An Italian debt crisis would be like Greece on steroids

Matteo Salvini, Italy’s deputy prime minister, could not have chosen a worse moment for both the Italian and the European economies to trigger an Italian political crisis.

Global economic policymakers and investors would be ignoring Italy’s deteriorating political situation at their peril since an Italian economic crisis has the potential to have large spillover effects to the rest of the global economy.

This is especially the case considering that the highly indebted Italian economy is ten times the size of that of Greece.  It is also the case considering that the European economy is already having to cope with the onset of a German economic recession and with the increased likelihood that Boris Johnson’s United Kingdom will crash out of Europe without a deal on October 31.

Now that Mr. Salvini has pulled the plug on the Italian coalition government, Italy will most likely be forced to go to the polls by the end of October to choose a new parliament. That is likely to usher in another period of considerable political uncertainty, which will make it difficult for the Italian government to pass a budget that will meet the requirements of the European Commission.

It will certainly not reassure investors that Mr. Salvini, whose League Party is strongly favored to win any Italian election, will be campaigning on an anti-European platform. Nor will it be of comfort that Mr. Salvini will be insisting on the introduction of a flat income tax that will cause the Italian budget deficit to widen.

Italy’s economy is in the weakest of positions to sustain a period of political turmoil. Not only is its economy already on the cusp of yet a third economic recession over the past ten years, it also has the Eurozone’s second highest public debt to GDP ratio after Greece. This is on top of a banking system that remains burdened with non-performing loans and an excessive holding of Italian public debt.

Italy desperately needs economic growth and low interest rates to dig itself out from under its high debt burden and strengthen its shaky banking system. Yet, especially in a worsening global economic growth environment, a renewed period of domestic political instability will put those conditions out of reach. With the German economy now in recession and the United Kingdom economy likely to be dealt a body blow by Brexit, Italy can expect little economic support from its European partners.

As investor confidence wanes, the Italian economy is likely to succumb to another painful economic recession that will further compromise its public finances. That in turn is likely to induce yet another wave of Italian bond selling that will cause a further increase in Italian borrowing costs relative to that in Germany.

As was the case with the 2010-2011 Greek debt crisis, an Italian debt crisis is bound to roil global financial markets. This would appear to be all the more so the case considering that Italy is the Eurozone’s third largest economy and that, with a total public debt of more than US$ 2 ½ trillion, it is the world’s third largest sovereign debt market after the United States and Japan.

Sadly, an Italian debt crisis would prove to be much more difficult to resolve than the earlier Greek debt crisis. This is not simply because of the larger amounts of money that would be involved in any Italian economic bailout package. Rather, it is also because of the likely reluctance of any Salvini government to comply with the painful budget austerity conditions that would be part of any IMF-ECB bailout package.

An unfortunate consequence of an Italian sovereign debt crisis is that it could heighten US-European trade tensions that might deal a further blow to an already weak European economy.  It might do so as any additional loosening of the ECB’s monetary policy in response to an Italian economic crisis would tend to weaken the Euro. That would lay the ECB open to repeated charges of currency manipulation by President Trump, who might then follow through on his threat to impose a 25% import tariff on European automobiles in November.

Hopefully, the Trump administration is paying close attention to Italy’s political and economic unraveling and preparing a crisis response in conjunction with its European counterparts. If not, we should brace ourselves for a very rough autumn in the global financial markets.

Desmond Lachman joined American Enterprise Institute (AEI)after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund’s (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and the multilateral lending agencies.

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