Warren Buffet famously said that when the tide goes out you find out who has been swimming naked.
In Europe, when the European Central Bank (ECB) soon dials back its bond-buying program, we are likely to find out that it is the Italian economy that has been swimming naked. This should be of deep concern for the Eurozone and world economies. While the Italian economy might be too large for its Eurozone partners to allow it to fail, it also might prove to be too large for them to bail it out.
Even before the COVID-19 pandemic, Italy’s economic and financial situation was challenging. The country continued to experience sclerotic economic growth and the level of Italian income per capita remained below its level in 1999 when Italy adopted the Euro. Meanwhile, the country continued to lose international competitiveness, it remained weighed down by an excessive public debt level, and its banking system continued to be largely unreformed.
By choosing Italy as its European epicenter, the COVID-19 pandemic dealt a particularly harsh blow to the Italian economy and put its public finances on an even more challenging path than before. Of particular concern was the fact that the economy’s collapse, coupled with stimulus measures to support the economy, caused the budget deficit to blow out to more than 10 percent of GDP. That, in turn, led to a skyrocketing in Italy’s public debt to GDP ratio to its present level of more than 155 percent. That level is some 25 percentage points higher than the country’s debt level during the 2012 Italian sovereign debt crisis and is its highest level in that nation’s 150-year history.
Over the past two years, despite an appreciable deterioration in its public finances, the Italian government was able to finance itself on highly favorable terms. Indeed, the spread between Italian and German government bond yields dropped to close to record low levels and at one point the Italian government was able to raise money at a negative interest rate.
The main factor that has allowed the Italian government to finance its ballooning budget deficit on favorable terms has been the ECB’s massive government bond-buying in response to the pandemic. Of particular support to Italy has been the ECB’s EUR 1.85 trillion Pandemic Emergency Purchase Program. No longer feeling bound by its capital key in making bond purchase, the ECB used its emergency bond-buying program to more than fully finance the Italian government’s borrowing needs.
Going forward, a major problem for Italy is that the ECB is now planning to substantially scale back its bond-buying program as part of its response to the rise in Eurozone inflation to its highest level since the Euro’s launch. The ECB has announced that it plans to end its Pandemic Emergency Purchase Program in March and that henceforth it plans to halve the pace of its overall bond-buying to EUR 40 billion a month.
With the potential scaling back of ECB bond-buying, it must be only a matter of time before we have another round of the Italian sovereign debt crisis. Stuck within a Euro straitjacket, Italy can no longer use currency devaluation as a means to offset the contractionary effect of budget belt-tightening on aggregate demand. This makes it difficult for the country to reduce its budget deficit without provoking a recession. At the same time, no longer being able to count on ECB bond-buying, the Italian government will have to increasingly finance itself in the market. It will have to do so with its public finances in a worse state than they were in during the 2012 debt crisis.
A prospective Italian sovereign debt crisis could have serious implications for the Eurozone and the world economic outlook. This is especially the case considering that the Italian economy is around ten times the size of that of Greece. One would think that if the 2010 Greek sovereign debt crisis sent ripples throughout the world economy, how much more so would an Italian sovereign debt crisis do so today.