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If Italy Gets Sick, the Whole World Catches a Cold

As coronavirus ravages Italy, the chances of a global economic downturn grow.
March 5, 2020
If Italy Gets Sick, the Whole World Catches a Cold
A tourist wearing a protective respiratory mask tours the Trevi fountain in downtown Rome on January 31, 2020. - The Italian government declared a state of emergency on January 31 to fast-track efforts to prevent the spread of the deadly coronavirus strain after two cases were confirmed in Rome. (Photo by Filippo MONTEFORTE / AFP) (Photo by FILIPPO MONTEFORTE/AFP via Getty Images)

Being the Eurozone’s third-largest economy and one of the Euro’s founding members, it is said that Italy is too big to fail if the Euro is to survive. Having a public debt of around $2.5 trillion, it is also said that Italy is too big to bail, because it would be too costly for the rest of Europe to prop up Italy’s shaky public finances.

If the highly indebted Italian economy were to take a turn for the worse, Italy could see a reprise of its 2012 sovereign debt crisis. Given the very size of Italy’s public debt and the fragile state of both the Italian and the European banking systems, such an emergency could pose a serious challenge to the global economic recovery.

Unfortunately, the fact that the coronavirus has chosen Italy as its preferred European abode heightens the chances that the country will soon succumb to its fourth economic recession in the last 12 years. And Italy’s gargantuan public debt makes a recession all the more perilous.

At 135 percent of GDP, Italy’s public-debt-to-GDP ratio is the second-highest in the Eurozone after Greece. Its current level is already above that which prevailed during its previous sovereign debt crisis eight years ago. By further compromising Italy’s public finances, a recession would again raise serious doubts about the country’s ability to service its public debt.

At a time when global investors are reconsidering their risk tolerance in the face of the viral threat, the last thing that the world financial system needs is another Italian debt crisis. Yet it is difficult to see how an overly indebted Italy will manage to avoid one as its economy stumbles.

Rome’s decade-long failure to bring down its public debt has largely reflected the country’s inability to grow within the straitjacket of the Euro. Italy has experienced a continuous loss in export competitiveness as a result of being a low-productivity economy stuck in a currency union with über-productive Germany. But their shared currency has prevented Rome from using exchange-rate depreciation to bolster exports. The Euro’s constricting effect on the Italian economy is demonstrated by the fact that Italy’s per capita GDP today is lower than when Italy joined the Euro in 1999.

Confined by the Euro and bound by the Eurozone’s rigid fiscal rules, there seems to be little that Italian policymakers can do to prevent a recession. At the same time, Italian policymakers can do little to prevent their borrowing costs from rising, should global investors become reluctant to roll over Italy’s maturing public debt.

A deterioration in the Italian economy is bound to undermine the country’s already shaky governing coalition and heighten political uncertainty. That, in turn, is likely to make it very difficult for Italy to comply with the conditions that the European Central Bank is bound to attach to any financial support that it may offer to prop up the country’s finances.

As the prospect of a sharp economic downturn becomes more likely, the ability of anyone in Italy or Europe to respond remains in doubt. The timing could not be worse.

Just as viruses more easily infect those who are already sick, coronavirus struck Italy as its economy was already contracting. Not only is the epidemic suffocating the country’s all-important tourism industry as foreign visitors cancel their visits. Its concentration in Northern Italy is also attacking the country’s industrial capacity. Meanwhile, Italy’s main trade partner, Germany, is already showing symptoms, while Germany’s largest trade partner, China, risks total economic cardiac arrest.

In gauging the world economic outlook, U.S. economic policymakers ignore the Italian economy at their peril. Italy, though relatively small, is of systemic importance to the global economy. Not only is the country the Eurozone’s third largest economy. It also has the world’s largest government debt market after the United States and Japan. As such, a sovereign debt crisis has the potential to contribute to a full-blown global financial market 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.