Recall that Italy’s government debt now equals roughly 130 percent of its economy (gross domestic product). If investors fear they won’t be repaid, they’ll rush to sell Italian bonds to limit their losses. That, perversely, would lower bond prices, raise interest rates and possibly trigger a panic.
Although this logic has long been true, it has taken on new urgency since the last Italian election in March, when — unexpectedly — the two leading populist parties, the leftish Five Star Movement and the far-right League, scored huge gains. It’s an unholy alliance, “as if Bernie Sanders and Donald Trump got together,” says Jacob Funk Kirkegaard of the Peterson Institute for International Economics, a think tank.
The result was a joint economic agenda that, if enacted, would explode Italy’s debt, say critics. The plan includes tax cuts, a minimum guaranteed income and higher old-age pensions. The Peterson Institute estimates the package’s cost between 6 percent and 7 percent of GDP. To prevent Italy from abandoning the euro, President Sergio Mattarella rejected the populists’ proposed government and effectively mandated a new election, which could occur as early as summer.
It’s a risky strategy, given widespread Italian hostility toward the European Union. “If the League wins the election,” says Kirkegaard, “it would be interpreted that Italians want to leave the euro.” Even so, Italians would be big losers if the economy nose-dived. Two-thirds of Italy’s bonds, reports the Peterson Institute, are held by Italians — individuals, banks, pensions, insurance companies.
Italy’s larger problem is that it has too much government debt and not enough economic growth to reduce it.
“Remarkably, Italy’s per capita income is lower today than it was on the eve of the country’s euro adoption in 1999,” writes economist Desmond Lachman of the American Enterprise Institute. In recent years, annual economic growth has been virtually nonexistent; from 2010 to 2017, it averaged annually two-tenths of 1 percent, according to figures from the International Monetary Fund.
As Lachman points out, only Greece has a higher debt-to-GDP ratio among countries in the euro zone. But the big difference is that Italy’s economy is 10 times as large as Greece’s, while its outstanding government debt of $2.5 trillion is the third-largest in the world, just behind Japan’s and the United States’. If Italy defaulted, it would almost certainly lead to “a full-blown European banking crisis,” writes Lachman, as banks wrote off bad debts.