How Worried Should We Be about an Italian Debt Crisis?

Olivier Blanchard (PIIE), Silvia Merler (Johns Hopkins School of Advanced International Studies; Bruegel) and Jeromin Zettelmeyer (PIIE)

May 24, 2018 1:30 PM
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Earlier PIIE research examined whether rising interest rates might unleash a debt crisis in Italy. The answer was "no," under two conditions: First, that rising interest rates reflected economic recovery; and second, that the Italian government would be prepared to cooperate with European authorities—the European Union, the European Stability Mechanism (ESM) and the European Central Bank (ECB)—to manage a loss of market confidence.

Ten months later, these conditions no longer hold. Political backlash to slow growth and immigration has produced the least cooperative government imaginable, a coalition between the left-populist Five Star Movement (M5S) and the right-populist Lega. And borrowing costs have started to rise in reaction. Does this mean that a crisis is imminent? If so, how bad would it be?

How Bad would a Debt Crisis Be?

The second question is easier to answer than the first. A crisis could be horrific, for two reasons. First, none of the powerful stabilization instruments that the euro area has developed over the years could be deployed to rescue Italy. Following crisis-related downgrades, Italy would no longer be eligible for the ECB’s quantitative easing bond-purchasing program. The ECB would stop accepting Italian bonds as collateral. Access to emergency support programs—the ESM, and through it, the Outright Monetary Transactions (OMT) program—would be conditional on fiscal adjustment, the opposite of what Italy's new government has promised. Unless the government were to change course, it would be forced to exit the euro, even if this is not its current plan.

And second, there is Italy’s interconnectedness and size. With the ECB using all available tools to limit contagion, the euro might survive Italexit. But an exit would nonetheless put Italy, the euro area economy, and the European Union in deep distress. With credit, investment, and consumer confidence collapsing, Italy would enter a deep recession. Redenominating assets and liabilities of Italian corporates and banking would trigger bankruptcies and legal conflict. The resulting acrimony—both within the country and across Europe—would dwarf what was witnessed during the 2010–12 crisis. If Italy also exits the European Union, a massive trade shock would aggravate the financial crisis and recession in Italy and Europe at large.

The Coalition's Fiscal Plans: Recipe for a Debt Crisis

How likely is such a scenario? To answer this question, one needs to take a closer look at the incentives facing the incoming coalition government. To succeed in the next election, the two parties will want to deliver on their major promises. Are the promises featured in the M5S-League contract compatible with a scenario in which Italy (and Europe) do not end up facing a debt crisis? And what might happen if they are not?

M5S and League's electoral promises are both centered on a more expansionary fiscal stance, although with major differences. M5S promised the introduction of a minimum guaranteed income—which appealed to voters in the economically suffering south. The League party promised a flat tax—which appealed to voters in the economically thriving north. Both parties advocated the repeal of a controversial pension reform introduced in 2011 by the government of former prime minister Mario Monti. The government contract between the two parties features all three promises. Moreover, both parties have committed to repeal an otherwise automatic hike in the value-added tax (VAT) planned in the 2018 budget.

How much would this largesse cost, and how might it be financed? Repealing the VAT hike would require €12.5 billion. As for the other promises, Carlo Cottarelli at the Osservatorio Conti Pubblici Italiani estimates that the League’s flat tax would cost around €50 billion, while M5S’ guaranteed income would cost about €17 billion. Scrapping the Monti government’s pension reform would add a further €8 billion. Counting in some of the minor promises, the total would reach a whopping €109-126 billion (6 to 7 percent of GDP).

The government contract is vague on how these measures would be funded. With respect to M5S’ minimum guaranteed income, it suggests that part of the cost could be covered with resources from the European Social Fund, but whether this would be possible, and to what extent, remains unclear. Both the contract and the original center-right program also mention the intention to eliminate deductions and lower tax expenditures, but provide no detail.  At the same time, it is worth recalling that the original center-right program was the expression of a three-party coalition with different views about the appropriate path for public finance. The League's economic projections included a much larger recourse to deficit financing than the center-right party Forza Italia’s projections did. The League broke away from this coalition to pursue the alliance with M5S. Without the restraining influence of Forza Italia, it may decide to follow through with its initial intentions.

As a result, the makeup of the incoming coalition, and its contract for governing, make it difficult to imagine a course of policy that would not put it on collision course with financial markets and the European Union. The magnitude of the increase in the deficit implied by the combined measures will likely violate all EU and domestic fiscal rules and put debt on an unsustainable trajectory. Furthermore, the possibility that the government may use “mini-BOTs”—tradable government securities for settling arrears, potentially creating a homegrown source of monetary financing inside the currency union—is deeply worrisome. Schemes of this type have been tried, and failed, in emerging-market crises. Markets may see them as the first step towards the reintroduction of a national currency—and they may well be right.

Government Not Likely to Correct Course Before a Debt Crisis Escalates—But Italexit Also Not Likely

Could one imagine the government program being implemented on a much-reduced scale, one that would avoid violating fiscal rules and risking debt sustainability? Perhaps. But given the lack of identified funding, this seems possible only if one of the coalition parties is prepared to significantly water down, or at least delay, its signature promises. This is what makes the current situation so worrisome. Any trajectory that avoids a collision would seem to require a climb-down by the League, M5S, or both, and this is not likely to happen voluntarily.

As a result, a scenario in which the government corrects course before the situation escalates appears unlikely. A scenario in which Italy loses market access—perhaps triggered by a downgrade—followed by an unsuccessful negotiation attempt with European authorities and Italexit, certainly looks possible. But it remains unlikely, for several reasons.

First, the government may eventually blink. A full-fledged crisis would hurt Italy at least as much as the rest of Europe. The Italian financial system is still fragile, and many banks are heavily exposed to government bonds. Two-thirds of Italian sovereign bonds are owned by residents. Hence, an across-the-board debt crisis is not a tool that an Italian government—even one that wishes to defy its international partners—can easily use to lower its debt at the expense of foreigners. A crisis leading to an Italian default would hurt mostly Italians, and so would its knock-on effects. It is hard to see how parties triggering such a crisis would not be punished in the next election.

Second, most of the policies that could bring Italy to the brink of crisis will be manifested in the revision of the 2018 or 2019 budget. These budgets need to be approved by both chambers of Parliament. The governing coalition’s majority in the upper one—the Senate—is slim: 6 votes. In the course of a sharp increase in borrowing costs triggered by an irresponsible budget (or its anticipation), that majority may well erode quickly.

Third, Article 81 of the Italian constitution introduces a balanced budget principle, and Article 97 states that general government entities, in accordance with EU law, shall ensure balanced budgets and the sustainability of public debt. A budget that too bluntly contravenes these rules could be deemed unconstitutional by the president of the Republic, who could refuse to sign it. This would clearly not be without costs—as it would start an institutional crisis and a phase of uncertainty—but it is possible.

As a result, one can imagine several scenarios in which escalating crisis conditions —rising borrowing costs, accelerating outflows—eventually induce a correction.  Under heavy pressure from businesses and Italians who wish to remain in the euro (perhaps a slim majority, but a majority nonetheless, according to Eurobarometer), the Italian political system will at some point pull the emergency escape trigger. This could come in several forms. In the face of a crisis, the coalition may decide to postpone or heavily water down its signature fiscal plans. Or it may press ahead and trigger a confrontation with the president or lose its majority in the Senate. Or it may collapse because one of the two coalition partners does not want to join the other in jumping off the cliff.

Because one of the scenarios in this class is likely to come to pass, Italy’s membership in the euro area may live to see another day. A European catastrophe may be avoided. But the costs of doing so could still be high, both for the political and social cohesion in Italy and for the future of Europe.

Follow the authors on Twitter at @ojblanchard1, @SMerler, and @jzettelmeyer.