It would be an understatement to say that something is rotten in the state of Italy’s economy. This should be of deep concern to the incoming Biden administration since Italy could be well on its way to another sovereign debt crisis. An Italian debt crisis in turn has the potential to derail the U.S. and global economic recoveries, especially considering that Italy is around 10 times the size of the Greek economy and that it has the world’s third-largest sovereign debt market.
Even before the COVID-19 pandemic chose Italy as its European epicenter, the Italian economy was in very poor shape. Since the country joined the Euro in 1999, the country’s per-capita income has declined. This means that today the average Italian citizen is economically worse off than he was some 20 years ago. Meanwhile, the country’s very poor productivity performance had resulted in a large loss of international competitiveness and its public debt had risen to a disturbingly high 135 percent of GDP.
The pandemic has now dealt the cruelest of blows to Italy’s tourism-dependent economy. It is now officially estimated that in 2020 the Italian economy declined by almost 10 percent, making it among Europe’s worst performing economies. Due to another surge in the pandemic, it is now expected that the economy will recover by only 3.5 percent in 2021 and will only regain its pre-pandemic level by 2023.
At the same time, the pandemic has raised serious questions about the country’s ability to service its debt. In 2020, the Italian budget deficit is estimated to have risen to over 10 percent of GDP while the country’s public debt-to-GDP ratio has skyrocketed to over 160 percent. That is by far the country’s highest debt level on record.
Stuck in a Euro straitjacket, which does not allow the country the option to depreciate its own currency to stimulate its external sector, Italy’s prospects for restoring order to its battered public finances do not appear good. If it engages in budget austerity, it risks deepening its economic recession and further eroding its tax base. But if it does nothing to reduce its budget deficit, its debt level will keep rising.
In normal circumstances, by now the Italian government would have had to pay significantly higher interest rates to borrow as investors increasingly came to doubt the country’s ability to service its debts. However, these are not normal circumstances in that the European Central Bank (ECB) has chosen to buy an ever-increasing amount of Italian government bonds to keep Italy’s borrowing costs low. Indeed, as a result of the ECB’s action, the Italian government can now borrow at a zero interest rate despite having public finances that have never looked worse.
The Biden administration would be mistaken to think that Germany, the ECB’s largest shareholder, will allow the ECB to indefinitely buy large amounts of Italian bonds to keep that country afloat.
Already last year, before the ECB began buying a disproportionate amount of Italian government bonds when undertaking quantitative easing, the German Constitutional Court raised serious questions about the consistency of the ECB’s bond buying operation with the Treaty of Lisbon. Now that the ECB is buying Italian government bonds with the explicit purpose of keeping Italy’s interest rates from rising, one must expect that the German Court will eventually prevent the Bundesbank from participating in the ECB’s bond-buying operations. It might do so on the grounds that the ECB is engaging in the monetary financing of a member country’s budget deficit, which is explicitly proscribed by the Lisbon Treaty.
Yet another reason for the Biden administration to brace itself for an Italian sovereign debt crisis later this year is that it is all too likely that Italy will lack the political will to undertake the economic reforms that the ECB might require of it to justify the ECB’s large scale Italian bond purchases. In this context, the growing public discontent with the Conte government over the pandemic’s recent resurgence does not bode well for Italian political stability in the year ahead.
In 2010, the Obama administration was caught flatfooted by the Greek sovereign debt crisis that roiled global financial markets. One would think that the incoming Biden administration can ill afford to make the same mistake with Italy especially given that, at around $3 trillion, Italy’s government debt today is a large multiple of that of Greece. For which reason one has to hope that the Italian economy remains very much on the incoming Biden administration’s radar screen.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.