Italy is Too Big to Fail

While the fundamentals of the Italian economy remain sound, the political uncertainty gripping the country has spooked markets. Tools created during the European debt crisis in 2009—such as the European Stability Mechanism (ESM)—are insufficient to support funding needs of the Italian sovereign and corporate sector for a sustained period of time. Interventions such as the ones deployed a few years ago by the ESM (and its predecessor, the European Financial Stability Facility) in collaboration with the International Monetary Fund (IMF) and the European Central Bank (ECB) for Greece, Ireland, Cyprus, Portugal, and Spain are not a viable option should yields on Italian debt continue to rise.

Italy today is very different from what it was in the summer of 2011. Back then a financial crisis triggered a political crisis which was resolved with the appointment of a technocrat, the former EU Commissioner Mario Monti, to the post of prime minister.

Today, Italy’s economy—Europe’s fourth-largest—is in more solid shape. Exports are booming and amount to more than 30 percent of the GDP. Private investment has grown at a 3 percent pace each year for the past three years. Consumer confidence is high. The country’s banking sector has also improved and flows of new non-performing loans are around 1.5 percent of total credit as compared to above 6 percent in 2011. As part of the eurozone, Italy has also benefited from low borrowing rates over the past few years as a result of the ECB’s loose monetary policy.

The political situation, however, is bleak. Italy has not had a government since elections in March. The populist coalition—Five Star Movement and the League—nominated a euroskeptic to be economy minister. Italian President Sergio Mattarella vetoed the proposal and named a former IMF official, Carlo Cottarelli, to serve as interim prime minister. If parliament votes in support of the caretaker government elections will be held in early 2019. If not, which is more likely, elections will be held sometime after August. However, with Italian politics, never say never.

In light of this political uncertainty, markets will remain volatile until the Five Star Movement and the League send a clear signal of their commitment to the eurozone.

The Five Star Movement-League draft coalition agreement included spending proposals that would have placed Italy’s public finances at risk, fueling the already very high public debt. It also included ideas that are inconsistent with forming part of a currency union (such as the introduction of a parallel currency). Other trial balloons, including accounting gimmickry involving the measurement of sovereign debt in the euro area, would have encountered swift opposition from other eurozone countries.

While there is a recognition in Europe that the monetary union’s fiscal rules may need reform, or at least simplification, there is no real consensus among member states on how that might work. These fiscal rules have their origin in a number of European agreements and limit the annual government deficit (to 3 percent) and the accumulated debt (to 60 percent) for members of the EU and those aspiring to adopt the euro.  Austria, Belgium, Greece, and Italy have routinely violated the 60 percent debt/GDP rule, while the proper functioning of the framework around the 3 percent deficit rule has been undercut by opportunistic violations by almost all eurozone members, including France and Germany.

Similarly, work on completing the monetary union with a system of fiscal transfers is in its early stages. Historically, progress here is usually thin or absent unless forced by a crisis, though the European Commission did make some important proposals around the sovereign bond-backed securities last week.

Neither strand of work—reform or the fiscal rules—nor institutional deepening will be completed this year or otherwise take into account the Italian political cycle and calendar.

The market may well soon force European politicians back to the table for crisis meetings. Likely elections in Italy in the fall could turn into a referendum on whether to stay in the euro. As a result, yield developments on government funding markets should be closely watched over the next few days. The situation can quickly escalate from a political crisis to a financial one that policy makers will find hard to contain.

Bart Oosterveld is director of the Atlantic Council’s Global Business and Economics program.

Andrea Montanino is a nonresident senior fellow in the Atlantic Council’s Global Business and Economics program. Follow him on Twitter @MontaninoUSA.

Related Experts: Andrea Montanino and Bart Oosterveld

Image: Former International Monetary Fund official, Carlo Cottarelli (pictured), has been entrusted by Italian President Sergio Mattarella to lead a caretaker government. (Reuters/Tony Gentile)