Italy Is Too Big To Fail, Too Risky To Be Ignored

by: Desmond Lachman

If ever one doubted that Italy should not have adopted the euro as its currency, all one need do is look at the country's present political and economic dysfunction.

Sadly, that dysfunction sets the stage for yet another round of the eurozone debt crisis once the European Central Bank (ECB) starts to normalize its ultra-easy monetary policy.

Hopefully, Washington is alert to the Italian political and economic situation, which could pose a real threat to the global economic recovery.

The truth of the matter is that Italy's adoption of the euro in 1999 was a recipe for economic failure. One has to wonder what Italian and European policymakers were thinking to have put a poor productivity performer like Italy in a monetary union with a productivity powerhouse like Germany.

In the event, over the past 20 years, Italy has managed to lose more than 20 percent in competitiveness to Germany. Stuck in the euro, it can no longer resort to currency depreciation to correct such losses in competitiveness.

Italy's loss of competitiveness, coupled with its need to undertake serious budget adjustment in a euro straitjacket, has contributed to its highly disappointing economic performance over the past two decades.

Remarkably, Italy's per capita income is lower today than it was on the eve of Italy's euro adoption. Equally remarkable is the fact that over the past decade, Italy has experienced a triple-dip recession, and it is yet to regain its pre-2008 crisis output level.

As a result of its sclerotic economic performance, Italy's financial market vulnerabilities have only increased. Its public debt-to-GDP ratio has kept rising to its present level of 133 percent of GDP, which makes Italy the second-most indebted country in the eurozone after Greece.

At the same time, a lack of economic growth has contributed to the weakening of the Italian banking system. That weakness is underlined by a level of non-performing loans that amount to around 15 percent of the banking system's balance sheet.

Sadly, there is little real prospect that the country will improve its poor economic growth performance anytime soon. This would seem to be especially the case considering the collapse of the Italian political center and the rise of populist parties in Italy's recent parliamentary elections.

Following those elections, the left-of-center populist Five-Star Movement together with the Eurosceptic League have between them 50 percent of parliamentary seats for the next five years. It is now also almost a certainty that a populist party opposed to real economic reform will be leading the next Italian government.

This has to raise the question: If Italy could not grow with a reform-minded government, why should we expect it to grow with a less reform-minded and a less budget-disciplined government?

The country's economic vulnerabilities are certainly not of a recent vintage. However, what has been keeping Italy afloat over the past several years has been a very favorable international economic environment and an ECB that has been buying large amounts of Italian government bonds as part of its quantitative easing program.

The question that international economic policymakers should now be asking themselves is what might happen to the Italian economy when global liquidity conditions tighten as the Federal Reserve raises interest rates and when the ECB exits its aggressive bond-buying program?

All of this should be of real concern to both European and United States policymakers. Having an economy 10 times the size of the Greek economy, Italy is too big to fail for the euro to survive in anything like its present form.

Yet, having the world's third-largest sovereign bond market, with €2.5 trillion in outstanding debt, it is probably too large an economy for Europe to save.

From a United States perspective, it would not seem to be too early to be thinking about contingency plans for internationally coordinated crisis resolution in the event that markets were to lose confidence in Italy.

Needless to add, Italy's economic vulnerability should be giving the United States pause about leading us into a trade war with China that could be a trigger for markets to become more risk-averse and for markets to focus on Italy's economic vulnerabilities.