When do you know you’re carrying too much debt? The first hint comes when lenders stop lending to you. Greece, Ireland, Portugal and Cyprus all found themselves shut out of the debt markets during the financial crisis. In came the bailouts.
Italy, the fourth most indebted country in the world, measured by debt to gross domestic product, is still able to sell sovereign bonds. But for how much longer? The more immediate question is whether Italy’s euroskeptic, populist government might use its budget standoff with the European Union to disengage from the euro, the use of which has prevented Italy from trying to devalue its way to prosperity.
Italy’s surging sovereign bond yields – the result of plans to widen the budget deficit substantially to pay for the populists’ election promises – has replaced Brexit as the most unsettling development in the EU. The EU can survive Brexit, which was never a member of the euro zone. But the exodus of Italy, a founding member of both the EU and the euro and the euro region’s third-largest economy, could sink both the EU and the currency.
Italy comes equipped with a bunker-buster bomb in the form of debt that potentially can’t be paid off (worth 131 per cent of GDP) and a coalition government that increasingly views euro membership as part of the problem, not part of the solution. The populists’ bust-up with the EU might harden their euroskeptic stance and put Italy only one election or one referendum away from waving arrivederci to the common currency. Mario Draghi, president of the European Central Bank, is fond of saying that the euro is “irreversible.” It is not. Every currency union invented has eventually reversed.
Italy’s assault on the EU and its fiscal-control mechanisms began in March, when Italians turfed out Paulo Gentiloni’s caretaker centrist government and replaced it with two populist parties, the League and the Five Star Movement, which cobbled together a coalition government by June. They were united in their euroskeptic views and populist economic policies, and not much else, though they have launched enthusiastic anti-migrant measures.
The arrival of the coalition government pushed up Italian bond yields (yields and prices move in opposite directions). About a week ago, when it became apparent that Giovanni Tria, the non-partisan finance minister who had resisted the populists’ plans to run a fat budget deficit, would get overruled, yields surged again, hitting the shares of Italian banks, which are loaded with government bonds. By Friday, the yields on the 10-year notes, at 3.4 per cent, had climbed to their highest level since 2014. The spread, or gap, between Italian bonds and equivalent German bonds, was 2.9 percentage points, the widest in the euro zone, bar Greece’s.
The coalition government’s draft budget plans to triple the budget deficit, to 2.4 per cent of GDP, has rattled the EU, which is worried about the sustainability of the payments on Italy’s €2.3-trillion ($3.4-trillion) of public debt. The fears are justified. The Italian government argues that GDP growth will trim the deficit after 2019, but their projections seem wildly optimistic. Growth in Italy is waning, as it is throughout the euro zone, and seems unlikely to hit the government’s forecast of 1.5 per cent next year – all the more so since the ECB’s growth-enhancing quantitative easing program is winding down.
But the Italian government shows no signs of backing down. A few days ago, League leader Matteo Salvini said he was ignoring the fiscal prudence pleas from European Commission president Jean-Claude Juncker because “I talk to sober people” – a reference to Mr. Juncker’s alleged drinking habits.
The populist government’s spending plans appear to lack the support of almost every economist (one of whom called the plans “suicidal”), but the Italian people seem to have no appetite for yet another budget based on fiscal contraction. The austerity budgets since 2008 have helped to keep Italy in recession, or close to it, for a decade and unemployment rates have remained at miserable levels – 10 per cent nationally and more than 30 per cent among young people.
The Italian government will win its battle with the EU. Italy is a big country and there is no way the populists will allow it to be pushed into humiliating submission, as Greece was. The government even seems to be enjoying the battle. The popularity of Mr. Salvini and his League party are on the rise. There is nothing the League would love to see more than arrival of a strong euroskeptic bloc in next year’s EU parliamentary elections.
But Salvini and Co. are playing a dangerous game. Bond investors are unforgiving and could push Italian yields to crisis levels if they see an out-of-control budget, one coupled with lack of reforms designed to boost Italy’s flagging productivity. (The government actually wants to roll back some of the reforms, such as the new pension law, that had earned the postcrisis governments some credibility.)
If Italy keeps its budget plans intact and refuses to respond to the pressure from investors, it could hit the fiscal wall, as it almost did in 2011 and 2012, when Mr. Draghi leapt to Italy’s rescue with a pledge to do “whatever it takes” to keep the euro intact. Italy can no longer count on another backdoor rescue and, perversely, the populist government may not want one. It could use the next financial crisis to try to break from the euro, a scenario that might be catastrophic for the Italian and EU economies. Brexit was always unimaginable until it actually happened. Italy’s exit from the euro is no longer unimaginable, even if it remains highly unlikely in the near term. But the populists’ reckless spending could pry the exit door wide open.
Eric Reguly