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Today, markets are displaying remarkable complacency toward a rapidly deteriorating Italian political and economic situation. They are doing so in a manner that is painfully reminiscent of how complacent they were in 2009 on the eve of the Greek sovereign debt crisis.
This could have major consequences for global financial markets considering that the Italian economy is 10 times the size that of Greece. Italy also has around 10 times as much public debt as Greece had at the time of its crisis.
Back in 2009, markets did not anticipate the Greek sovereign debt crisis despite the many signs that Greece’s public finances were on an unsustainable path. Indeed, as late as end 2009, the Greek government was able to borrow long-term at an interest rate that was barely 0.1 percent above the corresponding German government borrowing rate. This was the case despite the many signs that the Greek government would be forced in the end to engage in a dramatic debt restructuring that eventually cost its private sector debtors almost 95 cents on the dollar.
Today, despite the increasing signs that the populist Italian government could be on its way toward an eventual debt restructuring, and possibly even toward a Euro exit, markets are displaying a great deal of complacency about Italy’s economic prospects. Indeed, over the last few months the spread between Italian and German government bonds has narrowed considerably despite the increasing signs that the Italian government is losing control of its public finances.
One recent sign that the Italian government will have trouble in bringing its more than 130 percent of GDP public debt mountain under control is that the Italian economy has yet again entered into recession. Being stuck in a Euro straitjacket, Italy cannot reduce interest rates or resort to exchange rate depreciation to boost its economy. This effectively precludes it from using budget belt-tightening to improve its public finances for fear of deepening its economic recession.
Another sign that Italy’s public finances are likely to deteriorate appreciably in the period ahead is that its populist coalition government seems to be on a collision course with the European Commission on the question of the need for budget discipline.
Ignoring the commission’s warnings that on present policies Italy’s budget deficit is likely to rise to 3.5 percent of GDP in 2020, the Italian government is proposing the introduction of a flat 15 percent income tax to stimulate the economy. It is doing so even though that measure would cost around 1.5 percent of GDP and would lead to an increase in the public debt to GDP ratio to more than 135 percent.
A yet more disturbing sign of the wrong direction in which the Italian economy might be headed was the Italian parliament’s recent approval in an indicative vote of the issuance of so-called “mini-bots” to finance a larger budget deficit. Those mini-bots are small denominated Italian bonds that can be used by holders to make future tax.
These “mini-bots” are being seen in Brussels as a way for the Italian government to skirt the Eurozone’s budget deficit limits on member countries. They are also being seen as the introduction of a parallel currency that could smooth the transition of any future Italian exit from the Euro.
One has to hope that while markets might be turning a blind eye to Italy’s deteriorating economic and political fundamentals, global economic policymakers are not. As experience with the Greek sovereign debt crisis reaffirmed, crises often take a lot longer than one would have thought to occur, but when they do occur they do so at a very much faster rate than one would have expected.
With Italian economy being 10 times the size of that of Greece there is no room for global economic policymakers to again be caught off guard.
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.
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