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How Italy Could Crash the Global Economy

It’s unstable enough to need a major bailout, and big enough to crash the Euro.
May 1, 2020
How Italy Could Crash the Global Economy

Now that the coronavirus epidemic has pummeled the Italian economy, Europe will soon be confronted with a fundamental challenge: How will it prevent yet another Italian economic and sovereign debt crisis from causing the Euro to unravel?

At the heart of Europe’s problem is the fact that Italy, a founding member of the Euro and an economy some ten times the size of Greece, is simply too big to fail if the Euro is to survive. Yet at the same time, the Italian economy could prove to be too costly and risky for the rest of its European partners to bail out without imposing strict economic conditions. The Italian government would likely refuse such terms as politically unacceptable, especially as support for Europe among the Italian public is dwindling.

If the Euro is to survive, Italy’s European partners will have to find some way of bailing it out without imposing conditions that Rome will find difficult to swallow, and do it all without unduly compromising the Eurozone’s operating rules.

With the coronavirus having wreaked devastation in Italy, a second and more vicious sovereign debt crisis is looming. According to the IMF’s latest estimates, the coronavirus epidemic is now set to cause the Italian economy to contract by almost 10 percent in 2020. That in turn will cause Italy’s budget deficit to balloon to around 8.5 percent of GDP and its public-debt-to-GDP ratio to skyrocket from 135 percent to 160 percent by the end of the year.

If the IMF’s projections were realized, it would leave Italy’s public-debt-to-GDP ratio about 30 percentage points higher than that which triggered Italy’s last sovereign debt crisis in 2012. Little wonder then that markets are already beginning to question whether Italy will be able to meet its debt servicing commitments. This uncertainty has been reflected in a steady rise in Italy’s government borrowing costs relative to those of über-reliable Germany.

An important factor beckoning another Italian sovereign debt crisis is the fact that stuck within a Euro straitjacket, the country has great difficulty extricating itself from recessions. Not only does it lack its own monetary and exchange-rate policies to generate economic growth. All too often, its European partners require it to tighten its budgetary belt in the middle of a recession to address its deficit problem. These measures have resulted in Italy’s per capita income today being lower than it was in 1999, when Italy joined the Euro.

Italy’s weak banking system also impedes to the country’s economic growth prospects. Even before the epidemic, Italy’s banks were saddled with a mountain of non-performing loans and burdened with large holdings of Italian government bonds. In a deep recession, more of their loans will collapse as the country faces a wave of household and corporate bankruptcies.

In the event that Italy does need to be bailed out by its European partners, the cost of doing so will dwarf the earlier cost of the Greek bailout. With a prospective annual budget deficit of $200 billion and with government bonds of around $800 billion reaching maturity over the next two years, Italy’s government alone could need a $1 trillion bailout. In addition, its banks could need at least $500 billion in support to put them on a firmer footing.

Apart from the unprecedented size of the bailout, political conditions today in both Europe and Italy will make it more difficult to put together a bailout package for Italy than it was for Greece in 2010. On one side of the ledger, Italy’s Northern European partners are now more reticent than before to provide funding for their Southern European neighbors. On the other side, Italian political parties, and especially Mateo Salvini’s League Party, are less willing to follow the austerity policies preferred by their would-be lenders.

Europe has found last-minute solutions to seemingly intractable political challenges before. Indeed, European integration itself is a striking example of successful political innovation. For the sake of both the European and the global economies, we must hope that Europe has a little more ingenuity left. Fresh from the Brexit debacle, the last thing Europe needs is for the Eurozone to disintegrate. And at a time of great global economic uncertainty, the last thing that the world economy needs is another European sovereign debt crisis.

Desmond Lachman

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.