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Unlike Greece, Italy is too big to fail for the euro to survive in its present form, yet it could also prove  to be too big for Europe to save it.
Unlike Greece, Italy is too big to fail for the euro to survive in its present form, yet it could also prove  to be too big for Europe to save it.

Italy Could Set Off More Vicious Round of Eurozone Debt Crisis

All clues seem to be pointing in the direction of a gathering economic and financial market storm in Italy

Italy Could Set Off More Vicious Round of Eurozone Debt Crisis

As the world’s major central banks seem anxious to normalize monetary policy, there is one important factor that they are overlooking. It is that well before year-end, their plans to raise interest rates and to temper their asset-buying programs could be upended by an economic and financial market crisis in Italy, the eurozone’s third-largest economy.

Being around 10-times the size of the Greek economy and with a government bond market of around €2.5 trillion, Italy has the potential to set off another and more vicious round of the eurozone debt crisis, Desmond Lachman* wrote for The Hill.

That in turn could shake the global economy to its foundations. Unlike Greece, Italy is too big to fail for the euro to survive in its present form, yet it could also prove to be too big for Europe to save it.

Sadly, all the clues seem to be pointing in the direction of a gathering economic and financial market storm in Italy. Among the more important of these is the fact that Italy now has in place a populist coalition government comprised of the strange bedfellows of the left-leaning Five Star Movement and the right-leaning League.

It is not only that the new Italian government is now in the process of reversing the labor market and pension reforms of the previous government, making it highly unlikely that Italy will improve on its dismal economic growth record over the past decade.

Collision Course

It is also that the new Italian government seems to be embarked on a budget policy that will both put Italy on a collision course with its European partners and put the country’s public finances on an unsustainable path.

Underlining the risks to Italy’s budget is the fact that the Five-Star Movement is insisting on the introduction of a basic income support program that would significantly increase public spending at the same time that The League is insisting on the introduction of a flat income tax that is bound to reduce tax revenue collections.

Further clouding Italy’s growth prospects is the fact that the country will no longer be enjoying the favorable constellation of factors that supported its economy over the past few years. The European economy is now slowing, Italian interest rates are rising, and the country along with the rest of Europe is being hit by an international oil price shock.

Public Debt

It also does not help matters that the European Central Bank has announced that it plans to end its government bond-buying program by the end of the year. It is doing so just as questions are arising anew about Italy’s ability to service its public debt mountain because of the new government’s seeming lack of commitment to either economic reform or budget discipline.

To date, the ECB’s bond-buying program has provided the Italian government bond market with considerable support. As part of that program, the ECB has been purchasing almost €4 billion ($4.63 billion) a month in Italian government bonds.

If the economic clues seem to be pointing in the direction of an impending Italian financial market crisis, so too do the political clues. Under Salvini’s leadership, the League, which is supposedly the government’s junior coalition partner, is surging in the polls with its hardline immigration stance.

Coalition Tensions Rising

Not only is this raising tensions within the coalition government, it is also putting into question the League’s right-wing alliance with Berlusconi’s Forza Italia. This hardly bodes well for the effective functioning of the government, which would seem to be a necessary condition for maintaining market confidence.

Italy’s increasingly precarious economic situation is not going unnoticed by the markets. Since the new government has come into office in June, Italian government bond yields have almost doubled to 3%. Meanwhile the spread between Italian and German government bonds has surged to the highest level since 2014.

Hopefully, the new Italian government will heed the early warning signals that the Italian bond market vigilantes are sending it and soon reverse policy course.

However, considering how unlikely that prospect is until the Italian financial market crisis deepens, one has to hope that the world’s major central bankers are monitoring Italian developments. Then they might be less hasty in their rush to prematurely normalize monetary policy.

* Desmond Lachman was formerly a deputy director in the IMF's Policy Development and Review Department.

they are overlooking. It is that well before year-end, their plans to raise interest rates and to temper their asset-buying programs could be upended by an economic and financial market crisis in Italy, the eurozone’s third-largest economy.

Being around 10-times the size of the Greek economy and with a government bond market of around €2.5 trillion, Italy has the potential to set off another and more vicious round of the eurozone debt crisis, Desmond Lachman* wrote for The Hill.

That in turn could shake the global economy to its foundations. Unlike Greece, Italy is too big to fail for the euro to survive in its present form, yet it could also prove to be too big for Europe to save it.

Sadly, all the clues seem to be pointing in the direction of a gathering economic and financial market storm in Italy. Among the more important of these is the fact that Italy now has in place a populist coalition government comprised of the strange bedfellows of the left-leaning Five Star Movement and the right-leaning League.

It is not only that the new Italian government is now in the process of reversing the labor market and pension reforms of the previous government, making it highly unlikely that Italy will improve on its dismal economic growth record over the past decade.

Collision Course

It is also that the new Italian government seems to be embarked on a budget policy that will both put Italy on a collision course with its European partners and put the country’s public finances on an unsustainable path.

Underlining the risks to Italy’s budget is the fact that the Five-Star Movement is insisting on the introduction of a basic income support program that would significantly increase public spending at the same time that The League is insisting on the introduction of a flat income tax that is bound to reduce tax revenue collections.

Further clouding Italy’s growth prospects is the fact that the country will no longer be enjoying the favorable constellation of factors that supported its economy over the past few years. The European economy is now slowing, Italian interest rates are rising, and the country along with the rest of Europe is being hit by an international oil price shock.

Public Debt

It also does not help matters that the European Central Bank has announced that it plans to end its government bond-buying program by the end of the year. It is doing so just as questions are arising anew about Italy’s ability to service its public debt mountain because of the new government’s seeming lack of commitment to either economic reform or budget discipline.

To date, the ECB’s bond-buying program has provided the Italian government bond market with considerable support. As part of that program, the ECB has been purchasing almost €4 billion ($4.63 billion) a month in Italian government bonds.

If the economic clues seem to be pointing in the direction of an impending Italian financial market crisis, so too do the political clues. Under Salvini’s leadership, the League, which is supposedly the government’s junior coalition partner, is surging in the polls with its hardline immigration stance.

Coalition Tensions Rising

Not only is this raising tensions within the coalition government, it is also putting into question the League’s right-wing alliance with Berlusconi’s Forza Italia. This hardly bodes well for the effective functioning of the government, which would seem to be a necessary condition for maintaining market confidence.

Italy’s increasingly precarious economic situation is not going unnoticed by the markets. Since the new government has come into office in June, Italian government bond yields have almost doubled to 3%. Meanwhile the spread between Italian and German government bonds has surged to the highest level since 2014.

Hopefully, the new Italian government will heed the early warning signals that the Italian bond market vigilantes are sending it and soon reverse policy course.

However, considering how unlikely that prospect is until the Italian financial market crisis deepens, one has to hope that the world’s major central bankers are monitoring Italian developments. Then they might be less hasty in their rush to prematurely normalize monetary policy.

* Desmond Lachman was formerly a deputy director in the IMF's Policy Development and Review Department.

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