Italy Is Too Big To Fail

by: Desmond Lachman

One has to be dismayed by both Italian Deputy Prime Ministers Matteo Salvini and Luigi Di Maio's failure to grasp the major risks that a continued sell-off in Italian bonds would pose to the Italian economy. Equally, one has to be concerned about how complacent US policymakers seem to be about the risks that an Italian economic meltdown could pose to the US and global economic recoveries. These two considerations have to heighten the chances that next year Italy might derail the global economic recovery.

Italian Deputy Prime Minister Luigi Di Maio talks with Prime Minister Giuseppe Conte during his first session at the Lower House of the Parliament in Rome, Italy, June 6, 2018. REUTERS/Tony Gentile

Messrs. Salvini and Di Maio's repeated statements that a further increase in Italian bond yields will not cause the Italian government to back down from the expansionary budget that it presented to the European Commission would seem to be like a red flag to the Italian bond market vigilantes. As prospects rise that Italy is on a collision course with its European partners over the need for budget discipline, Italian bondholders will be inclined to keep selling Italian bonds. In the process, they will force Italian interest rates ever higher.

A key point that Messrs. Salvini and Di Maio fail to understand is that the Italian economy can ill afford interest rates much higher than the 3.5 percent they are at present. This is especially the case considering that Italian banks are holding around EUR 400 billion, or some 20 percent of Italy's GDP, in Italian government bonds. A further decline in Italian government bond prices would all too likely lead to a credit crunch by substantially eroding the Italian banks' capital base. That would certainly compound the problems of the Italian corporate and household sectors which are already facing higher borrowing costs as a result of rising Italian government bond yields.

Sadly, it also seems to be beyond Messrs. Salvini and Di Maio's grasp that a renewed Italian economic recession could tip the country's economy into a dangerous downward spiral. As the economy dipped, the budget deficit would further widen. It would do so as the tax base was eroded and as social expenditures were forced higher. That in turn would lead to a further bond market sell-off that would deepen the economic recession by further increasing interest rates and that would raise the specter of a downward economic spiral.

To their likely peril, US economic policymakers seem to be overlooking the very real risk that a full-blown Italian economic meltdown could trigger a global economic crisis that would reach our shores. Indeed, by pursuing an expansionary budget policy at this late stage in the US economic cycle, the Trump administration is forcing the Federal Reserve to have to raise interest rates by more than otherwise would have been necessary. That in turn is complicating the Italian economic outlook by leading to a more abrupt reversal in the global credit cycle than might otherwise have been the case.

The main source of risk that Italy poses to the global economy is that it is the world's third-largest sovereign debt market with more than US $2.5 billion in government debt. An uncomfortably large part of that debt is held by the French and German banks. If Italy were indeed to default on its 130 percent of GDP public debt-mountain, the European banking system would all too likely face a full-blown crisis that would have spillover effects for the rest of the global economy.

Another source of risk to the global economy is that an Italian economic crisis could lead to contagion to the rest of the European periphery. It might do so in much the same way as did the earlier Greek sovereign debt crisis. This would be especially the case were Italy to be forced to impose capital controls to protect its banks from a deposit run. One must suppose that bank depositors in the rest of the European economic periphery might take fright and send their money abroad thinking that the same thing as was occurring in Italy could occur at home.

Hopefully, the Italian government will soon back down from its recent defiant budget proposal before higher Italian bond yields tip the country's economy into a downward spiral. However, judging by the rhetoric coming out of Rome and by the Italian electorate's seeming support for a fight with Europe, it would seem to be a mistake for US policymakers to count on a happy Italian economic outcome. Instead, it would seem to be more prudent for them to hope for the best but to be prepared for the worst out of Italy.