Economist Herb Stein said if something can’t go on forever, it will stop. If Stein’s saying ever applied, it was to the currently unsustainable Italian public debt situation. Once the European Central Bank (ECB) stops buying Italian government bonds on the massive scale it has done in the past 18 months, Italy will likely be at the center of yet another round of European sovereign debt crisis.
It would be an understatement to say that Italy’s public finances are unsustainable. Italy’s public debt-to-GDP ratio skyrocketed during the pandemic to over 155% of GDP. It was the highest ratio in the country’s 150-year history and well above its post-WWII level. At the same time, the country’s budget deficit has exploded to over 9% of GDP in 2020 and 2021.
In the coming period, Italy’s public finances could be further jeopardized if the country’s fragile banking system needed significant public support. Underlying the risk of such an eventuality, Standard and Poor’s estimates that by 2022, the share of non-performing loans in Italian banks’ balance sheets could reach 10%.
Italy’s past history of frozen economic growth offers little hope that the country will be able to get out of its mountain of public debt. Since joining the euro in 1999, the Italian economy has practically stagnated, while Italy’s per capita income is now significantly lower than it was twenty years ago. The prospect of a new European pandemic wave casts a dark cloud over the tourism-dependent Italian economy and raises the specter of another Italian economic recession.
Italy’s unfortunate experience with fiscal austerity during the 2010 European sovereign debt crisis illustrated the futility of trying to restore public debt sustainability by tightening the fiscal belt in a country that is stuck in a euro straitjacket. After giving up its currency for the euro in 1999, Italy can no longer resort to currency depreciation as a means of stimulating its export sector to offset the impact of contraction on aggregate demand from fiscal austerity. Trying to do so would likely result in a recession that would nullify any advantage for Italy’s public debt situation to reap from public spending cuts and tax increases.
Over the past 18 months, the Italian government has been able to access the international capital market on very favorable terms despite the very compromised state of its finances. This was made possible by the unusually large purchases of Italian government bonds by the ECB as part of the ECB’s emergency pandemic purchase program. Indeed, the purchases of Italian bonds by the ECB under this program were approximately the same size as the gross borrowing requirements of the Italian government.
Unfortunately for Italy, the ECB cannot be expected to continue buying Italian government bonds indefinitely on the scale it has seen so far. In the context of rising European inflation, the ECB has already announced that it will end its emergency pandemic purchasing program in March 2022 and replace it with a longer bond purchasing program. modest. If European inflation continues to rise, it will only be a matter of time before the ECB decides to halt its bond buying activities altogether, as the Federal Reserve has already announced.
It is too likely that when the music of the ECB’s massive bond buying stops playing, investors in Italian domestic and foreign government bonds will focus their attention on this country’s gloomy public finances. When that happens, it is to be hoped that US and global economic policymakers will not be caught off guard, as they were in 2010 when Greece’s economic woes sparked a European sovereign debt crisis. This is all the more the case when one considers that this time around, the European sovereign debt crisis will be centered on Italy, a country whose economy is about 10 times the size of that of the United States. Greece.
Desmond Lachman is a Principal Investigator at the American Enterprise Institute. He was previously Deputy Director of the Policy Development and Review Department of the International Monetary Fund and Chief Emerging Market Economics Strategist at Salomon Smith Barney.