, Italy’s central bank has increased its share of government debt holdings and become a critical source of funding for the Italian government.

Little wonder that ratings agencies are getting nervous. In August, Fitch cut Italy's sovereign debt outlook to ‘negative’, meaning a downgrade over the next half a year is likely. Meanwhile, Moody’s Baa2 rating will be reviewed by the end of October (outlook: negative) and Standard & Poor’s will revise its BBB grade on 26 October. With such ratings, Italy is only two steps away from ‘junk’ status –and the first step may well happen this month.

Given all these developments, only the most Italophile optimist would not worry. Italy’s populist government is driving the country to the brink of an almighty debt crisis that will make the Greek crisis pale into insignificance.

When the world of finance was on edge because of Greece in 2010, we were talking public debt of just over Euro 300 billion. Italy’s government debt today is almost eight times larger at Euro 2.3 trillion.

Remember how difficult it was to bridge Greece’s financing needs. And the various bailout programmes administered by the International Monetary Fund, the European Central Bank, and the EU. It was a complex and controversial process which led the EU to the brink and contributed to political instability in many of its member states.

Italy’s debt crisis, if or rather when it becomes acute, will be different. The sheer size of Italian debt is beyond anything European institutions could manage. It is also doubtful whether the IMF would be prepared to intervene in the way it did in Greece.

At this stage, it is impossible to predict how an Italian debt crisis would play out in practice. The only thing one can predict with near-certainty: Italy’s debt situation will deteriorate over the next year and lead to a real Euro tragedy, not just a farce.

Dr Oliver Hartwich is the Executive Director of The New Zealand Initiative (www.nzinitiative.org.nz).

Stay in the loop: Subscribe to updates