For a long time, Italy has been Europe’s hidden crisis. Now, though, it’s becoming much more open.
The problem is simple enough: Its economy has forgotten how to grow. Indeed, even if you cast things in the most favorable light possible by adjusting for its shrinking working-age population, Italy’s economy is still roughly the same size today as it was in 2003. Which, together with the legacy of all the red ink it ran up in the 1980s, means that it’s had to run persistent primary budget surpluses just to keep its debt burden from spiraling up even more.
This combination of nonexistent growth and all-too-real austerity seemed like it would inevitably lead to a political backlash, which, right on cue, it did earlier this year. The vaguely left-wing Five Star Movement captured the country’s poverty-stricken South with its plan for a basic income for the needy, while the stridently right-wing party the League won in the more prosperous North with its promise to cut taxes and kick out immigrants. Together, then, they’ve formed a government of onetime outsiders whose slightly less restrictive budget looks like at least a minor repudiation of Europe’s reigning fiscal orthodoxy.
How is this a crisis then? The answer is that Europe isn’t treating this like a relatively small-bore disagreement — Italy’s populist government, after all, is only proposing to increase its deficit from 0.8 to 2.4 percent of GDP — but rather as a direct challenge to the “ever closer union” they’re trying to create. It’s one thing, you see, to run a bigger deficit, like France will next year, when you’re apologetic about it and are ruled by the very avatar of Europhilism that is French President Emmanuel Macron. But it’s quite another when you seem to be making a point of flouting the rules, and don’t seem all that committed to the idea of the European project. And so the European Commission, the supranational body that has the authority to reject any country’s budget, has signaled that it might take the unprecedented step of doing so if Rome doesn’t show more obeisance for the deficit rules they all agreed as part of Europe’s Fiscal Compact.
That, in turn, has been enough to send Italy’s borrowing costs creeping back up to levels that, while still far below the ones that threatened to push it out of the euro zone in 2011, are still uncomfortably above the completely benign ones that prevailed as recently as 2016. Even more ominous than that, though, is that this has made the gap between Italy’s 10-year borrowing costs and Germany’s jump back up to levels last seen in 2013. Markets, as you can see below, are beginning to worry that Italy’s debt is riskier than everyone else’s.
It’s worth thinking about why that is exactly. It isn’t that bond investors are nervous about Rome’s budget plans themselves. Those, as we said before, only call for modestly higher deficits that shouldn’t make their overall debt any less sustainable. No, it’s that markets are worried about Europe’s reaction to Rome’s budget plans.
The simple story is that Italy’s economy is only as stable as the European Central Bank allows it to be. There are a few reasons for this. The first is that euro-zone countries can be vulnerable to self-fulfilling panic where their borrowing costs go up because it looks like they might default, and it looks like they might default because their borrowing costs have gone up so much. This is, in fact, what nearly brought the common currency down in 2012. And the only way to stop it from happening is for the European Central Bank to say it won’t let it. In other words, that it’s willing to use its potentially unlimited supply of euros to buy as many bonds as it takes to keep a country’s borrowing costs down.
Now, this hasn’t been an issue the past few years because the ECB has already been buying bonds in an effort to stimulate a stronger European-wide recovery. But it could be one soon, since that bond buying is scheduled to come to a close at the end of the year. At that point, the ECB would require Italy to adopt a new austerity budget to get any help — which probably wouldn’t happen considering that that’s the very thing it’s trying not to do. It’s no wonder, then, that markets are betting the ECB will let Italy’s borrowing costs keep going up.
The other part of this is that, because bond prices go down as the interest rate on them goes up, these higher borrowing costs are also bad news for whoever owns Italy’s debt. Which, of course, are none other than Italy’s banks. In the best case, this hit to their capital position would force them to cut back on their own lending; in the worst case, it might make some of them need a bailout. But, in any case, it would make the Italian banking system as a whole more dependent on, you guessed it, aid from the ECB.
The result has been a slow-motion game of chicken in which Italy is trying to run a bigger budget deficit and Europe is saying it will use extreme measures to stop it from doing so. Because that’s what deliberately allowing Italy’s banks and borrowing costs to get in a more precarious position really is: an implicit threat to kick it out of the euro. How is that? Well, Italy would need to be able to print its own money to save its banks and keep its borrowing costs from becoming unsustainable — which doesn’t take much when you already have the third-largest stock of debt in the world, like it does — if the ECB won’t do those things for it anymore.
But what makes this a game of chicken and not just a one-sided threat is that an Italian default and exit from the euro would immediately put other countries under pressure as well. The idea is that if it could happen to one of them, it could happen to any of them. The ECB theoretically could contain the financial fallout from this, but whether it actually would is an open question. It would have to move fast in the face of likely German resistance and wouldn’t have much room for error. It’s a theater of the absurd: 60 years of integration being held hostage by a few decimal points worth of deficit spending.
Welcome to Europe in 2018.