The Italian government is on a collision course with both the European Union and market forces. The government’s strongman Matteo Salvini accuses the EU Commission of being the enemy of Europe and declares that Italy is not going to withdraw in the face of an attack by financial profiteers. The Commission has started steps to put Italy into the so-called Excessive Deficit Procedure (EDP) at the end of which Italy would face financial sanctions. Italy has not backed down. There is a real danger that the outcome will be a new euro crisis, compared to which a no-deal Brexit would be a minor problem.
The Italian Government’s draft budget for 2019 is in clear conflict with the rules of the EU’s fiscal policy. The so-called structural deficit will increase by 1.2 percentage points according to the EU Commission’s latest forecast (0.8 pp according to the Italian government) even though it should decrease by at least 0.6 percentage points. The Italian government is aiming to reduce the public debt from 130.9% to 126.7% in 2021. However, the predicted change is clearly less than required by the so-called debt rule. Moreover, the Government’s deficit and debt forecasts are based on optimistic estimates of GDP growth and the interest rate. The EU Commission projects no decline in the debt ratio.
Italian fiscal policy is also in conflict with what investors consider a reasonable risk. The interest rate for 10-year government bonds in Italy has oscillated recently at 3.3% – 3.7%, which is 1.5 to 1.9 percentage points higher than in the spring before the new government took office.
The Italian government apparently regards neither of these problems as fundamental. Those who agree with their policy can even find grounds for the approach.
A conflict with EU rules is not unusual and will not necessarily have dramatic consequences. The rules are complex and open to interpretation, and have proven “flexible”. Breaking the rules has not led to sanctions, i.e. to interest-bearing or interest-free deposits or fines, for any state. Why then would a large country like Italy now face problems? One response is that the rules have been tightened and Italy’s violation is clear. Yet imposing sanctions would be unprecedented. The Council would have to consider the consequences, should Italy refuse to pay. There is no EU policy or army to collect the fine.
Similarly, an interest rate of some 3.5% as such does not imply an overwhelming additional burden on Italy’s public finances in the short term. This is 0.7 percentage points higher than the average interest rate for the Italian national debt in the current year. This means that the Italian state’s debt-servicing charge will increase by 0.16 percentage points of GDP per year, if the debt is rolled over by just under 400 billion, and by about 1 percentage point when the entire debt stock has been rolled over. While this is not at all insignificant, particularly given the effect of the more than 2% real interest rate on economic activity, the situation will not quickly plunge the public finances into an unsustainable situation.
The problem, however, is that market doubts of Italy’s debt management capability could deteriorate very quickly and interest rates could rise to new levels. It is difficult to predict when and exactly why investors will panic.
In any case, it is clear that the Italian government’s fiscal policy, which opposes EU norms, taken together with neglect, or even the cancellation, of reforms to support economic growth and employment, will increase the risk of panic. On the one hand, this is simply because the more indifferent the Italian government is towards controlling the deficit and strengthening economic growth, the higher the risk of insolvency will become. Open non-observance of the rules also means that the already weak confidence of other countries in Italy’s ability or willingness to adhere to what has been jointly agreed will deteriorate further.
Yet a certain amount of such confidence is needed in order for Italy to receive support from other countries and EU institutions if it is subjected to actual capital flight. Financial assistance from the European Stability Mechanism (ESM) requires an adjustment programme to which the beneficiary country is committed. If there is no confidence that such commitments will be adhered to, it may be difficult to find political support for granting financial assistance.
Correspondingly, the OMT promise made by the ECB in 2012, according to which the ECB will announce its readiness to support the government bond markets of a country subjected to unjustified speculation through bond purchases, is also linked to commitment to the ESM’s adjustment programme.
In the event of a crisis, as the third largest country in the euro area, Italy can of course rely on the fact that its insolvency would trigger a huge crisis across the euro area. Italy’s GDP is 15% of the euro area’s GDP and national debt accounts for 23% of the total debt of members of the common currency. For Greece, the figures in 2009 were 2.5% and 4%, respectively. This means that Italy would have to be supported, i.e. Italy is “too big to fail”. A crisis of this kind would almost certainly involve Italy abandoning the euro in a situation where there is no mechanism for orderly restructuring the debts of member states. As a result, other euro area states would incur losses from the Italian central bank’s debts with the ECB, i.e. from so-called Target balances (approximately 500 billion euros in August). If a major founding member like Italy left the euro area, the credibility of the entire EMU would be put to the test in an entirely new manner.
However, this extortion scenario is counterbalanced by the fact that it would be very difficult for northern European governments to obtain public support for assisting Italy, which has broken the rules and mismanaged its own economy, even if the alternative would be a major recession. In any case, the damage around Europe would be smaller than in Italy. By leaving Italy to its own devices, they would avoid liabilities that could be many times the amount committed to supporting Greece. So in political terms, Italy is “too big to save”.
If panic reactions begin, it will put the ECB in a very difficult position. First of all, the ESM has around 380 billion euros available as support funds, enabling it to finance just one year of the Italian state’s gross financial requirements. This would be unlikely to appease the markets. Besides, the ESM’s decision-making mechanism is slow and based on unanimity. The ECB has no similar restrictions.
Secondly, the decline in the market values of government bonds would undermine the solvency of the banks, because around 10% of their receivables are sovereign bonds. This and an increase in general uncertainty would lead to a flight of deposits and other short-term funding; to finance these, the banking system would have to increase its borrowing from the Italian central bank and, in turn, the Eurosystem. At the same time, the risk ratings of Italy’s government bonds would probably deteriorate in such a manner that bonds are no longer valid as a collateral in ordinary central bank financing.
The ECB would very quickly have to decide on the size of risk it is willing to accept with regard to Italy. Capital flight tends to accelerate very rapidly once it has begun. The situation would be the same as in the summer of 2015 when the Greek government’s irresponsible policies led to dramatic capital flight. However, the stakes are many times higher on this occasion. In technical terms, it would be up to the ECB to decide on whether the Italian banking system remained viable and Italy remained part of the euro area. However, despite its formally independent status, the ECB cannot make such a decision without the adequate political support of the Member States.
Italy’s irresponsible policy is also hindering reform of the EMU. The willingness of other Member States to agree to reforms that will involve risk pooling with Italy will be further undermined by Italy’s open defiance of the common rules, while allowing debt to grow and blaming EU institutions for its problems. This is tragic, because the creation of a banking union, for example, would reduce the risk that the difficulties of Italy’s banking sector might lead to problems with the public finances. The highly indebted Italy itself would clearly benefit from such risk sharing. It is clear that, even at best, the banking union will be in no position to provide significant help with managing the current situation in Italy. However, Italian policy will also make it difficult to promote the banking union to prevent and mitigate future problems.
It is easy to imagine a “perfect storm” at some point before the European Parliament elections next spring. Global economic growth is slowing due to protectionism, for example, while a hard Brexit would increase the general uncertainty in Europe. Investors are starting to transfer their funds from risk-sensitive targets to safer ones. To maximise its support, the Italian populist government is continuing to break the EU’s rules and accuses the union of interfering in Italian affairs. In other countries, critical attitudes towards Italy, and all aid and risk sharing, are increasing. In addition, Angela Merkel, perhaps the strongest figure in European politics and the backstop for solving a potential euro crisis, is already losing her position in Germany. Europe’s ability to establish the common political will needed for crisis management is beginning to look less and less possible. The markets start to panic, and Italy’s interest rates start to rise towards the levels seen in the crisis years.
It is difficult to envisage a good solution other than the Italian government returning to responsible policies before the situation turn into an acute crisis of confidence and the associated accelerating capital flight. This would lower interest rates and reduce the political obstacles to support from the ESM and to the mobilisation of the ECB’s OMT promise, where necessary. At best, even small support measures would be unnecessary. Similarly, EMU reforms – above all the banking union – would have a better chance of moving forward in such a way that the monetary union will be better able to withstand any risks that materialise in the future.
In principle, a drift into acute capital flight could end with a solution similar to that imposed on Greece in 2015. At the last minute, the Italian government could change policy and accept a strict adjustment programme, which is a prerequisite for receiving financial support from the ESM and for gaining the ECB’s support. Other Member States would have to accept any financial support decision for fear that the euro area would otherwise plunge into a severe recession and even fall apart. Agreeing to such support would probably require improvised debt restructuring, which would at least involve extending the debt maturities. It is unclear how successful this would be without specific legislation and an institution created for such a purpose.
However, it is not at all certain that the necessary political will could be found even for limited debt restructuring. It is perfectly possible that a chaotic situation would emerge. On the other hand, if implemented, a strictly conditional financial support package would lead to deep bitterness in both Italy and the euro countries that must agree to such support. The consequence would be long-term strife and a probable gradual process of disintegration.
The EU was able to “muddle through” the euro crisis, but with no points for style. Contrary to the message of many doomsday preachers, the EU has proven highly durable. It may still cope with the threat posed by Italy without major damage. However, this will require a change of direction in Italian policy.